A DEFLATIONARY SPIRAL
IS THE RISK NOW
NOT IF WE LEARN THE LESSONS OF PAST DEFLATIONS.
by William Schmidt, Ph.D.
(C) 2008 www.tigersoft.com
Allan Greenspan says we are experiencing a once in a century financial
tsunami, the causes of which he says he does not fully understand. The Federal
Reserve and the US treasury are supplying truly
massive amounts of NEW credit to
almost a trillion dollars since September 3rd. Most of that money is not yet
being used by businesses. New hiring is at a stand still. The Fed is pushing
a string. Business confidence cannot be created with liquidity, though it
ought to stop a banking panic. I say "ought to". Look at the chart
Citi-Group. The stock shows massive insider selling, distribution and
professional selling from t he Opening to the Close. A breakdown below
the support level at 12.6 seems highly likely. The measure of aggressive
selling (OBV) is making new lows. So does TigerSoft's powerful Closing Power line.
TigerSoft's Index of 57 foreign ETFs is
more than 55% since its May peak. The breakdown in
prices in August showed that a world-wide recession
had probably started. That sent commodities of all types
All industries and all markets everywhere in the world
are in steep
declines now. We often here, there's always a
somewhere. That is not true now. There is no
sanctuary, except CASH. That is a pretty good
definition of DEFLATION.
Lessons from Economic History
John Maynard Keynes closely observed the Depression
in England from 1929-1933. He had come to his views from within
the British Treasury as a key UK representative at the Treaty of
Versailles after World War I. He correctly foresaw the economic
disaster that lay ahead if war debts and reparations were extracted.
He was against trying to extract crippling war reparations from
Germany and for the forgiveness of Allied war debts by the US.
He was not listened to. England did not fully recover in the
intra-war years and Germany was humiliated and impoverished,
with the result that Hitler came to power.
Sir Alfred Mond
As Keynes watched, the Depression unfold, he dusted off the
views of a Liberal politician and creator of ICI, the huge British
chemical firm. My own dissertation's research of UK Cabinet
Papers shows that Alfred Mond, as First Commissioner of
Works from 1916-1921 in the Lloyd George Coalition government
ardently advocated for massive public works' expenditure,
saying that the soldiers coming home from World War I should
be given dignifying work to repair the infrastructure of Britain
after its long neglect, because of World War I. He wanted
private investment to become more productive. He was from
Swansea, Wales. He wanted a jobs creation program in
places where it would be most needed. Mond was very
prescient. His views were squelched in the Cabinet
by Conservative Austen Chamberlain, the Chancellor of the
Exchequer and brother of Neville Chamberlain. My dissertation
showed that Chancellors in the intra-war period always pursued
policies of retrenchment, short-term balancing the budget
and protecting the Pound, no matter the level of unemployment
and economic suffering.
Keynes, the economist, in the 1930s, contended that left to
themselves (laissez-faire) economic conditions would worsen
in a recession, when there was deflation. This was his central
proposition. The economy would not be self-righting as classical
economists had maintained.
In his General Theory of Employment, History and Money
(1935) he made a number of points which have transformed
economic theory. In a deflation era, wages and prices are falling;
confidence wanes and so money is hoarded and not invested.
The expectation of falling wages and falling prices becomes
self-fulfilling as businesses postpone or cancel new projects.
Because deflation favors creditors, wealth is re-distributed
towards the rich. But they spend a smaller proportion of their
income than those of modest means, so there is under-consumption,
in general. And that makes for over-production, lay-offs and
falling wages and prices. A deflationary spiral develops.
To break the deflationary spiral requires the government
to give tax breaks to working people or launch public works'
job creation programs, even though, in the short-run, this causes
a budget deficit to grow. Since workers will spend nearly all
of any extra money they get through tax breaks or new jobs,
that will have positive reverberations through out the economy.
A single dollar in tax breaks for a worker or a single dollar
paid that worker in a new government created job will add
$3 or $4 dollars to GNP. In this way, fuller employment can
be regained and the surplus of unsold goods will get absorbed.
