Why the government fears deflation and you shouldn’t

“Deflation – what’s in it for me?”

I guess that’s the first thought in the morning for most people. And rightly so.

Why?

  • For one, it’s coming (well, unless we get inflation instead – or more likely: both).
  • Second, it has everything to do with your job security, savings, loans, investments, wealth and future living standards; in short your life.

If you thought (not) chasing the stock market at highs was unnerving, deciding on buying gold or not was stressful, or that increasing automation and the death of jobs sounded scary, wait until you understand deflation.

Takeaways:

  • Falling prices are not bad
  • Avoid debt
  • Deflation is actually the remedy
  • You can expect higher real income
  • Negative profit margins and cheap stocks
  • Cycles cycle
  • Huge public debt spells catastrophe and depression
  • Who wins? Make sure it’s you

deflation inflation sprezzaturian

4 reasons the government wants you too to fear deflation

  • Exacerbates debt. Deflation makes public debt repayment more difficult (debt is nominal and fixed, and if the price of everything else rises, then tax revenues increase too).
  • Can’t be taxed. Another way of saying that is that a wage increase can be taxed, regardless of your real income trend, whereas falling prices and constant wages can’t.
  • Lowers GDP. Deflation reduces nominal GDP (lower prices of everything produced) while debt (nominal, remember?) stays the same (actually it most likely rises quickly due to the typical budget deficits during deflation, stemming from less tax revenues and higher stimulus expenses). Thus the debt/GDP ratio rises in deflation, and with it the risk of higher interest rates and default.
  • Ruins banks. Just as the real value of public debt increases during deflation, private debt does too. Your mortgage keeps growing in relation to your (falling) wage. Sooner or later first you and then the banks become insolvent.

inflation deflation 3

Consumption is not postponed due to falling prices

You often hear people say that deflation makes people postpone purchases, which in turn reduces corporate revenues, leading to layoffs and yet less consumption.

In the real world, however, we all know that falling prices on cell phones, computers and other electronics, e.g., stimulate even more sales and earnings. Despite absolute certainty of rapidly falling prices, we line up during iPhone launches and beg to buy at the most expensive prices possible.

In addition, the things we want and need to consume we buy anyway: food, clothes, transportation and so on. However, investments, in particular speculative “investments” and luxury might and should be postponed.

 

Asset prices will fall and that is good

What does happen is that the prices on assets like stocks and houses fall in a deflation – first from frothy levels to normal, and then sometimes undershoot and become cheap.

What should you as an investor or consumer think of falling prices? Very good, of course:

  • Cheaper housing? You can buy a bigger one.
  • Cheaper stocks? You can buy more of them and then earn dividends for several decades, as well as see prices increase to normal and even expensive levels after you bought cheaply.
  • Cheaper gold and other commodities? You can buy more jewellery, more of the products that are made from iron, oil, grain, sugar etc.

 

Those with too much debt deserve what is coming

…unless you bought with too much leverage of course. If you let evil and greedy politicians and ignorant central bankers fool you into borrowing to buy overpriced assets, then you’ll be in trouble – or at least you’ll be stuck with whatever assets you already have.

Newcomers and other unleveraged people, however, will be able to invest their savings in cheap stock or buy living quarters at firesale prices.

deflation inflation sprezza

Lessons

Okay, so what’s in it for you… reading this article, I mean, apart from being a little more knowledgeable, a little better prepared and inoculated vs. the deflation is bad propaganda?

Here is what I want you to take away from this post:

Falling prices are not bad. You know this in your heart. It’s only if you are too indebted it can be bad. Or, possibly if you are looking to scale down from a large house to a smaller, then the difference will be a little smaller too.

Hence, avoid debt to the extent that it will chain you to your current asset base. As long as you have unencumbered assets left after the price falls you should be able to scale up and then ride the comeback with more than you had going down.

Deflation is actually the remedy for a sick economy. Deflation should be welcomed. It punishes speculative borrowing and investing, while making prices more reasonable for the poor (but debt-free).

