Over the past year, the stock market has seen a strong bull rally off of its March 2009 low which has certainly been great for many people's investment accounts. Unfortunately, it has also led many in the mainstream financial industry (media taking heads, traditional brokers, large bank economists, politicians etc..) back to the same level of blind optimism and complacency that was seen prior to the 2008 crash. Investors who share this complacent view of the market are likely in for another shock because before the economy can return to real growth and prosperity much of the malinvestment that was built up over the years of low interest rates and easy money must be cleaned out of the system. The government and Federal Reserve Bank have been implementing significant measures to try and prevent this natural economic process from occurring, however, the economy is too large and complex to be controlled by a handful of individuals. Most of those who are proponents of free markets will likely agree that the large amount of malinvestment in the economy will inevitably lead to another crash, and one that is likely bigger than that experienced in 2008. However, there is currently an interesting debate between those who believe that the current state of the economy will lead us towards a period of strong inflation (possibly even hyperinflation) and those who believe the opposite will occur and we will instead see deflation. The occurrence of either significant inflation or deflation will have serious and drastic effects on all areas of the economy. Although that being said, a period of strong inflation will result in the financial markets performing in a much different manner then a period of strong deflation. Inflation will lead to a significant nominal rise in the price of real estate, commodities, stocks, and virtually all other asset classes other than the dollar, which will decline in value. While a period of deflation will see a decline in the price of almost all asset classes and a rise in the value of the dollar. As such an investor who can correctly anticipate which of the two scenarios will play out will put themselves in a position to profit handsomely.
Before one can examine the likelihood of an occurrence of either inflation or deflation these concepts must be properly defined. Inflation is an increase in the total money supply and credit in an economy, which subsequently leads to a decrease in the relative purchasing power of each dollar. Deflation on the other hand can be defined as a decrease in the total money supply and credit in the economy which leads to an increase in the relative purchasing power of each dollar. These definitions are different from the common perception of inflation and deflation, that being an increase in the price of goods for inflation, and a decrease in prices for deflation. It is crucial to understand that an increase in the price of goods is a common consequence of inflation, while a fall in prices is a common consequence of deflation, but the changes in price are not the cause of inflation or deflation, but rather a symptom. It is actually possible to have inflation but not necessarily see an accompanied rise in the price level, or to have an increase in the price level but not have any inflation, the opposite being true for deflation. Another common misconception with regards to inflation and deflation is to only look at changes in the money supply to make a determination on the presence of inflation or deflation. But in an economy with fractional reserve banking, changes in credit must be viewed in the same manner as actual increases or decreases in paper dollars as credit competes for goods and services and allows individuals to make purchases in the exact same manner paper dollars do. Thus, for inflation to occur there must be a net increase in the level of credit and paper money in the economy, while deflation will occur if there is a net decrease in the level of credit and paper money.
Before one can examine the likelihood of an occurrence of either inflation or deflation these concepts must be properly defined. Inflation is an increase in the total money supply and credit in an economy, which subsequently leads to a decrease in the relative purchasing power of each dollar. Deflation on the other hand can be defined as a decrease in the total money supply and credit in the economy which leads to an increase in the relative purchasing power of each dollar. These definitions are different from the common perception of inflation and deflation, that being an increase in the price of goods for inflation, and a decrease in prices for deflation. It is crucial to understand that an increase in the price of goods is a common consequence of inflation, while a fall in prices is a common consequence of deflation, but the changes in price are not the cause of inflation or deflation, but rather a symptom. It is actually possible to have inflation but not necessarily see an accompanied rise in the price level, or to have an increase in the price level but not have any inflation, the opposite being true for deflation. Another common misconception with regards to inflation and deflation is to only look at changes in the money supply to make a determination on the presence of inflation or deflation. But in an economy with fractional reserve banking, changes in credit must be viewed in the same manner as actual increases or decreases in paper dollars as credit competes for goods and services and allows individuals to make purchases in the exact same manner paper dollars do. Thus, for inflation to occur there must be a net increase in the level of credit and paper money in the economy, while deflation will occur if there is a net decrease in the level of credit and paper money.
