The Deflation Time-bomb   

By Mike Whitney

10/01/08 "ICH" -- -- We are to about see how much George Bush really believes the “supply side” mumbo-jumbo he's been spouting for the last 7 years. Last week's Labor Department report confirmed that unemployment is on the rise (5%) and that corrective action will be required to avoid a long and painful recession. There's a good chance that the Chameleon in Chief will jettison his “trickle down” doctrine for more conventional Keynesian remedies like slashing interest rates, government programs, and tax relief to middle and low income people. On Monday Bush announced that his team of economic advisors was patching together an “Economic Stimulus Package” that will be unveiled later this month in the State of the Union Speech. The goal is to rev-up sagging consumer spending and slow down business contraction. Ironically, the UK Telegraph dubbed the stimulus plan Bush's “New Deal”. It's a shocking about-face for a president that has been clobbering the middle class since he took office and who balks at even providing temporary shelter for disaster victims. Now Bush is going to have to give away the farm just to keep the economy from crashing. Good luck. Clearly, the prospect of a system-wide meltdown in banking, real estate and equities has become a "Road to Damascus" moment for lame-duck George.

The uptick in unemployment is just the final part of an otherwise bleak economic picture. Manufacturing is hurting too. Last Wednesday, the December ISM Manufacturing Index plunged to 47.7, its lowest level in five years. The news put the stock market into a 200-plus nosedive and sent gold soaring over $800 per ounce. Since then, the news has gotten progressively worse. The market fell another 200-plus points on the Labor Dept's report on Friday, followed by 238 point jolt on Tuesday on rumors of (potential) bankruptcy at mortgage lending giant, Countrywide Financial, and a 2.6% plunge in pending housing sales from the National Association of Realtors. By the time ATT announced its fears of “reduced consumer spending” the market was already barrel-rolling towards earth in a sheet of flames.

The Dow Jones is now 10% off its yearly high, the official sign of a correction. More important, equities blew through their support levels indicating a basic change in the market's trajectory. Its a primary bear market now and any rebound will be temporary. There's still a lot of fat to be trimmed before overvalued stocks return to the mean. No wonder Bush is nervous.

The constant rate cuts and geopolitical jitters have sent gold skyrocketing. Since August 2006, gold has gone from $650 per ounce to $887; a whopping $237 in just 5 months. If that is not a indictment of the Federal Reserve and their “loosey-goosey” monetary policy; then what is? According to the Wall Street Journal “gold and oil have run almost in perfect tandem. The price of gold has risen 239% since 2001, while the price of oil has risen 267%. That means if the dollar had remained as 'good as gold' since 2001, oil today would be selling at about $30 a barrel, not $99.” (WSJ; 1-4-08)

That's right; the price of gas today is attributable to war, tax cuts and the relentless expansion of credit by the Federal Reserve---NOT OIL SHORTAGES!

Escalating energy prices are increasing the cost of food production which creates a self-reinforcing inflationary cycle. Additional rate cuts will only weaken the dollar further and put an even greater burden on maxed-out consumers.

Before he left on his “Victory Tour” of the Middle East, Bush said:

"When Congress comes back, I look forward to working with them, to deal with the economic realities of the moment and to assure the American people that we will do everything we can to make sure we remain a prosperous country."

The economic realities that Bush will be facing are the anticipated “hard landing” from a nationwide housing slump coupled with a credit crunch that is strangling the banking and financial industries. The country is lurching recklessly into a deflationary death-spiral while Bush makes a pointless junket to the scene of his biggest foreign policy flop. What a joke. When he returns, Bush will find that he is constrained in his “stimulus” plan due to massive fiscal deficits which are the result of the enormous tax cuts and gluttonous military budget.