Higher income? It is difficult to ask for a raise, even in a strong economy (not least in these death of jobs and automation galore days), but it’s even harder for an employer to lower your wage for a normal non-performance related job – even in a deflation. Actually, if enough people fall below a certain standard of living (due to their own mistakes) and have no more venues for borrowing left, they will demand and get wage increases(!), which will cut deep into the currently bloated corporate profit margins. If you are debt-free you can still tag along the potential wage increase train among falling prices.

Negative profit margins and cheap stocks. Also, remember that, if you are looking for cheap stocks already. Many companies will lose money sooner or later due to less sales and higher wages – that can be difficult to remember at the peak. On top of it all, a wage spiral can turn into a rate rise spiral making life for both lenders and debtors even more difficult. Don’t be that guy.

Cycles cycle. However, as difficult as losses are to think of at the peak, record margins are far from mind at the trough. If you have cash ready, bargains should be plenty at the bottom. They usually are, even if it’s been unusually long since the last time. Fortunes are made or lost depending on your correct anticipation of the inherent cyclicality in most things.

Just one thing – debt! There actually is one very big drawback of deflation. If debts are already (too) high (public debt, corporate debt, household debt, stock market margin debt, bank leverage, hedgefunds/Private equity leverage) and a large part of the economy depends on stock brokering, fund commissions, loan administration, housing etc., then a lot of people will soon find themselves unemployed and with unemployable skill sets.

Depression. That will cause lower tax revenues, increase state and federal costs (food coupons…), cause civil unrest, calls for higher tax rates, not to mention make selling products and services to all those people all but impossible. Retail chains, restaurants, travel agencies, airlines, taxi drivers, you name it… Everyone will feel the pain. And you too, because the ones mentioned will have second order effects on your employer or your business or you directly almost no matter how far you are from the epicenter in the money business.

Who wins? It’s not the end of the world though. Even in Spain and Greece life goes on, more or less as before, despite 25% unemployment (>50% youth unemployment). People still have to eat just about the same number of calories as before and preferably buy their food as cheaply as possible and cook it themselves, so farmers and groceries should prosper. I’m sure you can come up with several more industries to hide in, no matter how deep the crisis becomes. Alcohol and tobacco? Water and electricity utility companies (oh, no,… loaded with debt unfortunately).

This article also ties in with the post on negative interest rates I wrote in February. Check back on it for a few quick points on education, mortgage and stock market strategies in a NIRP world.

 

Summary

  • Plan your debt level to not get crushed in the coming deflation (or high inflation and surging interest rates)
  • Be ready to pick up bargains (e.g., keep a Quatro Stagione investment portfolio now – including cash, physical gold and possibly attractive but undeveloped land), by having unencumbered assets or cash and a basic idea of what industries and single stocks you dare buy when there’s blood in the streets
  • Make sure you are self sufficient or have employable (preferably non-financial) skills.
  • Be prepared to argue for higher wages, even in a deflation. People will lose their jobs, but the valuable ones will keep theirs, and with higher pay (if needed to cover living costs)
  • Think critically. I don’t have the exact answers. Keynes definitely didn’t. Yellen and Obama certainly don’t have a clue. Neither do academics, your teacher or Nobel prize winners. Howard Marks might. Raoul Pal too. Maybe Marc Faber can weigh in, or Kyle Bass, Jeremy Grantham, Peter Schiff, Steve Keen, Vitaliy Katsenelson or even John Mauldin, Fred Hickey or John Hussman.
    • Search for and read the works of these guys, or just bookmark mikaelsyding.com and subscribe to my newsletter and I’ll help you as best I can to stay up to date.
  • We are in a grand experiment right now; the biggest money printing experiment ever. I’d say the last big one was during the last days of Rome*. That was fun. Whether we’ll end up in a devastating debt-deflation or a likewise ruinous high-inflation environment remains to be seen. Quite likely both.
    • *Oh, don’t forget Germany in 1923, Zimbabwe recently and right now Venezuela and Argentina, among others.
  • Uncertain technology. Layered on top of this debt fueled oligarchical and nepotistic economy is an accelerated technological evolution, possibly leading to a productivity boom never seen before, or an automated hell and death of jobs.

 

May you live in interesting times

Unfortunately you do, whether you like it or not.