The most common argument that those in the inflation camp make to support their premise is that the massive and accelerating spending by government can only be funded by an increase in money supply and government debt and this will inevitably lead to inflation. At first glance it is hard not to agree with this idea especially with government debt (federal, state, and local) currently standing around $10 trillion. Also this number is very likely to continue to grow with the possibility of massive health care reform, social security and Medicare obligations, and other spending programs on the horizon, the only feasible way to fund these programs (as well as pay the interest on current debt) is to print more money. Other than printing money the only other way the government can fund their growing size is to raise taxes, and most politicians realize that this is extremely unpopular and as such would much rather raise money through the "silent" tax of money printing. Inflationists also point out that with declines in the private sector and rising unemployment levels, governments will see the need for continued and larger stimulus packages in the future, and again the vast majority of the money to fund future programs will come from increasing the money supply and government debt. While these arguments are certainly warranted, in order to make an educated hypothesis on the likelihood of either inflation of deflation one needs to examine the economy more closely and look beyond just the supply of money and the size of government debt by additionally examining the entire pool of credit in the economy.
When people say that the United States is in the midst of a credit bubble they are not kidding. While the total money supply as measured by its broadest aggregate, M3, is approximately $14 trillion (refer to this chart), the total amount of credit based on Federal Reserve statistics is $53 trillion or almost four times that of the money supply. The fact that the amount of credit dwarfs the amount of "real" paper dollars in the economy makes it obvious that any changes in the level of credit will have a serious effect on the existence of any inflation or deflation. In the United States the largest holders of debt are the financial sector, households, and businesses. More specifically the domestic financial sector holds approximately $16 trillion of debt, households just under $14 trillion, and businesses approximately $11 trillion (these stats can be confirmed here in this Federal Reserve release, as can the other stats for the remainder of this paragraph and the next). The rest of the debt is split among the federal government with $7.6 trillion, state and local governments who hold $2.3 trillion, and foreigners with $2 trillion. The fact that the amount of debt outstanding between the financial sector, households, and businesses is almost 200% higher than M3 is quite staggering. Furthermore, given that private debt is approximately 80% higher than M3 plus total government debt (federal, state and local), shows that the behaviour of private credit will have a huge impact on any inflation or deflation.
Now before getting ahead ourselves it is important to examine how credit is currently behaving and whether a credit collapse is likely. First of all, the three largest portions of total credit, the financial sector, households, and businesses have all seen a collapse in credit over the past year to year and a half. The financial sector is currently leading the credit collapse with declines over the first three quarters of 2009 of 10.4% (-$1.78 trillion), 12.5% (-$2.13 trillion), and 9.3% (-$1.53 trillion). Household credit on the other hand, of which $10.3 of the $14 trillion is home mortgage debt, has experienced a more moderate decline since the third quarter of 2008, having lost a total of 7.6%, the largest single quarter decline of 2.6% coming in the third quarter of 2009 (which is the most recent quarter reported on). Finally, business debt began to decline in the second quarter of 2009 and has since fallen a total of 4.8% over the last two quarters. In terms of government debt, those in the inflationist camp are correct; the government is indeed increasing in size with accompanied massive increases in their debt level. In total federal government debt has rose a staggering 161% since the 1st quarter of 2008. However, while this would indeed be inflationary if the other larger portions of credit were increasing or staying flat, they are not. For example over the first three quarters of 2009 financial sector debt declined a total of $5.44 trillion, household debt declined $0.73 trillion, and business debt fell $0.48 trillion, for a total decline of $6.65 trillion. On the other hand the sectors which have seen rising credit over the same quarters in 2009 are led by federal government debt increasing $4.82 trillion, state and local government debt increasing by $0.3 trillion, and foreign debt rising by $0.66 trillion, for a total increase of $5.78 trillion. Therefore, even with federal government debt increasing 71.4%, state and local government 13.1%, and foreign debt increasing 34.6% over the first three quarters of 2009, the change in credit over this time was still a net decline of $870 billion. This shows the massive uphill battle that the government will face to cause inflation if there is to be a serious collapse in the private credit bubble, as even relatively moderate percentage declines in financial sector, household, and business debt over 2009 could not be offset by a massive increase in government debt.
