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Tuesday, August 19, 2008

 

deflation strengthens


another month, another step down in credit supply. following on the last update, via yves smith comes reporting from the telegraph's ambrose evans-pritchard.

Data compiled by Lombard Street Research shows that the M3 ''broad money" aggregates fell by almost $50bn (£26.8bn) in July, the biggest one-month fall since modern records began in 1959.

"Monthly data for July show that the broad money growth has almost collapsed," said Gabriel Stein, the group's leading monetary economist.

On a three-month basis, the M3 growth rate has fallen from almost 19pc earlier this year to just 2.1pc (annualised) for the period from May to July. This is below the rate of inflation, implying a shrinkage in real terms.

The growth in bank loans has turned negative to a halt since March.

"It's obviously worrying. People either can't borrow, or don't want to borrow even if they can," said Mr Stein.

Monetarists say it is the sharpness of the drop that is most disturbing, rather than the absolute level. Moves of this speed are extremely rare....

Monetarists insist that shifts in M3 are a lead indicator of asset prices moves, typically six months or so ahead. If so, the latest collapse points to a grim autumn for Wall Street and for the American property market. As a rule of thumb, the data gives a one-year advance signal on economic growth, and a two-year signal on future inflation.

"There are always short-term blips but over the long run M3 has repeatedly shown itself good leading indicator," said Mr Stein...


there has been further amplification of the debate within the economic community regarding inflation versus deflation. in spite of steve waldman's very cogent view -- and historically informed at that, as policymakers have generally opted for inflation over deflation as the more politically palatable -- i have subscribed to the eventuality of a surprising and fairly severe deflation as a result of the nascent deleveraging of the economy, rather along the lines of the japanese example. while i qualitatively agree with waldman in some respects, the size of the credit bubble makes it difficult for me to envision the requisite speed of monetary expansion that would be required to offset deflationary deleveraging.

at this time, the federal reserve isn't expanding the aspects of money supply that it controls. it has lowered rates, but credit supply and demand are declining anyway as banks and consumers both seek balance sheet repair. it has provided the use of its balance sheet to large banks and broker/dealers, but offset those facilities through open market operations. as credit supply evaporates, this is resulting in the near-crash of broad money aggregates that the telegraph is reporting.

the debate will be settled if or when the fed sees fit to respond to this collpase by expanding money supply in an attempt to offset the contraction of credit supply.

the first question is this: will the fed try? that is deeply debatable, and depends on our view of what the fed is. karl denninger would tell you and correctly that the fed is a bank owned and operated not by government but by banks, and it is deflation -- not inflation, but deflation -- that better suits banking.

The banker makes money in terms of real value in a deflationary environment. You, on the other hand, being debt, get rammed.

Ok, now let's look at hyperinflation. ... what happens to the banker? He gets reamed in both holes. ...

Those who argue that Bernanke will "hyperinflate" have a tiny little problem with their thesis. That thesis depends on Bernanke and the rest of the banks (who are, in fact, his masters as well as his servants) acting in a fashion that is explicitly against their own self-interest.

See, banks normally want a small amount of inflation. Just enough to make it not worth it for you to hoard cash, as it slowly devalues. This forces you to spend and invest, lest you see your purchasing power disappear.

But what a bank never wants to see is an inflation rate that is above their lending "spread", or the difference between their cost of funds and what they charge. If that ever happens then they lose big; remember, all banks are leveraged and as such small "percentage" base losses get multiplied by their leverage ratio!


whether or not denninger is correct depends largely on the extent to which the fed remains politically independent and loyal to its constituency of bankers. as deflation really gathers momentum and becomes a populist cause celebre, i sincerely doubt it will retain even its somewhat questionable current level of political independence. the zeitgeist of demotic america seems to suggest it cannot hold as the naked tool of oligarchs.

secondly, however, there is the question of whether or not printing can as a pragmatic matter proceed with sufficient pace from a base of several hundreds of billions to offset the unwinding of tens of trillions in debt. what is theoretically possible may not as a realistic matter be achieveable.

yves smith sees first deflation and then ultimately a policy response of currency devaluation and inflation -- a mechanism similar to that operated in the great depression in britain and the united states, and also in japan in the 1990s, both with mixed success. but the difficulty of that policy response will be the massive net international debtor position of the united states today. the potential of foreign creditors fleeing the dollar in revulsion of a soft default to precipitate a currency crisis and deep depression is the elephant in the reflationary room. while waldman sees this as shifting the pain of adjustment onto external parties, the result would be a much more intense form of credit collapse within the united states than we've seen.

at the moment, the evidence of monetary aggregates and falling asset and commodity prices demonstrate that deflation is clearly pushing through the system. the deleveraging is underway. interested observers will now have to wait for the fed and treasury to return serve -- the ball is in their court.

UPDATE: clarification via mish.

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