The economy is in a transition phase from one semi-steady state to another. It’s payback time after 100 years of the US Fed with increasing money and gold manipulation and a belief in central planning. Thus, the coming 10 years will probably be very difficult and stressful. After that however, humanity might be facing a new spring and golden era, powered by the Singularity enabling technologies: nanotech, biotech, robotics and AI (or GAIN = Genetics, AI, Nanotech).

inflation deflation technological singularity depression

Life was pretty simple there a while: Make a reasonable effort in school, get a job, work yourself upward, borrow a little to buy a house and pay back the loan in a few years.

That life is no more. Education doesn’t guarantee a good job, robots are (slowly) taking over, low interest rates (and thus elevated prices) mean you have to borrow huge amounts just to pay for school and a house, becoming a debt slave for life and risking bankruptcy at even a tiny increase in interest rates.

Money printing, budget deficits and run-away derivatives markets cause systemic risks that could wipe out the dollar, lead to gold confiscation, increased taxes, lower welfare and so on.

I’m not trying to scare you, just open your eyes to a few possible adverse outcomes of a number very long trends that are simultaneously reaching critical states. 

Sounds complicated? Why don’t you just subscribe to my newsletter instead and future-proof yourself that way? Simple.

However, you are still the one who ultimately will have to manage your debts, skills, income and investments. Don’t trust the government, don’t trust your banker, don’t trust me. Trust no one. (Retard’s Playbook)

deflation inflation

Death of money

For further in depth reading I recommend Jim Rickards’ book The Death Of Money. It’s a bit heavy here and there (when reading around midnight I often fell asleep after just a page or two), but most of it is very informative, exciting and inspirational.

The last few chapters with 3 scenarios to ponder, 7 signals to watch and a few pieces of investment advice are particularly good.

To prepare for the coming deflation/inflation/social unrest, watch out for disorderly hoarding of physical gold and changes in the price of gold and the dollar, structural changes in the IMF, system crashes, the Chinese trust Ponzi scheme unraveling and a few others.

Negative interest rates – what does it mean and what must you do?

Negative Interest Rates Everywhere

Negative interest rates are all the rage among central bankers these days. Today even the usually so moderate swedes lowered the policy rate to a negative -0.1 per cent.

What should you do about it? What does it mean for your job security, stock portfolio, pension etc.? Read on…

(or skip to the very end for a few quick points on education, mortgage and stock market strategies in a NIRP world; Negative Interest Rate Policy).

Earlier this year, the Danish central bank did the same (several times, actually, over the course of a few weeks; going deeper and deeper into negative territory).

The European central bank, ECB, had since long cast off its previously conservative German heritage and gone negative. The same goes for the Swiss National Bank.

Not even the U.S. or Japan have gone negative (yet)

Amazingly, neither Japan or the U.S. have tried negative rates – otherwise strong advocates of monetary experimentation.

They prefer the more “moderate” stratagem of printing trillions of new dollars to purchase newly minted treasuries and bonds from their friends at the big banks instead. (The Treasury issues bonds that the banks buy. Moments later, the latter turn around and sell the bonds to the central bank at a slightly higher price, pocketing the difference. It’s a nifty way to enrich banks while simultaneously circumvent the rules against central banks buying bonds directly from the Treasury).

What Draghi (ECB) & Ingves (Sweden) et al. are trying to do vs. what actually happens

In theory lower interest rates, including negative ones, are supposed to:

lower  borrowing costs for companies (Lower borrowing costs mean more investments will be profitable and thus companies borrow more, invest and hire more people. Higher employment means more consumption and even more hiring in a virtuous cycle)

make banks safer (increased profits and strengthened balance sheets, thanks to lower funding costs due to, e.g., lower deposit rates paid to clients and lower coupons, or yields, on issued bonds)

lower the costs for households (lower interest rates on loans both directly and indirectly, as real estate and other companies get lower interest costs)

lower the borrowing costs for the government (reducing the burdens of a welfare state, enabling more transfers and subsidies)

stimulate more risk-taking (moving savers from zero-interest investments, like accounts and bonds, to equity and start-ups, thus promoting growth)

Increase inflation (higher prices and stable tax rates mean higher tax income for the state, thus making more room for welfare transfers. Higher prices on everything also means that loans [that are nominal] will fall as a proportion to income and asset prices. The latter is good for everybody with loans, but bad for everybody with savings)

What’s so special about negative rates?