While the declining levels of credit in 2009 do provide evidence for a coming deflationary period it is essential to examine whether the decline in 2009 was an aberration, or whether economic conditions will lead to continued and accelerating declines in net credit levels. It is highly likely that government spending will continue at high levels, and probably even accelerate, as such for deflation to occur the economy will need to see falling credit in the private sector of the economy. Those who support the deflation hypothesis, however, believe that this is indeed what will happen as conditions are ripe for a collapse which will be led by declining credit in the financial sector, household sector, and business sector. There are obviously many interrelated reasons why a credit collapse is likely to occur, however, possibly the two strongest come from a change in consumer psychology or mood and the continued decline in the real estate sector.
Many economists often overlook consumer psychology as it is very difficult to measure objectively. However, it is an extremely important driver of the economy and directly relates to increases and decreases in credit. Credit cannot just magically increase; it will only increase if individuals or businesses are willing to take on higher levels of credit, no matter what politicians and government officials want to believe. From the early 1990s until around 2007 individuals were continually willing to take on ever increasing amounts of credit, and the government and Federal Reserve were happy to oblige. This consumer mind frame was largely influenced by a continued rise in housing prices, a fantastic bull market, and a relatively low unemployment rate. Given that humans are notoriously bad at making predictions, the majority just assumed that these housing market, stock market, and job market trends would continue in the same bullish direction for the majority of their lives, and thus they would be able to continue to service their rising debt levels. However, this view quickly changed in 2008 with the stock market crash, the collapse of the housing market (which unlike the stock market has yet to rebound), and an unemployment rate which if one includes those who have given up looking and those who have only been able to find part time work is at a staggering 17%. Consumers have now seen a decline in home values of up to 50% in some regions, a stock market that even with the huge 2009 rally is still about 30% off its 2008 high and is no higher than it was at the turn of the century, and are also experiencing an economy where almost 1 in 5 people are unemployed or underemployed. In other words these events have led to a crushing blow in consumer psychology which will have a drastic effect on the amount of debt consumers take on as well as the amount they can pay off in the future. After seeing home values crash no longer will so many want to take on massive mortgages, nor will they continue racking up massive credit card bills believing they can supplement their incomes with stock market returns and increases in home equity, and those who are out of a job will not be able to obtain credit even if they wish to. In other words, without a doubt the consumer's tolerance for credit and ability to service it has greatly declined, and this is definitely a deflationary sign.
Furthermore, in terms of psychology, the psychology of the public towards government also has a significant influence on the level of credit in the economy, as the public’s mood has a serious impact on politicians’ ability and willingness to act. While the government may want to impose massive spending bills, bailouts, and stimulus programs they can only do so as long as public disapproval does not become too great. While in many cases the government seems to ignore the will of general public they can only go so far, if anger and frustration mounts and opposition towards increasing government size and debt becomes to0 great the government will be forced to scale back, or at least not expand as fast. This is one point inflationist tend to ignore, for while it is true the government in its current state can print as much money as it would like, and can take on massive amounts of debt, ultimately this can only be done for as long as the public mood permits it. Another point relating to psychology and government debt is that the US government can only continue to increase its debt if those in the debt market continue to accept government bonds and treasuries. If government debt continues to see a massive growth market participants are likely to require higher and higher interest rates on government debt instruments to counter the risk of the US government defaulting. This again is a limit on the growth of government debt, and shows that the existence of inflation or deflation is contingent on the willingness of individuals to take on more debt themselves and furthermore to allow the government to continue to expand the size of its own debt.
While changes in the psychology of consumers and market participants will play a massive role in any changes to total credit, the current economic sector that is likely to have the biggest influence in a credit collapse is real estate. The reason for this is because a massive portion of the total credit, not only in the household sector, but also the domestic financial sector, and the business sector is tied to the real estate market. The household sector's connection to the real estate market through mortgages alone is enormous, in December 2009 (based on this Fed release) single-home mortgages made up $10.8 trillion of the total household credit of $13.6 trillion, or in other words a staggering 75%. The commercial mortgage level on the other hand, which is related to business debt, is not nearly as high, but still significant at approximately $2.6 trillion. Now if you include farm mortgages and mortgages on multifamily residences the net level of mortgage debt in the US economy is around $14 trillion, or in other words almost twice the value of the entire federal government debt, or approximately equal to that of the entire M3 money supply. These numbers make it quite clear that the performance of the real estate market will play a significant role in the presence of either inflation or deflation.