“This isn't like 2000 when the US was running a large fiscal surplus of $300 billion or 2.5% GDP,” said economist Nouriel Roubini. “Now that all the fiscal stimulus bullets have been spent on the most reckless and unsustainable tax cuts in history—the administration is left with very little room (to maneuver) in bad times...We are now stuck in a situation where the room for any meaningful fiscal stimulus...is gone....We did indeed waste all our macro policy bullets in 2001-2004 in “the best recovery that money can buy” and now we are left with relatively limited room for monetary and fiscal policy stimulus. This is one of the main reasons why the recession of 2008 will be more severe and protracted than the mild 2001 recession.” (Nouriel Roubini's Global EconoMonitor)

Still, there will be a stimulus package--however meager--and there'll also be more rate cuts by the Fed. That means that gold and oil will continue to soar and the dollar will continue to get hammered. Bernanke's options are limited; as are Bush's. The system is grinding to a halt and the Fed chief will have to use the tools at his disposal to try to stimulate economic activity. It won't be easy. Presently, he faces a number of challenges. Home prices are falling, retail spending is off, commercial real estate is in a sharp downturn, and many of the major investment banks are capital impaired from their poor investments in mortgage-backed bonds. If the Fed's "low interest" smelling salts don't revive the comatose American consumer---and get the cash registers at Target and Billy McHales ringing again—the world will face a global slowdown. That's why the Fed Funds rate will probably get hacked by 50 basis points by month's end and Comrade Bush's economic team will concoct a fiscal bailout plan worthy of Fidel Castro.  

ARE WE THERE, YET?

A growing number of market analysts believe we're already in recession. David Rosenberg of Merrill Lynch put it like this:

"According to our analysis, this [recession] isn't even a forecast any more but is a present day reality." Rosenberg argues that a weakening employment picture and declining retail sales signal the economy has tipped into its first month of recession....Mr Rosenberg points to a whole batch of negative data to support his analysis, including the four key barometers used by the National Bureau of Economic Research (NEBR) - employment, real personal income, industrial production, and real sales activity in retail and manufacturing.” (UK Telegraph)

Whether one chooses to call it a recession or not is irrelevant. When the two behemoth asset-classes—real estate and securities—begin to cave in, there's bound to be some ugly fallout. Housing stayed strong during the dot.com bust. Not this time. No way. The whole system is keeling over and it could take the bond market along with it. As the two gigantic equity bubbles lose gas; consumer spending will stall, business activity will slow, more workers will get laid off, and prices will tumble. Equities and commodities will be hit hard (even gold) and housing prices will dive to new lows as the pool of potential buyers grows smaller and smaller.

These problems will be further aggravated by the lack of personal savings and the huge debt-load which will push increasing numbers of homeowners, credit card customers, even student loan recipients into default. By 2009, bankruptcy will be the fastest growing fad in American pop-culture.  

HOUSING DOOM

Many experts are now predicting that home prices will dip 30% by the end of 2008. That means that nearly 20 million homeowners will be “upside-down”, that is, they will owe more on their mortgage than the current value of the house. (Imagine owing $400,000 on a home that is currently worth $325,000!) 40% of all homeowners in the US will be upside-down by the end of next year. This is a grave systemic problem that will have widespread implications. Experts already know that when mortgage holders have “negative equity” they are much more inclined to put their keys in the mailbox and skip town. Hence, the name for this increasingly common practice---“jingle mail”. Secretary of the Treasury Henry Paulson is desperately trying to put together a national “rate freeze” to avoid, what could be, the most devastating surge of foreclosures the world has ever seen. Paulson's rate freeze does not offer “New Hope” as promised but, rather, a lifetime of servitude paying off an asset of ever-decreasing value. Underwater homeowners are better off taking the hit to their credit and letting the bank repo the house. Let the bank worry about it. They created this mess.

The housing bubble is deflating faster than anyone had anticipated. Overall sales have slipped more than 40% from their peak in 2005 whereas, prices have gone down a mere 6.5%. Prices, which are a lagging indicator, have a lot further to drop before they touch bottom. Robert Schiller, Professor of Economics at Yale University and author of “Irrational Exuberance” “predicted that there was a very real possibility that the US would be plunged into a Japan-style slump, with house prices declining for years.

