Credit Bubble

Inflation / Deflation and Credit Bubble

Since the FED was created in 1913, it has been inflating credit. This credit expansion has accelerated since 1980s. The resulting credit bubble is now in the process of busting since 2007.

For an investor, it is important to know the effects of this credit expansion. It has fueled the stock market bubble of 1980s and 1990s. It has fueled the greatest housing bubble in history of mankind. It has fueled the consumer economy in the US.

When the expansion of credit stops, it’s effects are rolled back. It will feel like a decrease in total money supply. Less money will be chasing an over supply of goods and services. Prices compared to US dollar will have to fall. That is called deflation. We already see this in stocks, housing, commodities.

Here are some charts from Credit Suisse. They have released these to counter the scary total debt-to-gdp charts you may have seen on the internet. These bankers claim that these charts do not indicate excessive debt burden.

Credit Suisse says:

Chart I below has been circulating in some form or another for some time. It purports to show how disastrously overleveraged the US private sector has become, and is the most frequently cited piece of information used to justify extremely bearish views about the real economy, banking shares and the equity market itself.

The implicit or explicit argument is that the US private sector debt to GDP ratio must inevitably be cut back to a similar level to the early part of the 20th century, or perhaps even to the levels of the 1950s. This would imply private debt shrinking from 350% of GDP now to between 50 and 150% of GDP, something likely to be associated with a repeat of the 1930s depression or worse.

Unfortunately, this chart is both technically wrong and analytically meaningless in our view. As such it is arguably the most dangerous piece of propaganda to come out of the current crisis.

Dept to GDP Chart

Chart 1: Credit Market Dept to GDP

Private Debt to GDP Ratio

Chart 2: Private Debt to GDP

This is how the (aggregate debt) chart should look… the earlier data was extracted from the Economic Report of the President and adds together household debt and corporate debt, both financial and non-financial. This report was discontinued in the 1970s. The later data comes from the flow of funds accounts and breaks out financial and non-financial debt, starting in the 1950s. The growth in the two measures is very similar for the overlapping periods, but the levels are somewhat different. Chart I splices the two series together, using the higher number as the base.

This does not imply that banks, hedge funds and investment banks did not become dangerously over-leveraged in the last cycle, but it does imply that one could and should look at quite different statistics to measure this. For example, the leverage of hedge funds or investment banks, or the haircuts imposed on different types of collateral in the repo market. These measures of leverage have already plummeted and we see no valid reason to believe that they are still above prudent or sustainable levels. Quite the opposite if anything.

“Our third chart looks only at household sector debt to GDP. Here, two points are clear: 1) the household sector was massively underleveraged in the 1950s, and 2) only in the last housing boom did household leverage clearly exceed the levels of the 1920s. If there is a problem with household leverage, then it is a relatively recent one and not necessarily massive in scale.

Household Debt to GDP Chart

Chart 3: Household Debt to GDP

So Credit Suisse, the bankers, are telling us to go get more debt. OK.

Let us see what the American Consumer is saying:

Here is a poll from September 4, 2009, CNN Money:

Americans are saving, not spending

Here 26% said SAVE. 42% said PAY DOWN DEBT. That is a whopping 68%. Credit Suisse charts indicate a household debt of just Great Depression levels, and they try to say it is OK.

But what they are forgetting is as follows:

  • Debt has never been this high before. In 1930s, the ratio looks high because GDP fell. Today GDP is all time high but debt is even higher! Debt has been increasing FASTER then GDP all this time! The growth we had last 3 decades is an illusion.
  • Today we consume more than we produce. And the government hopes this can continue (how??).
  • Jobs are being outsourced, production capacity is moving away, opposite of 1920s, 1930s.
  • Government debt is also reaching all time high which indicates a necessity to increase tax burden on households.
  • In the old days debt was used to create factories and we invested in our productive capacity. Today it is invested in granite countertops.
  • Baby boomers are reaching their retirement age. So far their generation defined the trends and their transformation from buyers/investors to savers/sellers is likely to be a headwind against markets.

Therefore there are enough reasons to believe that credit deflation is possible and likely. Some say FED can counter this by inflating the credit again, as they are trying now.

Total Bank Credit is Deflating

Total bank credit is deflating as seen in this chart by St. Luis Federal Reserve January 14th , 2011):

bank credit deflates

Notice that it had been going up non-stop for decades. The problem is that without government spending, this chart needs to go exponentially higher for each unit of GDP increase every year in the future. That means people must borrow exponentially more. This is because when we borrow, banks create money, they do not lend existing money. For this borrowed money to be paid back as principal + interest, the interest portion needs to be created by even more borrowing in the future so that people can earn it and pay back what they owe. Do you think there is such thing as perpetual borrowing? Can we really borrow non-stop and still afford the monthly interest payments? Sooner or later, it ends.

Bank Credit Deflation Rate

Total bank credit is deflating as seen in this chart by St. Luis Federal Reserve, percent change in total bank credit:

bank rcedit deflation rate

What is the FED doing to fight deflation?

FED is printing money and giving it to the banks to cancel out the bank losses. Otherwise the insolvent banks would be in a great liquidity crunch and above bank credit charts would have been in much much worse shape. This new printed money is not making it’s way to the economy and the people, so it is not causing inflation. So far, this is merely a scheme to keep the banks, which are otherwise bankrupt, afloat by buying their junk using this money. Notice that due to constant bank credit inflation over many decades, the US dollar already lost it’s value, thus printing this money is not necessarily inflationary. This money merely keeps the dollar low which otherwise would be much higher than where it is today.

Adjusted Monetary Base Expands

Why is the economy struggling?