Businesses will start to make profits again. Confidence can
be regained. And, as economic prosperity is restored, more
taxes start coming in and the federal budget will become more
1926-1939 Britain went back on Gold Standard. Unemployment
Public works programs were not pursued. Instead, there was one round after
another of belt-tightening budget cuts. Protecting the Pound became the orthodoxy
of the British financial establishment. In the 1930s, Neville Chamberlain, as
Chancellor of the Exchequer and then as Prime Minister, fought Churchill in British
Cabinet meetings, and opposed increased defense spending, even as Nazi military
power grew. JM Keynes, the famous economist, witnessed first hand this
and advocated public works programs, since deflation, he said, was
Herbert Hoover - President - 1929-1933
By 1929 wealth had become very highly concentrated. But the rise in
stock prices in the 1920s has produced an abundance of confidence
and credit. so jobs were plentiful and working people could bottom
to buy what they needed. The market's steep advance was fueled
by margin rates of 5%, not unlike the US Housing bubble from 2003-2006.
In 1928, the Federal Reserve hiked interest rates. In Europe, financial
empires started to topple. In the Fall of 1929, the stock market crashed 49% in
only 3 months.
As now, the stock market CRASH caused credit to shrink, confidence to
disappear and unemployment to rise. Commodity prices fell, as did the
prices for producer goods, though commodity prices fell more because
commodity production was more inelastic. (In 2008, we see the same
phenomenon. - See the TigerSoft charts at the bottom of the page
Financial institutions failed left and right. Personal and business
bankruptcies were commonplace. (My grandfather built and sold houses.
When the Depression came, he could not sell them and went bankrupt.)
Foreclosures on homes and farms soared. People could barter for
what they needed in rural areas. But in the city, 25% of the people were
unemployed by 1933. Hoover, his band of classical economists and
financiers believed that the best medicine for the economy was for the
government to tighten its belt. Workers should take smaller wages, so that
businesses would be able to hire them. The decline in the stock market
was beneficial because it would wring out dangerous speculators.
and wealthy. The economy should be left to itself to recover. Balancing
the budget was seen as necessary to get rid of wasteful spending. The
Federal Reserve did not loosen credit. The Dollar was strong. Banking
circles liked the international business that a strong Dollar created. They
liked being paid back with Dollars that bought more than when they
made their loans. And, so, Hoover, and his friends among classical
economists and bankers waited for the recovery that they thought
would come naturally. They waited in vain. The Stock Market fell
from 383 to 43 shortly before he left office. Without investment confidence
and with investors a lot poorer, businesses contracted, consumption
shrunk, as did wages and unemployment reached 25% in early 1933.
This further dropped US government revenue. Deflation spiraled out of
control and turned into a Depression. Monetarists claimed that if the
Fed had been more accommodating, the worst of the Depression might
have been avoided. Keynesians say that demand for goods and services
needed direct stimulation through fiscal policies, reduced taxation and
public works and government spending.
After Japan's stock market crashed in 1990-1992, the Bank of Japan tried to
remedy the debacle by lowering interest rates. Though interest rates there
approached 0%, the Japanese economy remained sluggish. Only the
Global Bull Market of 2003-2007 ended the long stagnation. Interest rates
reductions by themselves did not overcome a spiraling lack of confidence and
deflation. The collapse of real estate prices in Japan was similar to what has
happened in the US.
"Banks lent to companies and individuals that invested in real estate. When
real estate values dropped, these loans could not be paid. The banks could
try to collect on the collateral (land), but this wouldn't pay off the loan. Banks
have delayed that decision, hoping asset prices would improve. These delays
were allowed by national banking regulators. Some banks make even more
loans to these companies that are used to service the debt they already have"
Japanese Banks had a higher percentage of loans which were "non-performing".
That limited their ability to lend more money and shrunk their cash reserves. In
situation, Japanese people became afraid of bank failures and preferred to buy
Gold or Treasury Bonds (especially American). The deflationary spiral in Japan
was intensified by the availability of inexpensive Chinese manufactured goods.
Chinese productive capacity keeps
expanding. The pricing of exports from China
are a key. Low priced imports make for deflation. As the US Dollar
imports from China will accelerate, hurting US production and jobs.
SHOULD YOU SELL NOW?