Professor Shiller, co-founder of the respected S&P Case/Shiller house-price index, said: “American real estate values have already lost around $1 trillion [£503 billion]. That could easily increase threefold over the next few years. This is a much bigger issue than sub-prime. We are talking trillions of dollars’ worth of losses.” (Times Online)

Schiller's on the right track, but his estimates are way too conservative. After all, in 2002, the median price of a single-family home in Los Angeles was $270,000. But, by 2006, the cost of that same house had doubled, to $540,000 -- “pushed by unbridled speculation fueled by unparalleled access to mortgage capital.” (LA Times) The problem was cheap credit that was readily available to anyone who could fog a mirror. All that has changed. The banks have tightened up their lending standards, and jumbo loans (loans over $417,000) are nearly impossible to get. So, why doesn't Schiller believe that prices will return to 2002 levels? They will. And they'll go even lower; much lower. In fact, real estate is quickly becoming the leper at the birthday party; everyone is staying away. That means that prices will fall---and more rapidly than anyone imagined. The word is out on housing and it's not good. The blood is in the water. Get out before the pool of mortgage applicants dries up entirely.  

BANKING TSUNAMI

The US banking industry has never faced greater challenges than it does today. Many of America's largest and most prestigious investment banks are seriously under-capitalized and buried beneath hundreds of billions of dollars in complex, structured investments that are being downgraded on a weekly basis. On top of that, many of the banks main sources of revenue have vanished as investor interest in sophisticated mortgage-backed bonds and derivatives has disappeared altogether. For example, the sales of collateralized debt obligations (CDOs) “plunged 85% to $15.69 billion in the fourth quarter”. Also, “The value of Alt-A mortgages…issued in the third quarter fell 64% to $39.3 billion from the second quarter’s record high of $109.5 billion .... S&P said the dramatic drop is the result of ‘unprecedented credit and liquidity disruptions’ for both borrowers and lenders” (Dow Jones) These are steep declines and represent a serious loss of revenue from the banks' bottom line.

Many of the banks are simply in “survival mode” trying to conceal the magnitude of their losses from their shareholders while attempting to attract capital from overseas investors to shore up their sagging collateral. (via Sovereign Wealth Funds)

The banks are now struggling to fulfill their function as the main conduit for providing credit to consumers and businesses. They have curtailed their lending as their capital base has steadily eroded through persistent downgrading. The Federal Reserve has tried to resolve this issue by opening a Temporary Auction Facility (TAF) which allows the banks to secretly borrow billions from the Fed without the embarrassment of disclosing the transaction to the public. The banks are also free to use Mortgage-backed securities (MBS) and commercial paper (CP) as collateral for securing the Fed repos. It's a sweetheart deal and more than 100 financial institutions have already taken advantage of the Fed's largesse.

This is a bad sign. It indicates that the banks are seriously overextended, “capital impaired” and need a handout from the Central Bank to keep from defaulting. It means that the vaults are stuffed with worthless mortgage-backed slop that they are deliberately hiding from their shareholders and depositors. If there was adequate regulation then the banks would never have been allowed to dabble in such risky debt-instruments as subprime loans and toxic CDOs. The whole catastrophe could have been avoided. Instead, hundreds of billions of dollars will be wiped out, a number of banks will fail, and public confidence in their institutions will be shattered.

This week, the Federal Reserve announced that it “will increase the size of two scheduled auctions of emergency loans by 50 percent to $30 billion as part of a global attempt by central bankers to restore faith in the money markets”. (AP) In other words, the Fed will provide an even bigger begging bowl to prop up the banks to maintain the appearance of solvency. It is an utter sham. 