Nothing really. What matters is the difference between nominal rates and inflation, adjusted for risk.

However, psychologically, nobody wants to pay money for the “privilege” of owning a bond or keeping money at the bank. Hence, people and decision makers feel forced to do just about anything with their cash, except keeping it idle at the bank.

In theory, when rates go negative, people spend their cash on more shopping and shares on the stock market.

Quantitative Easing (bond buying for newly printed money) aims to boost the effects of low rates

The Swedish central bank (SCB) today decided to accompany the negative policy rate with some bond buying. Most central banks do that nowadays. The Bank of Japan, of course, has done it for several decades (all but proving it doesn’t do any good).

The SCB started carefully with 10bn SEK (1.2bn USD), which would be equivalent to approximately 40-50bn USD in the US. The Fed typically buys in the trillions (1 Tn/year) so don’t worry; the Swedes still honor their heritage of moderation.

A 500% interest rate was the best they could do

A historical note: 23 years ago, when I was still at business school, the SCB raised its policy rate to 500%, manifesting beyond all doubt that it had no clue at all to what it was doing. Now the SCB is trying negative rates instead. I dare predict future economists won’t look back with admiration to today’s experiment either.

QE is thought to relieve weak hands of their bonds and put cash in their hands.

That cash then needs to be reinvested (and hardly in anything paying negative interest). The cash thus moves up the risk ladder into, e.g., longer term bonds, large corporate bonds, or even stocks with historically stable dividends. Gradually, investors at all levels are pushed further up the ladder and some money ends up at the very top; in new investments and start-ups, which should promote economic growth.

So, why ever have have positive or high, instead of negative interest rates? (or, what really happens is this)

If you buy into the Keynesian world view, where it’s a good thing to have politicians manipulate the economic cycle by varying interest rates and budget deficits, why not go “all in” and set negative rates once and for all?

Why not have ever falling rates, plunging deeper and deeper into the negative every year? Why have taxes at all, why not just issue debt to cover all welfare costs and let the central bank buy it all?

The intuitive answer is easy: It’s impossible, you can’t print wealth.

Money isn’t worth anything if you can’t get anything for it. Somebody has to work and produce. Somebody has to postpone consumption (a.k.a. “save”) for there to be anything to invest, for there to be anything produced. With negative rates there will be very little saving going on, but a lot of speculation and consumption instead.

Everybody knows you never go full retard in monetary policy.

The lessons from Zimbabwe, Venezuela and not least Germany (1923), are still fresh and raw in the memory of most economists. The death of money or hyperinflation is the most devastating economic phenomenon there is. Production ceases completely and an ever increasing bulk of money chases after an ever diminishing pool of assets and goods, fueling wild speculation and zero long-term investment.

Apart from doomsday scenarios, this is what negative rates means for you

In short, it actually means a doomsday scenario, just very slowly. The lo-down:

You’ll earn less interest on your bank account. Since most people don’t have any cash this is probably not a problem for you. If you have retired and live off a state pension, cash savings or bond coupons – tough luck!

Your variable interest housing loan becomes cheaper. Good for you, more money over for other things. Get out there and splurge!

Share prices, house prices and other asset prices rise for a number of reasons (most of them temporary and psychological). Good for you if you have all the assets you want. Bad if you were planning to buy more.

Companies start investing in anything they can find that might produce more return than the cost of borrowing. This means a lot of investments with lower return than usual get done. These lower quality projects fail more often. In addition, if interest rates rise, investors lose money even if the projects deliver as promised.

Short-term, the economy gets a boost, unemployment falls etc, as it did in 1996-2000 and 2003-2007, but when the low quality projects mature or interest rates rise, the true costs of low quality investing (malinvestment) become obvious. Remember that central banks lowered interest rates, to no avail, all the way down in the 2001-2002 and 2008 stock market crashes.

Longer-term, jobs disappear, banks fail.

