Deflationerrory Thinking

By John Galt

January 1, 2008

Sigh. There is a philosophical battle among the bears and doomers and it’s really quite frustrating as both parties are somewhat correct. This will be of the epic evolutions in history as one side says the housing crash and credit crisis will usher in another deflationary recession or depression a la the 1929 model, while the other party says it will be 1979 with a dash of 1929 flavoring. I think the philosophical debates can be summed up in the words of the famous philosopher Aristotle when he looked at his class and yelled in Greek “SHUT UP ALREADY!”

There is enough room and validity in both arguments to say everyone is correct to some extent, but the deflationists are going to lose in 2008. While I am not about to proclaim some all-knowing all-seeing vision nor present a litany of technical reasons for my argument as Jim Rogers has taken care of that multiple times for me in 2007, there is some basic analysis of history which gives everyone a clue as to where we are heading economically and when the peak theoretically should occur. The basis for this thinking is a dash of economic expertise from various commentators around the world, some historical analysis of markets and human behavior, and of course the reality of political influence on markets during an election year. There are many who stare at their monitors and figure the world beyond that point of reference is not worth measuring as everything they need to know is taught to them in a tick by tick movement of graphs and the trades they execute to profit from them. There is another groupthink which accepts the economic measurements and statistics presented by political authorities and make investment decisions and advice upon them, which is not only foolish but dangerous. There is a real world out there and once you observe that, yes Jim Cramer that’s a hint to you, you realize that the solution to some of the problems on a short term or interim basis are not what they should be but will matter as the end result.

First and foremost if you begin measuring indexes in terms of non-fiat monetary points of reference it does not take long to realize that the real money has been and will continue to be in commodities. Heck, even if you use the fiat points of reference, the S&P 500 closed at 1469 at the end of 1999 and on December 31, 2007 closed around 1468. Hardly a ringing endorsement of the “buy and hold” strategy but even more importantly, a damnation of what the tinkering with the system has done to your retirement program if you let the banksters and voodoo brokers play with your account and proclaim “fantastic” 3% gains year over year which are far below the rate of real inflation. If you use the charts that, the site the John Williams has been nice enough to publish and maintain the measures of real inflation based on the formula used in the 1990 and for many years before, you see that real inflation in 2007 was well in excess of 11% and obviously made your 9% gain in the NASDAQ, 3.5% gain in the S&P and the broadly watched Dow of 6.4% a somewhat moot point (do the math).

This may not scream monetary inflation but it gives you a hint that despite a concerted effort to reflate the system since 2003, starting with Sir Alan Greenspan’s cuts to 1% of the Fed Funds Rate, the efforts to reflate the equity bubble has pretty much been a failure. This means that with an election approaching and the less practical and experienced group of Federal Reserve Governors have a challenge in 2008. That challenge is to violate their academic education and follow through with Benron Bernanke’s helicopter laden mission of dropping money on fires to extinguish them. The first quarter of 2008 should provide a lesson in just what his line of thinking really is and just how the inflationary fire will be stoked beyond the imagination of anyone in the deflationary camp.

The warning signs for the collapse of the securitization of debt are nothing new and the so-called “credit crisis” of 2007 was actually first warned of back in the late 1990’s. In the October 26, 1998 issue of Business Week, there were warning signs of what was to happen a decade later in the article title “A $2.5 Trillion Market You Hardly Know” Economist Henry Kaufman warned in this article that these markets do underscore a risk and to quote from the article:

‘’the illusion of liquidity.’’ They worry securitization is based on a false premise–that because you can make a loan tradable today, you can trade it tomorrow. ‘’

That concern became a reality and tomorrow is here. The banksters have been cornered in 2008, facing a choice of openly declaring their losses and gambling that the government will subscribe to the “too big to fail” mentality or continue to string the losses out quarter after quarter inducing the specter of continuing doubt into the bond and equity markets which will insure the high levels of volatility we have seen month after month will continue. It’s a classic historical quandary as the failure to shut down the trusts and stock funds in the late 1920’s and openly declare the fraud behind the design of many of them increased the volatility after the Great Crash of 1929 and destroyed the investments of many Americans who bought into the “you can’t lose on Wall Street” mentality which has once again popped it’s ugly head into the modern thinking. It is in my opinion that we will hear the screams of the deflationary side of the discussion the loudest in the first half of 2008 as the banksters dump their bad news on to the markets en masse in the first two to three months of 2008. If they fail to do this we’ll be in for a year long wild ride with the Federal Reserve and Treasury playing the role of fireman putting out fires everywhere and the actually economy drifting into a deep recession rather than a touch and go landing in the first quarter of 2008. I lean towards the put it all on the table, force a market correction which correlates with the actual recessionary conditions the rest of the economy is experiencing and forcing the Federal Reserve and U.S. Government to reflate on a massive scale. The instability will give some rise or bounce to the U.S. Dollar Index but in reality it is a dead cat bounce which might tease the traders into thinking achieving the 80 level is realistic, but from a historical perspective, this currency, our currency, must be taken out and shot for the resolution to the solvency crisis to occur. The U.S. will reflate on a massive scale and create a huge inflationary dilemma for the next administration in 2008. This re-inflation will make the daily and weekly activity of the Federal Reserve in 2007 pale by comparison.

