I’ve been watching Nogger’s Blog for awhile now to keep an eye on the agriculture sector. Here are some recent disturbing highlights:

Wheat: Living On The Edge
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I was born in 1970, but even though I was a small child during most of the 70’s, my elders regaled me with many tales of the inflationary decade. They never told me about a short deflation that happened in 1974, but maybe they just don’t know a deflation when they see one. I’ve found some interesting evidence for deflation in 1974 lately, so I wrote this article to investigate further.

Deflation? In the 70’s?

Mike Shedlock (a.k.a. Mish) is a well-known financial blogger who believes we are having another deflation right now. In December, Mish wrote a post called Humpty Dumpty On Inflation where he accuses those of us focused on inflation of performing what he calls the “inflationista two-step” because we don’t admit that falling housing and stock market prices constitute a deflation.

Near the end of the article, Mish offers a spreadsheet chart of 15 conditions and shows how he thinks they would look under deflation or inflation, and, of course, he ventures to say that the 15 deflation conditions all match what is happening right now. Here’s a small version of his chart, and you can click it to open a larger image from Mish’s site directly:

On a lark, I decided to take a look at each of these conditions and see whether they were present during the 1974-1976 credit crunch. Here’s what I found in a brief google session.

What Happened in 1974?

1. Falling Treasury Yields?
   

   No: 10 year yields stayed 7-8% in 74-76.
   Maybe: 5 year yields went from 8.1 to 6.1% during that period.
   Yes: 6 month yield went from 8.1% to 4.5% peak to trough 74-76.

   Depends on what maturity, but we’ll just call this a “maybe” and count it as a “no”.

2. Falling home prices?
   

   Yes.
   Home prices fell from about 1972 to 1976. Then they took off.
   The UK was also in the middle of an epic housing bust, just like we are now.

3. Rising Corporate Bond Yields?
   

   Yes.
   See first chart on this article.

4. Rising Dollar?

Yes.
Oddly enough, the dollar did rise sharply for a period of time around 75-76.

5. Falling Commodity Prices?
   

   No.
   Pretty stable between the oil price spikes of 1973 and 1979.
   This means is that commodity prices are correlated with oil prices.
   (but we peak oilers knew that already)

6. Falling Consumer prices?
   

   No.
   CPI went from 10% to 2.5% between 75 and 76.

   But wait a second. Despite Mish’s claim, we don’t actually have falling consumer prices NOW, so I don’t know where Mish gets off putting this in there. We may be getting close to flat in the short term, but John Williams shows how the same methodology that was used in the 1970’s would currently show 4% inflation, even MORE than we had in 1975.

   Mish has to use the Case-Schiller version of CPI to get his negative number. I find it hard to justify taking out the Homeowner’s equivalent rent components without taking into account all of the other manipulated components that John Williams has also identified over the last several years.

   So, we can say this: we did have a big slowdown in CPI in 1974, kinda like now. Did that mean the inflationary decade was over? Nope. It just took a break for a deep recession.

7. Rising Unemployment?
   

   Yes.
   5.1% in Jan 1974 to to 9% in May 75

8. Negative GDP?
   

   Yes.
   Went from 5+% growth in 72-73 to negative for both 74 and 75 (MS excel spreadhseet link).

9. Falling Stock Market?
   

   Yes!!
   1973-1974 saw the Dow down over 40% in the US.
   Down 73% in the UK.

   I hope people take a second to think about that. A 40+% decline in less than two years? That’s what we just had in 2008! And this happened the same way in 1974? A year after brand new record high oil prices in 1973? Really? Wow.

   This is starting to look like a good facsimile to today. If you go look at what gold did after bottoming in 1976 — it makes me want to go out and buy some right now!

10. Falling Credit Marked to Market?
    

    Yes.
    It was called a “credit crisis” because there were actual credit issues.
    Franklin national bank failed in 1974. It was the 20th largest bank.
    “Net chargeoffs as a percentage of average total loans increased in 1974 and even more in 1975.”

11. Slowly Rising Base Money Supply?
    

    No.
    It went from 10% yoy growth down to yoy 6% growth 74-76.
    I don’t call this “slow” growth.
    Never went under 6% growth rate until the recession was over.

12. Spiking Base Money Supply %wise (as happened in great depression)?
    

    Yes.
    If you look at the graph in Mish’s article, the spike he talks about is also present right at the beginning of the 1974-1975 recession.

