August 5th, 2010

Deflation: Déjà vu All Over Again

The last post generated more discussion than most and rightly so. Gloom abounds in and around the market these days. On the fundamental side, there’s the stream of CNBC guests discussing the prospect, risks and negative consequences of deflation. On the technical side there’s the blizzard of warnings sent out doomsayer like the people at Elliott Wave. This is what they wrote in a promotional piece I recently received from them:

“The major stock indexes lost more than HALF their value, but it’s not because “half” of all shareholders tried to dump their stocks. Not even close….More people can still decide to sell, but it won’t take many. When they do, prices can fall a lot further.”

If you want to know how all this will end, I recommend you read “Lords of Finance”, one of Best Books of the Year on the NYTimes Book Review in 2009, by Liaquat Ahamed. Ahamed traces the actions of the four major central banks of the first half of 1900’s from the start of WW I to German hyperinflation to the Roaring 20’s to the Great Depression to the risk of deflation in the US to the start of WW II. Going through it was like reading a historical mystery, you couldn’t wait to see what the next shoe would be to drop.

It was also perhaps a little like reading a science fiction novel since the similarities between then and now was so eerily similar. Reading the last few chapters also revealed what might be down the road in our future. The economy in 1931 was in the Great Depression and, like there is today, there was also a great divide between those wanting budget cuts and increased taxes to balance the budget and those who wanted the US to increase Federal supports. The constraint was that the US was on the gold standard. That meant that government finances were limited by the amount of gold held by the Fed and the Treasury.

Deflation was the fear then too and no one knew how to end it. After consulting with economists of different points of view, Roosevelt surprised them all shortly after taking office by taking the dollar off the gold standard, effectively resulting in a $US devaluation.

“Taking the dollar off gold provided the second leg to the dramatic change in sentiment, which had begun with the bank rescue plan, that coursed through the economy that spring….injected $400 million into the banking system during the following six months. The combination of the renewed confidence in banks, a newly activist Fed, and a government that seemed intent on driving prices higher broke the psychology of deflation, a change reflected in almost every indicator. During the following three months, wholesale prices jumped by 45 percent and stock prices doubled. With prices rising, the real cost of borrowing money plummeted. New orders for heavy machinery soared by 100 percent, auto sales doubled, and overall industrial production shot up 50 percent.”

I’m no economist, but I disagree with people like Larry Kudlow who continue to argue for “kind dollar”. He recently wrote

“In sound-money terms, it would be okay with me if the Fed held the monetary base steady for a long, long time. That would keep the dollar stable and would probably keep gold prices steady. If investors actually believed in a stable policy, perhaps the greenback would rise while gold fell.”

I think that, if it becomes more an more apparent that we are on the verge of sliding into a deflationary period, I would keep my on the following indicator:

That’s the US Dollar Index. It worked to stave off deflation in the 1930’s and 40’s and it will probably work now. Plus, perhaps the only way we can pay off our debts is to deflate our way out of them. It wasn’t a bad strategy then and it may not be a bad one now.

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  • Anonymous

    US Dollar Index (USDX) kept dropping from 2000 -2010.It looks like we have reached the bottom.That also means the huge run in $GOLD is about to be over…

  • Anonymous

    Guru, what is your take on $copper? $385 is huge resistance, coming down from here or break through $385?

  • Joe

    I don't follow copper so don't have an opinion. As far as $US is concerned, I think I might take the other side of that trade. The $US has to deflate much more in order to jump start the economy and make paying off our debt more manageable.

    Those who see the market making a huge double top leading to a further massive decline might also be able to see the Dollar's action between 2004 and now as a huge symmetrical triangle consolidation in the making. If I'm right then gold has some ways to go.