However, the influence of the real estate market on credit levels is not contained to the household and business sector but is also seriously tied to the domestic financial sector. The domestic financial sector, which as was mentioned earlier holds around $16 trillion of debt, is made up of primarily government sponsored enterprises (GSEs, main ones are Fannie Mae and Freddie Mac), commercial banks (i.e. Bank of America), savings institutions, asset-backed security issuers, and financial companies (i.e. Goldman Sachs). To delve a little further into this sector 80% of the debt held by these institutions is comprised of corporate bonds, GSE issues, and mortgage pools. Mortgage pools, which are obviously connected to the performance of the real estate market, are basically groups of mortgages with similar characteristics which are pooled together and sold to investors on the secondary market as mortgage-backed securities. As of December 2009, according to the Federal Reserve, these mortgage pools totalled approximately $7.6 trillion, and as the footnote on the Fed release states this total is based on the "outstanding principal balances of mortgage-backed securities insured or guaranteed by the agency indicated." A good explanation of mortgage pools and their role in the domestic financial sector is provided by Thomas Woods in his book Meltdown:
While the declining levels of credit in 2009 do provide evidence for a coming deflationary period it is essential to examine whether the decline in 2009 was an aberration, or whether economic conditions will lead to continued and accelerating declines in net credit levels. It is highly likely that government spending will continue at high levels, and probably even accelerate, as such for deflation to occur the economy will need to see falling credit in the private sector of the economy. Those who support the deflation hypothesis, however, believe that this is indeed what will happen as conditions are ripe for a collapse which will be led by declining credit in the financial sector, household sector, and business sector. There are obviously many interrelated reasons why a credit collapse is likely to occur, however, possibly the two strongest come from a change in consumer psychology or mood and the continued decline in the real estate sector.
Many economists often overlook consumer psychology as it is very difficult to measure objectively. However, it is an extremely important driver of the economy and directly relates to increases and decreases in credit. Credit cannot just magically increase; it will only increase if individuals or businesses are willing to take on higher levels of credit, no matter what politicians and government officials want to believe. From the early 1990s until around 2007 individuals were continually willing to take on ever increasing amounts of credit, and the government and Federal Reserve were happy to oblige. This consumer mind frame was largely influenced by a continued rise in housing prices, a fantastic bull market, and a relatively low unemployment rate. Given that humans are notoriously bad at making predictions, the majority just assumed that these housing market, stock market, and job market trends would continue in the same bullish direction for the majority of their lives, and thus they would be able to continue to service their rising debt levels. However, this view quickly changed in 2008 with the stock market crash, the collapse of the housing market (which unlike the stock market has yet to rebound), and an unemployment rate which if one includes those who have given up looking and those who have only been able to find part time work is at a staggering 17%. Consumers have now seen a decline in home values of up to 50% in some regions, a stock market that even with the huge 2009 rally is still about 30% off its 2008 high and is no higher than it was at the turn of the century, and are also experiencing an economy where almost 1 in 5 people are unemployed or underemployed. In other words these events have led to a crushing blow in consumer psychology which will have a drastic effect on the amount of debt consumers take on as well as the amount they can pay off in the future. After seeing home values crash no longer will so many want to take on massive mortgages, nor will they continue racking up massive credit card bills believing they can supplement their incomes with stock market returns and increases in home equity, and those who are out of a job will not be able to obtain credit even if they wish to. In other words, without a doubt the consumer's tolerance for credit and ability to service it has greatly declined, and this is definitely a deflationary sign.