    It isn’t of the same magnitude, so somehow it doesn’t count for Mish, but this is because he wants to say Stagflation and Deflation have different indicators. What he actually shows is that every recession isn’t exactly the same, and that depressions might be higher magnitude than recessions. Well, DUH!

13. Banks Hoard Cash?
    

    Yes.
    Bank Credit as a % of GDP began to fall from a peak at the end of 1974. See Figures 7 and 14 here.

14. Rising Savings Rate?
    

    Yes.
    How could it have risen from an already high rate of 10% before the 1974 during a recession?
    But it actually did rise to 14% for a quarter, which is still the highest rate on record since 1960.

    And how can savings NOT rise from zero percent the last few years??? This point is pretty disingenuous by Mish. C’mon, the fact it has risen to a measly TWO percent again is NOT an indicator of deflation!

    People are hoarding cash at a 2% annual rate?
    And this is an indicator of a rampant deflation? Puh-lease!

15. Purchasing Power of Gold rises (compared to other commodities)?
    

    Yes.
    “such as in 1974 when the CRB topped out in February and gold not until the end of December”

Running the Numbers

So, there we have it. That’s what happened in 1974. Let’s see how those conditions stack up against what is happening today and the great depression and see if Mish has helped us identify a long-overlooked deflation in 1974:

So, if we toss out Mish’s bogus claim that consumer prices are falling today, then he only really showed that 14 out of 15 of these conditions are present now. In 1974, we actually had 13 of the 15 present.

Does this mean Mish helped us find a long lost deflationary episode? Or that Mish has found some indicators of economic turmoil and confused them for indicators of deflation? I’d have to say I think it is the latter. This doesn’t mean we don’t have deflation today, or that we won’t, but it does mean that Mish has only proven that we’re in a period of economic turmoil.

Limits to Growth (again)

One of the main differences between the 1930’s and the 70’s and now is the state of our monetary system. There was nothing preventing us from printing all the money we needed in the 70’s just as there is nothing to restrain the Fed today. The 30’s were entirely different because of the role of gold in global monetary affairs.

The other difference was that the 1930’s were a time of massive abundance everywhere, while the 70’s and this decade are times of limits. Franklin Delano Roosevelt adeptly decscribed the deflationary conditions in his first inagural address of 1933:

Nature still offers her bounty and human efforts have multiplied it. Plenty is at our doorstep, but a generous use of it languishes in the very sight of the supply.

Generous use languishes in sight of plentiful supply precisely because we had all the goods in the world but no money to chase them. In modern times with the limits to growth approaching a second time, we have the opposite conditions: money everywhere but not enough goods to keep this world running the way we’ve been running it.

In the 30’s, all the oil wealth was still ahead of us and resources were cheap and available. In the 1970’s, we brushed against the limits to North American growth, and our only escape was through the project of globalization, which brought the resources of the rest of the world to the markets of the West. The “disinflation” of the 80’s and 90’s came as the result of the relative success of that globalization project. But now, once again, we’re brushing against the limits to growth, with oil supplies about to decline and a population of over 7 billion people that is still growing. Except this time the limits are global, and there are no more reprieves to be found in lost corners of our planet.

When we look at things from this perspective, it is obvious that the theme of the 5 years on either side of 2009, just as were the years on either side of 1974, will be inflation, and not deflation. Stock markets will go down 40% sometimes during tumultuous economic periods, but if we keep our eye on the big picture, the themes will be clear as day.

-Robert

With the financial turmoil of late 2008, many commentators who have previously called for a deflationary bust like the Great Depression are now claiming victory. They point to the lower stock market prices, housing prices and higher trade-weighted dollar values as indicators that we are in a deflationary period. But are we really?

Defining Terms

Definition of terms is always required before meaningful answers can be given. If we look to google for definitions of inflation, we see that most explanations are offered in terms of “rising prices”. Some definitions do correspond more closely with ours, which is:

an increase in the supply of money relative to the supply of goods in a given economy.

This definition comes with a significant advantage in understanding the role of money in an economy, most of which is driven by including the word ‘relative’. That word helps us understand that inflation and deflation are descriptions of what happens when the ratio of money to goods changes. Under this definition, you can get inflation from a drop in money supply, so long as you have an even larger drop in aggregate goods supply. You can also have deflation with a rising money supply, and all it takes to have that is an even larger increase in goods supply.