INFLATION vs. DEFLATION

The size and scale of the approaching recession is impossible to forecast. The real estate and stock markets will undoubtedly see trillions of dollars in losses, but what about the estimated $300 trillion dollars of derivatives, credit default swaps and other abstruse counterparty options? Will the global economy freeze up when that ocean of cyber-capital suddenly evaporates? Will that virtual wealth simply vanish into the ether when the underlying assets (CDOs, MBSs, ABCP) are downgraded to pennies on the dollar, or when the number of home foreclosures catapults into the millions, or when the dollar slips to a fraction of its current value? No one really knows.

But Atlanta Fed President Dennis Lockhart summarized what we can expect in a speech he gave last week titled “The Economy in 2008”. He said:

 “A sober assessment of risks must take account of the possibility of protracted financial market instability together with weakening housing prices, volatile and high energy prices, continued dollar depreciation, and elevated inflation.”

Amen.

What the upcoming recession “will look like” has been the topic of a fierce debate on the Internet. Everyone seems to agree that this is not a typical economic downturn resulting from overproduction, under-consumption or malinvestment. Rather, it is the crashing of humongous equity bubbles that were generated by the Fed's abusive expansion of credit and the unprecedented proliferation of opaque structured-debt instruments. Many believe that the unwinding of these bubbles will trigger a round of hyper-inflation which is already evident in soaring food, energy and health care costs. These prices are bound to increase substantially as the Fed continues to cut rates and further undermine the dollar.

But the real issue (it seems to me) is the unfathomable loss of market capitalization, the growing insolvency of maxed-out consumers, and the inability of the banks to freely extend credit to responsible loan applicants. These three things are likely to drag down all asset-classes, slow business activity to a crawl, and compel consumers to hoard rather than spend. The dollar will strengthen in an deflationary environment. (if that is any consolation?)

Paul L. Kasriel, Sr. V.P. and Director of Economic Research at The Northern Trust Company answers some typical questions about deflation in a recent interview with economic guru Mike Shedlock (Mish): .

Mish: Would you say that consumer debt in the US as opposed to the lack of consumer debt in Japan increases the deflationary pressures on the US economy?
 

Kasriel: Yes, absolutely. The latest figures that I have show that banks' exposure to the mortgage market is at 62% of their total earnings assets, an all time high. If a prolonged housing bust ensues, banks could be in big trouble.

Mish: What if Bernanke cuts interest rates to 1 percent?
 

Kasriel: In a sustained housing bust that causes banks to take a big hit to their capital it simply will not matter. This is essentially what happened recently in Japan and also in the US during the great depression.

Mish: Can you elaborate?

Kasriel: Most people are not aware of actions the Fed took during the great depression. Bernanke claims that the Fed did not act strong enough during the Great Depression. This is simply not true. The Fed slashed interest rates and injected huge sums of base money but it did no good. More recently, Japan did the same thing. It also did no good. If default rates get high enough, banks will simply be unwilling to lend which will severely limit money and credit creation.

Mish: How does inflation start and end?

Kasriel: Inflation starts with expansion of money and credit.
Inflation ends when the central bank is no longer able or willing to extend credit and/or when consumers and businesses are no longer willing to borrow because further expansion and /or speculation no longer makes any economic sense.

Mish: So when does it all end?

Kasriel: That is extremely difficult to project. If the current housing recession were to turn into a housing depression, leading to massive mortgage defaults, it could end. Alternatively, if there were a run on the dollar in the foreign exchange market, price inflation could spike up and the Fed would have no choice but to raise interest rates aggressively. Given the record leverage in the U.S. economy, the rise in interest rates would prompt large scale bankruptcies. These are the two "checkmate" scenarios that come to mind. (read the whole interview at http://globaleconomicanalysis.blogspot.com/2006/12/interview-with-paul-kasriel.html) 

Summary: When banks don't lend and consumers don't borrow; the economy crashes. End of story. The whole system is predicated on the prudent use of credit. That system is now in terminal distress. Everyone to the bunkers.

Perhaps the whole “inflation-deflation” debate is academic. The real issue is the length and severity of the impending recession. That's what we really want to know. And how many people will needlessly suffer.