Are we Hearing Voices from the Past?

Deflation and policy makers' attempts to defeat it:

The U.S. and the world experienced deflation throughout the 1920's and 1930's due to overcapacity in almost every industry. At first the deflation was mild and perceived as a good thing as prices on commodities and consumer goods fell gradually giving consumers a sense of greater wealth. Gradually, however, the benign disinflation turned to outright deflation as the debt bubble upon which all of the over-capacity was built collapsed in a deflationary disaster.

How was this bubble allowed to form? Inventions such as electricity, the automobile, the airplane, the mass production system and others had vastly increased productivity of businesses world-wide and thus hid much of the asset inflation that was taking place. The Fed unknowingly continued its easy money policy right up until the day the bubble popped when it attempted to slow down the stock market speculation too late with a small hike in interest rates. Its attempts afterwards to re-inflate with rate cuts failed miserably. Today, Alan Greenspan has chosen a similar route in keeping interest rates too low as the asset bubble began to get out of hand back in 1995. In a key difference, however, he appears to have chosen to ignore the speculation in the stock market. Instead of doing anything about it, he continues to pour more gasoline on the fire while occasionally telling the fire it is burning a little too hot and should cool down, all the while continuing to pour on more accelerant. It will be interesting to see where nature will finally pop the bubble since the Fed appears unwilling to do anything about it. Meanwhile the deflationary forces around the world continue to build and are only made worse by continued U.S. consumption.

Deflation in the 1920's and 1930's was a true disaster. From 1919 to 1931, a bail of cotton plunged from $.43 to barely a nickel. By 1931, corn was 1/12 its cost just three years earlier in 1929, but the deflation was not just limited to agriculture, automobiles dropped to just 1/3 of the cost of what they went for 1929. The producers of commodities and agricultural products were the first to feel the deflationary pinch and began the protectionist movement that overtook the world.

Similarly today, pork prices are so low that it costs U.S. farmers more to send the pigs to market than they get from selling them. A pound of coffee sells for around $1.12 compared with $1.58 just 12 months ago, and crude oil prices have plunged to the low teens, the lowest levels in decades. The CRB (Commodity Research Bureau's basket of 17 commodities) has crashed from a level of 240 when the Asian crisis began in October of 1997 to 188 in December of 1998, or a 22% decline and a 20 year low (see Figure C). This deflation is not limited to just the U.S. either. The Hong Kong Consumer Price Index dropped 1.6 percent for the month of December in 1998 giving Hong Kong its second month of official deflation. Consumer prices fell 0.7 percent in November registering their first decline in 23 years as consumer spending has dried up in the face of the severe recession and rising unemployment. The worst hit sectors in December were clothing and footwear, where prices dropped 16.2 percent, and housing rentals, which fell 3.4 percent.

The internet will more than likely be more of a profit killer than the holy grail that many today think it will be. The net only adds to the deflationary forces engulfing the world. Due to the lack of barriers to entry and low cost of selling over the web, profit margins are likely to become razor thin if not nonexistent in the future as companies battle on the net for market share. Whereas before you might pick up a product at the mall because "you were there" and didn't want to drive across town. Now you just "click" onto the next site and pick up whatever you need, and if that site is too expensive you "click" on the next one. Sites are already popping up that search the entire net for the lowest price of a specified good. On January 20, 1999, Internet retailer Onsale Inc. unveiled a plan to sell computers and accessories at wholesale cost. This is likely just the beginning. Obviously, this is wonderful for consumers, but consumers need income to buy these goods, and income will be hard to come by as companies' margins are squeezed from competition on the net, and they layoff workers to replace them with internet sites, all contributing to the deflationary spiral.

In a trend that will likely continue, more and more trade disputes are popping up between countries as deflation takes hold and protectionist feelings grow just as they did in the 1930's. The U.S. and EU are already in a bitter dispute over restrictions on banana imports into the EU. The U.S. has threatened tariffs on EU imports into the U.S. in retaliation. The EU has asked the World Trade Organization's General Council to rule on whether the United States has the right to impose such sanctions. The EU initiative is designed to head off an expected U.S. request for WTO authorization to place punitive, 100-percent tariffs on selected imports from Europe as of Feb. 1. The United States of course believes it is justified in the action, insisting that the EU has not changed its banana import regime to comply with a WTO ruling that it discriminates against U.S. multinationals in favor of producers from former European colonies in Africa and the Caribbean. You get the idea of where this is going. Protectionism is never positive for trade.