While so many of us focus on the day to day activity of the Federal Reserve, the reality is that all of the central banks of the world realize that if they do not engage in a massive reflation effort, not only will the US Dollar crash and burn, it will bring their economies down with it. Those who subscribe to and maintain the fallacy of fiat currencies will do whatever has to be done to maintain the status quo as long as possible. This means they will actively engage in a policy of currency destruction to a point in 2008 and this policy will continue worldwide until one nation or group of nations elects to stop the policy of importing American inflation and changes the structure of their currency. The most logical and obvious group will be the Gulf Cooperation Council and their desire to withdraw from the U.S. Dollar peg at some point when domestic prices become intolerable to maintain political stability. Once we see this group of nations engage in a change or withdrawal of the dollar peg, the final leg up in America’s inflationary nightmare will begin. The other nation which has a long standing geopolitical reason to burn the dollar would be Russia who could easily stir the markets into complete disarray by reformulating the Ruble to a backing using platinum, gold, oil and the Euro.

The concept of commodity inflation with enduring asset deflation has been a warning that Jim Sinclair and Jim Rogers have been warning about for over two years now, but to much of the American middle class it has not meant anything of importance until they noticed the one measurable, tangible asset, their homes, begin to decline in value. The entire American bubble of this past four years was built on the concept that real estate never declines and that homes are an investment. Sadly, the entire investing philosophy of the American was implanted in their soul during the tech bubble of the late 1990’s and millions of people are still subscribing to the “buy and hold” investing strategy praying their tech nightmares can be re-inflated to save their retirements. Now the political and economic power elite have to create a bubble and quickly to prevent the deflationary spiral they have sworn with the screams of “never again” and rapidly or they will lose control of the situation. The economic and political elite of this nation have realized that to save the nation from a deep recession or worse they must take the last act of pouring gasoline on to the inflationary fire. The result of that will be one more major equity bubble leading into the election season. Thus why I think they will allow and encourage wage and tolerate commodity inflation in a desperate last gasp to keep the consumer alive and spending to postpone the day of reckoning until the elections are complete.

Beyond the obvious political and Keynesian reasoning to expect more government intervention in the markets and one final futile effort to inflate our way out of debt, if you look at the charts below, you will see the development of a parabolic sense of reality, where all of the charts have developed their own momentum, not just in our little slice of heaven, but in markets worldwide.

Of those charts for our domestic economy pictured above which is disturbing just happens to be the CPI-U chart of inflation and deflation. If you notice that prior to the great market crash of 1929 we had a relative period of price stability on a percentage basis based on the government supplied information. Then you see what appears to be relative stability from 1990 onwards except that one has to keep in mind the reversion to hedonic pricing in the inflation calculations and the distortion of the numbers since that time. Unfortunately the first and last chart indicate the real level of concern. On a pricing basis in constant 2005 dollars the screaming siren of inflation is loud and clear for the last 30 years and has basically gone hyperbolic. The amount of credit market debt has also made that frightening turn into economic hyper-drive which indicates to anyone with half a brain that there are only two alternatives to correcting the problem: Default or inflation. The consensus is that they can inflate “gently” without triggering hyperinflation but the reality is that they need the hyperinflation to take care of the government debt obligations and bail the banksters out of the dilemma they face. This is not just a U.S. problem. The price of gold, a warning sign and insurance policy which indicates future economic and geopolitical instability has demonstrated that the inflationary problems are being spread out worldwide by our policies and economic mismanagement.

Other than the obvious indication that our currency is losing value over the long term, the rest of the world to keep our consumer based orgy of spending alive has shown the willingness to devalue their currencies in concert with the dollar. This will not have a happy ending for any nation or any one thinking that we are going into a deflationary recession in 2008. It is this writer’s opinion that the commodity price increases will continue as Russia, China, and India continue to use their dollar reserves to purchase commodities of all types, be they energy, agricultural or industrial and therefore continue to pressure the U.S. economy as we begin the final gasping actions of inflating to preserve our standard of living and political stability. Once this effort fails and the inevitable collapse in our current system, over burdened with fraud and deceit in it’s economic and political hierarchy, happens in 2009, we will see the deflationary nightmare to correct thirty years of excessive consumer, corporate and government spending. In the interim, the deflationary drop in prices we should see in the first quarter of 2008 should only be considered a “head fake” while the banksters and investment houses attempt to scare the central banksters worldwide into flooding the system with trillions of dollars in freshly printed digidollars to preserve the status quo of the fiat system. Do not get fooled into this “deflationerrory” idealism as it impacts the markets in the weeks to come. The flood and impact of this past summer’s interest rate maneuvering take on average eight to nine months to trickle down to the consumer level. Just in time to spike the inflationary punch this summer and during the election.

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