The economy’s resilience and growth potential has been hollowed out by low quality investments. The easy job gains in real-estate, financial markets, service industries and consumption during the NIRP* induced boom are soon lost again. The loans for second houses, stocks, third cars, watches and other consumption go bad, consumption fall, and banks fail (subsequently rescued with tax money – congratulations all tax payers, they’re doing it again. But, no worries, the bankers will get to keep their bonuses from the boom).

*NIRP=Negative Interest Rate Policy

Inflation takes hold. Sooner or later inflation takes hold, due to more money and less goods. Then interests rise and many holders of variable rate mortgages will be toast. There actually already is rampant inflation – it’s just that it’s in assets, instead of goods. Whatever inflation there is in goods, the authorities choose not to include in the calculations, but there is a limit to how much they can hide.

Banks take more risk (and sooner or later go bankrupt) since they know the state and central bank will save the bank with tax payers’ money when needed. Up until the bankruptcy/state rescue bankers can pocket their bonuses and get to keep the money after the inevitable collapse.

Financial markets fall (they always do, sooner or later – and have already halved twice in less than 10 years; 2001-2002 and 2008-2009). Whatever artificial appreciation of stock prices accomplished today will be gone tomorrow. Bank failures in the wake of higher interest rates, malinvestments and bad loans is often a reliable way to start a market crash.

The value of a stock today is the discounted sum of about 25-50 future years of cash earnings after tax. Those earnings are being eroded, due to easy money, by current malinvestment and speculation, instead of sound long term investments in production. A mania in the wake of negative interest rates actually reduces the value of stocks, leading to lower lows in the downturn than what otherwise had been the case. Thanks Draghi! Thanks Ingves!

Enough with the economics and Fimbulvetr stories. What should you do now?

Should you fix your mortgage rate, borrow more, buy stocks, study, WHAT?

To start with, -0.1% isn’t that different from 0% or +0.25%, so you really could ignore the whole circus. As you were. In theory though… (and ceteris paribus):

In the short term things will look better. More employment, higher stock prices, higher house prices. In the long term things will still turn ugly.

This is how I would prepare:

Make yourself change resistant; don’t take your job for granted. Acquire more skills, make yourself indispensable, look for future-proof work places. Many will relax in the easy times of negative rates, but you should work harder than ever to secure your place in the job-less future to come.

Amortize your loans, or fix the rate for 7-10 years. Interest rates have never been as low as they are today. Don’t just do as all the other lemmings and go deeper into debt with variable interest rate – be contrarian and either reduce your debt (you can afford to amortize now that your monthly interest cost is so low) or fix the rate for a long time, in case inflation eventually ramps.

The family of two medical doctors I lived with when I studied finance asked me in 1990-92 whether I thought they should change their mortgage to variable interest (10-12% or so) or continue with 5-10 year fixed rates at around 12-15%. I repeated what I had learned in school (“you have always gained from variable rates”, except the very recent period). I hope they listened, because they were quite worried that rates might rise again, from 12%!

The coming decade, 2015-25, we are due such an exception again, where fixed rates are better than variable. Do you dare to time your fixing? Early 2015, late 2015? 2016? 2017?

I wouldn’t buy stocks or more living space. A very short summary of the entire article and the consequences of ultra-low rates would be “This already happened“. As I said, the small increment lower doesn’t change anything much. Stocks (everywhere) and house prices (Sweden; they never fell in Sweden during the financial crisis) have already skyrocketed due to ultra-easy money.

Stocks: Guess what will happen when rates rise, when profits fall, when speculation loses its luster, when growth expectations crumble… Do you think stocks will rise or fall then? Once again, remember that stocks crashed more than -50%, twice, while the Fed kept lowering its policy rate.

Once speculation fades and stocks are seen as risky (potentially negative returns to the tune of -10-60%), then zero or even negative rates in risk-free instruments will be seen as superior investment alternatives. As John Hussman keeps telling his readers, the writing is already on the wall in that respect, as gauged by increased dispersion of market internals (yield spreads, stock sectors etc).

In other words, investors are becoming more and more anxious and any little thing can topple that first crucial domino that fells the rest.

Stocks overshoot, and stocks undershoot. Respect that cycle and use it to your advantage rather than the other way around.

 

Obviously no consequence coming...

Obviously no consequence coming…

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