Furthermore, in terms of psychology, the psychology of the public towards government also has a significant influence on the level of credit in the economy, as the public’s mood has a serious impact on politicians’ ability and willingness to act. While the government may want to impose massive spending bills, bailouts, and stimulus programs they can only do so as long as public disapproval does not become too great. While in many cases the government seems to ignore the will of general public they can only go so far, if anger and frustration mounts and opposition towards increasing government size and debt becomes to0 great the government will be forced to scale back, or at least not expand as fast. This is one point inflationist tend to ignore, for while it is true the government in its current state can print as much money as it would like, and can take on massive amounts of debt, ultimately this can only be done for as long as the public mood permits it. Another point relating to psychology and government debt is that the US government can only continue to increase its debt if those in the debt market continue to accept government bonds and treasuries. If government debt continues to see a massive growth market participants are likely to require higher and higher interest rates on government debt instruments to counter the risk of the US government defaulting. This again is a limit on the growth of government debt, and shows that the existence of inflation or deflation is contingent on the willingness of individuals to take on more debt themselves and furthermore to allow the government to continue to expand the size of its own debt.
While changes in the psychology of consumers and market participants will play a massive role in any changes to total credit, the current economic sector that is likely to have the biggest influence in a credit collapse is real estate. The reason for this is because a massive portion of the total credit, not only in the household sector, but also the domestic financial sector, and the business sector is tied to the real estate market. The household sector's connection to the real estate market through mortgages alone is enormous, in December 2009 (based on this Fed release) single-home mortgages made up $10.8 trillion of the total household credit of $13.6 trillion, or in other words a staggering 75%. The commercial mortgage level on the other hand, which is related to business debt, is not nearly as high, but still significant at approximately $2.6 trillion. Now if you include farm mortgages and mortgages on multifamily residences the net level of mortgage debt in the US economy is around $14 trillion, or in other words almost twice the value of the entire federal government debt, or approximately equal to that of the entire M3 money supply. These numbers make it quite clear that the performance of the real estate market will play a significant role in the presence of either inflation or deflation.
However, the influence of the real estate market on credit levels is not contained to the household and business sector but is also seriously tied to the domestic financial sector. The domestic financial sector, which as was mentioned earlier holds around $16 trillion of debt, is made up of primarily government sponsored enterprises (GSEs, main ones are Fannie Mae and Freddie Mac), commercial banks (i.e. Bank of America), savings institutions, asset-backed security issuers, and financial companies (i.e. Goldman Sachs). To delve a little further into this sector 80% of the debt held by these institutions is comprised of corporate bonds, GSE issues, and mortgage pools. Mortgage pools, which are obviously connected to the performance of the real estate market, are basically groups of mortgages with similar characteristics which are pooled together and sold to investors on the secondary market as mortgage-backed securities. As of December 2009, according to the Federal Reserve, these mortgage pools totalled approximately $7.6 trillion, and as the footnote on the Fed release states this total is based on the "outstanding principal balances of mortgage-backed securities insured or guaranteed by the agency indicated." A good explanation of mortgage pools and their role in the domestic financial sector is provided by Thomas Woods in his book Meltdown:
"Traditionally, a homeowner took out a mortgage at his local bank and made monthly payments to that institution. More recently, banks have been able to sell these mortgages on what is called a secondary mortgage market to institutions like Fannie Mae, which then are entitled to receive the monthly mortgage payments associated with them. Fannie, in turn, bundles many of these mortgages together and markets them as mortgage-backed securities. When an investor buys one, he is buying a share of the pool of income that results from all the mortgage payments homeowners make on these mortgages every month."
The realization of the vast amount of private credit in existence and the fact that a large percentage of this credit is tied to mortgages allows one to see how the performance of the real estate market will have a significant impact on whether the economy experiences inflation or deflation. Currently the trends in the economy are more strongly pointed towards a continued deterioration in the real estate market then an improvement, and this could lead to the destruction of a lot of credit if an increasing number of mortgages go delinquent and more homes get foreclosed. The credit collapse of 2008 was caused largely by declining home values and an increased rate of foreclosures and these trends are accelerating even though the stock market has experienced such a strong bull rally. The high unemployment level will likely exacerbate defaults on loans, as obviously those out of a job will have a lot of trouble making mortgage payments, and this is indeed what appears to be happening. The percentage of home loans in delinquency or foreclosed reached a whopping 14% in the third quarter of 2009, with the number of homes foreclosed increasing to 4.47%, up from 2.97% in 2008.