Additionally, on January 12, 1999, President Clinton threatened Japan with trade sanctions should it continue to flood the U.S. with foreign steel. U.S. Trade Representative Charlene Barshefsky said of the conflict with the Japanese:

"It is no secret that trade tensions between the United States and Japan are increasing quite dramatically. We stressed that the United States can't be the importer of only resort, which is our current situation."

The fact is, as Mrs Barshefsky points out indirectly, that the U.S. is the only importer and is the only force of demand separating the world from an outright economic depression. The excess capacity built up during Asia's over-investment bubble that popped in 1997 has now been trained solely on the United States as we are the last consumer of the world's goods. Brazil is the latest country to devalue its currency in an attempt to stimulate exports and stem the outflow of foreign reserves from the country's central bank. These devaluations are basically cost-cuts across the board for that country's exports, increasing the pricing pressure world-wide. What is likely to follow are competitive devaluations from other Latin American countries in an attempt to compete which could set off a whole new round of devaluations in Asia, namely in China, as the deflationary forces accelerate.

U.S. policy makers and Fed officials are desperate to keep the U.S. economy going to fight these forces. They have pulled out all of the stops to keep Americans consuming. Since the summer of 1997, the International Monetary Fund and Bob Rubin and company have pumped $180 billion into Thailand, Indonesia, Korea, Russia and Brazil. This was a great lesson for speculators: "if you make a stupid investment and it goes bad, don't worry. Someone will bail you out. We'll just print up more money!" This was the same lesson that investors learned from the Mexico bailout only a few years ago. To this same end, the Fed has ballooned the money supply in an attempt to keep the economy moving and keep the financial market bubble liquid so Americans will be duped into continuing take on ever more debt and consume. M3 money growth increased during the 3rd quarter of 1998 alone by $200 billion, a full 60% greater than the same period in 1997. The problem with this remedy is that it only buys time and is not a solution to the problem. David Tice, of David Tice and Associates which manages the Prudent Bear Fund, points out that:

"Central bankers can add liquidity to the system but importantly, cannot control where this liquidity goes, nor can they force bankers to lend or borrowers to borrow. This is why yield quality spreads rise, as the markets gravitate away from borrowers more likely to default. Monetary velocity slows, and banks will restrict credit once defaults start to rise. The problem in both the global and American economy is too much credit, and attempting to loosen credit further will not solve any problems."

Once the current stock market mania inevitably falters, what reason will there be to borrow? History has shown us both in Japan of the 1990's and the U.S. of the 1930's, that cutting short-term interest rates will not encourage borrowing in an atmosphere of over-capacity and credit bust. Japan cut short term rates 8 times in the 1990's from 7% almost to zero in an attempt to stimulate the economy. The borrowers of this money unfortunately avoided the deflationary conditions of Japan and instead used the money to buy stocks and bonds in the U.S. and Europe, helping create the bubbles we have today. Similarly, after the stock market crash of 1929, the Fed cut the discount rate from 6% to 2% and yet still the money supply did not increase. The "pushing on a string" phenomena was encountered as no matter how hard the Fed tried to increase the money supply, they failed because the few borrowers that were credit worthy were reluctant to borrow when they knew that prices would fall more in a month or so. Granted, the Fed waited until after the Crash in 1929 to cut rates, but in the end our Fed is only likely to make the inevitable outcome that much worse. By attempting to postpone it, the liquidity has simply poured into stocks and further inflated the stock bubble (more paper chasing other paper). The resulting bust will be that much worse and last that much longer. As Bill Fleckenstein of Fleckenstein Capital has said, "it's like trying to cure an alcoholic by giving him a few more shots of tequila." Fleckenstein has been calling the US market a bubble for several years now, even as most investors have laughed at him. Coincidentally, he was getting the same response from most investors in Japan when he was calling that market a bubble in 1989. Turns out he was right, and made his fortune being short when the Nikkei crash ensued.

Away from the stock market, the real economy is showing the increasingly negative effects of the global deflation. The Washington Post just reported that layoffs are up 54% for the first nine months of 1998 over last year. Gillette, Raytheon, Applied Materials, LSI Logic, and Motorola are laying off a whopping 11%, 16%, 15%, 17% and 10% of their workforce, respectively. America's trade deficit surged in 1997 as global economic troubles cut into demand for U.S. exports and cheaper Asian currencies made those goods more competitive in the American market. When all the data is collected, the deficit for 1998 is expected to have hit an all-time high of around $167 billion, compared to $110 billion in 1997, with forecasts for another record deficit this year as well. Of course, as long as money is sloshing around in the global casino known as the U.S. stock market, nobody cares about these things, but they will matter again and more than likely… soon.