You may think deflation is not a threat now. After all FED has printed money and injected into the economy, right? Not exactly. There is not enough political will to print money when economy seems to be OK. But the will to print appears AFTER deflation hits. In a deflationary crash, even though FED makes credit easier, it is hard to turn the boat around due to the following reasons:

1. Lenders (banks) do not want to lend because they think they may not get their money back. This is because the money supply is shrinking rapidly. All prices around you were based on inflated bank credit. People borrowed and bought things and inflated prices along with salaries. It is very possible that all prices and salaries can be cut in half if the money supply shrinks 50%. Then it will be very hard to pay back a fixed rate loan.

2. Borrowers do not want to borrow because they think they may not be able to pay it back. This is normal because people see job cuts, companies cut costs, prices fall, so how can they be sure that they will make same salary in the future to pay back what they owe.

3. For price inflation to happen, people must have alot of money to chase too few products. What we have now is the opposite. We have wage reduction. We have high debt levels. We have excess capacity producing too many products. The supply exceeds the demand. The prices will fall, not go up. All companies are selling less, good results are just a result of cost cutting. When one company does it, it is good. But when all companies do it, cost cutting is detrimental to the economy. Earnings will go lower. Imagine an IT company produces software and hardware, but cuts costs: layoff workers, freeze salaries, stop investments. Their customer is a bank. If the bank cuts costs what will they do? They will say: Hey we are not buying new software from this IT company this year. We will run with fixer upper systems we have, sorry. This mentality will effect everyone’s earnings! It may sound good for the bank, but it is bad for the IT guy. There is a chain reaction.

Almost all of the money supply in the economy is in terms of bank credit. This monetary system is prone to a deflationary crash. There is a herd effect in the population. People borrow and spend altogether and they stop borrowing altogether. This creates cycles like kontradiev wave. The herd effect causes great booms and great busts. This is explained in Conquer the Crash.

Conquer the Crash foresaw the financial crisis back in 2002 and explained in detail how it would unfold. It is like a history book about the future. Must read.

From a long term investing perspective, it is imperative that we the investors time the market and allocate our assets accordingly to avoid the devastating effects of a deflationary collapse.

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Here is Consumer Price Index for all items:

Consumer Price Index

Deflation Survival Guide

By Elliott Wave International, May 26, 2010: “US money supply plunges at 1930s pace… The M3 money supply in the U.S. is contracting at an accelerating rate that now matches the average decline seen from 1929 to 1933, despite near zero interest rates and the biggest fiscal blitz in history.”

M3 is deflating

Deflation is suddenly in the news again. It’s a good moment to catch up on a few definitions, as well as strategies on how to beat this rare economic condition.

And who better to ask than EWI’s president Robert Prechter? He predicted the first wave of deflation in the 2007-2009 “credit crunch” and has written on this topic extensively.

We’ve put together a great free resource for our Club EWI members: a 63-page “Deflation Survival Guide eBook,” Prechter’s most important deflation essays. Enjoy this excerpt — and for details on how to read the eBook in full free, look below.

What Makes Deflation Likely Today?

Following the Great Depression, the Fed and the U.S. government embarked on a program…both of increasing the creation of new money and credit and of fostering the confidence of lenders and borrowers so as to facilitate the expansion of credit. These policies both accommodated and encouraged the expansionary trend of the ’Teens and 1920s, which ended in bust, and the far larger expansionary trend that began in 1932 and which has accelerated over the past half-century. Other governments and central banks have followed similar policies. The International Monetary Fund, the World Bank and similar institutions, funded mostly by the U.S. taxpayer, have extended immense credit around the globe.

Their policies have supported nearly continuous worldwide inflation, particularly over the past thirty years. As a result, the global financial system is gorged with non-self-liquidating credit. Conventional economists excuse and praise this system under the erroneous belief that expanding money and credit promotes economic growth, which is terribly false. It appears to do so for a while, but in the long run, the swollen mass of debt collapses of its own weight, which is deflation, and destroys the economy. A devastated economy, moreover, encourages radical politics, which is even worse.

The value of credit that has been extended worldwide is unprecedented. Worse, most of this debt is the non-self-liquidating type. Much of it comprises loans to governments, investment loans for buying stock and real estate, and loans for everyday consumer items and services, none of which has any production tied to it. Even a lot of corporate debt is non-self-liquidating, since so much of corporate activity these days is related to finance rather than production.

Total Credit as a Percetage of GDP

Figure above is a stunning picture of the credit expansion of wave V of the 1920s (beginning the year that Congress authorized the Fed), which ended in a bust, and of wave V in the 1980s-1990s, which is even bigger.

…it has been the biggest credit expansion in history by a huge margin. Coextensively, not only is there a threat of deflation, but there is also the threat of the biggest deflation in history by a huge margin. …

Read the rest of this important 63-page deflation study now, free! Here’s what you’ll learn:

  • What Triggers the Change to Deflation
  • Why Deflationary Crashes and Depressions Go Together
  • Financial Values Can Disappear
  • Deflation is a Global Story
  • What Makes Deflation Likely Today?
  • How Big a Deflation?
  • Much, Much More

Deflation and Fiat Currency

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Deflation eBook

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Deflation is Everywhere: What it means for you
The mainstream media couldn’t predict the biggest bear market in 100 years; how do you expect them to anticipate what will unfold next? Watch this quick video clip from financial analyst and sought-after speaker Steven Hochberg about why you should challenge the consensus view for inflation. Then access the full 20-minute video, FREE.
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Are we starting another Great Depression?

Credit / Debt Bubble

Ellen Brown explains how the banks create money of out thin air and how this causes inflation and deflation.

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Robert Prechter explained how this system would crash in his 2002 bestseller book “Conquer the Crash”. 2nd edition was released October 2009 and updates the deflationary crash scenario based on latest developments.

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