Another interesting trend is that historically home prices do not turn up until after unemployment has peaked, this is represented by the following graph, which shows the unemployment level in relation to the Real Case-Shiller index, which is a measure of US home values. Also, in terms of mortgages another harmful sign is the fact that as adjustable-rate mortgages (ARMs) reset to higher rates, this will force more and more homes into foreclosure. It is estimated that approximately 88% of ARMs were taken out between 2004 and 2007, with as many as 1.3 million issued in 2004 and 2005 alone. Given that rates on these are set to reset between 2010 and 2012, this could potentially bring another crushing wave of foreclosures. Due to the massive influence that the real estate sector has on the level of credit in the American economy it is essential for investors to monitor the trends which drive it as they will provide a lot of evidence about whether we will experience inflation or deflation.
It is also important to realize that the economic trends driving the deterioration in the real estate market are also affecting other areas of the economy. For example an increasing number of people losing their jobs and declining home values will change the spending habits of individuals while also influencing their ability to pay off other types of debt such as car loans, student loans, and credit card debt, and this will lead to a further deterioration of credit. Which is what is happening as the latest consumer credit number from the Fed indicate that in November 2009, revolving credit (i.e. credit card debt) declined at an annual rate of 18.5%, while non-revolving credit (student loans, car loans etc...) declined at an annual rate of 3%. While the total level non-revolving and revolving consumer credit is $2.5 trillion, far less then mortgage debt, it is still significant. Furthermore a declining level provides more evidence of changing consumer psychology and spending patterns and these changes will affect areas like the retail, auto, and manufacturing sectors of the economy. So even while mortgage debt is certainly the most dominant area of credit in the economy it is by no means the only area seeing a contraction.
While a current credit contraction is something that most will agree on (especially after examining the numbers), due to the dominance of neoclassical economic thought in today's society, many may still come to the conclusion that it will not be too damaging to the economy. Ben Bernanke, sums up the neoclassical view of an unwinding credit bubble in his book the “The Macroeconomics of the Great Depression: A Comparative Approach”, where he dismisses the view proposed by Irving Fisher that it was in fact an unwinding credit bubble that led to the Great Depression :
“Fisher’s idea was less influential in economic circles, though, because of the counterargument that debt-deflation represented no more than redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups it was suggested, pure redistribution should have no significant macroeconomic effects.” (Bernanke 1995, p17)
This view is extremely flawed, as a collapsing credit bubble does not result in a net redistribution from debtors to creditors, but rather a decline in the real wealth of both parties. Debtors who are unable to service their debts eventually go bankrupt and lose their assets which makes them poorer. Creditors also become worse off as they lose the interest payment stream on the loan, a portion of the principle, and in the instance where they do receive an asset back in return, those assets are in most cases extremely devalued. One only needs to look at the impact of the current housing market collapse to see that the decrease in the wealth of homeowners was not made up by an equal increase in wealth by banks; both were undeniably made worse off. The fact that the individual heading the Federal Reserve Bank subscribes to such wildly unrealistic, purely theoretical views only makes an impending crisis more likely, and unfortunately direr.
To conclude, in attempting to determine whether a coming wave of inflation or deflation is more likely it is essential not to concentrate only on the money supply in the economy but also more importantly on the aggregate level of credit. While the main premise of inflationists is that the expansion of government debt and money printing can only lead us to inflation, one must take into account that total government debt (federal, state and local) is only about $10 trillion of the total $53 trillion of credit, or a meagre 18%. For this reason, if private debt which is much larger then government debt collapses then the inflationists can only be correct if the government is able to expand at a much faster pace than private debt contracts. Another important point is that while in theory the government could print as much money as it wanted and expand its debt to extraordinary levels, this is only possible if the public allows for it and if those in the debt market are willing to take on the debt the government issues, and these are big ifs. Finally, one thing that most of those in the inflation camp and those in the deflation camp will agree on is that economic bubbles, like all other bubbles are ephemeral in nature, and without a doubt the US is currently in the midst of a credit bubble. So the question becomes does the government have enough power to keep this bubble inflated or has the time come for it to pop.
Note: There is an excellent series of interviews on the website financialsense.com which provide insight on the views of inflationists and deflationists. I highly recommend listening to them as it essential for any serious investor to come up with their own conclusions after being presented with evidence from both sides. The interviews can be found here, listed under the December 26th 2009 broadcast.
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