The word ‘relative’ also keeps us looking at whether we have too much money chasing too few goods, and if we do, then we’ll call it inflation.

Another advantage of this definition is that it forces us to note that goods and money cross borders: we have to count an influx of Chinese goods and an outflow of US dollars to understand whether we might have an inflation or a deflation on our hands.

Shadow Stats

During the Clinton years, just as during all administrations from FDR through JFK and into the present day, some government numbers have been redefined to make the population think things were better than they were. This sort of manipulation keeps confidence high, and confidence is an important component needed to keep a consumer economy running at full steam. If government understates inflation, it benefits from:

1. Keeping entitlement payment increases low, and
2. Overstating real GDP growth,

both of which make the sitting government look like they are doing a better fiscal job than they probably are. This is incredibly tempting for governments, so we need not blame one party or another for harvesting such lucrative political fruits.

One place to see how this works is at John Williams’ Shadow Stats. John has tracked reconstructed government measurements to reflect the real numbers without the manipulation over time. This means we can use his data to see more of an apples-to-apples history. I’ll make use of three of Williams’ charts below.

Money Supply

So, setting aside our “relative” measures for the moment, let’s just look at what is happening with money supply in U.S. dollars. John’s “M3 continuation” chart helps:

Money supply measures are still growing. For those watching the financial markets, we all know about the bailouts, and we can see how those are affecting M1 since the Fed started pulling out all the stops. If we measured inflation by measuring only money supply, then this chart doesn’t seem to indicate there has been deflation.

Consumer Price Index

But what about prices? There is an interesting aspect to the money supply chart above. What if the M1 increase is explained by people fleeing the stock markets and piling into cash? Isn’t that deflationary? Many people argue that if prices are crashing because of the economic turmoil, then who cares what the money supply chart says?

Remember, our definition specifies inflation in terms of the money and goods ratio, not in terms of prices themselves. Yet, we can still look at what is happening with prices to see if the piling into cash argument has any merit. Once again, John Williams has a chart we can look at:

The numbers show that consumer prices are still rising. Yes, the rate of price increase has slowed, but the price direction is has still not gone negative in this decade! Not once! Even the suspect government numbers still show a continuous, even if slower, rise in prices. I circled them on the chart above so you can see what I’m getting at — even by unbelievably low and suspect measures, we’re still not seeing general price declines.

Money Relative to Goods

What happens when we start to look at goods supply?

When we account for inflation properly, we find out that some of the GDP officially reported by the government was probably just inflation reported as increased productivity. This is why Williams shows us in a recession for quite some time, even if the markets didn’t know it.

So, when we look at money supply relative to goods supply, this doesn’t support deflation either. The basic facts are:

• Money Supply in dollars has nearly always grown at a positive rate
• GDP is probably somewhere between flat and -3%
• More money with declining goods supply is inflation by our definition
• The expected result of inflation is rising prices for goods…
• Which is exactly what the CPI reports

So, money supply is increaing, prices are rising, and new supplies are not coming online because our economy is actually shutting down. So, where is the deflation, exactly?

Asset Prices & Deleveraging

Valuation of assets have come down considerably, and people seem to want to call this deflation. We don’t think it is deflation, because we can still see rising money supplies, we don’t see rising goods supply, and we see the rising consumer prices just as we’d expect.

However, it is true that prices have fallen greatly in the stock markets and in housing. Other durable [and most all future financed] goods are seeing price declines, too. What all of these items have in common is that most of them are bought with borrowed money, or what finance people call ‘leverage’. Since the credit crunch, borrowing has become difficult and many people have been forced to sell some things to repay loans on other things, and this includes stocks that were bought with borrowed money.

Are Credit and Money the Same Thing?

With all this deleveraging, lots of credit has been destroyed. Banks are leveraged just like the people they loan money to, so when people who owe banks money default, then banks find the rest of their portfolio is now overleveraged, and they need to raise money to meet their own regulatory margin requirements.

The question comes up about whether credit is the same thing as money, and whether destruction of credit counts as deflation. I think the answer is “no”. Credit is the ability to make new loans, and thus the ability for banks to make new money. Halting credit is thus a great way to prevent new inflation, but does it actually destroy non-credit money out there? Not really.

Are Defaults Deflationary?

What about defaults, don’t they destroy money? Actually, they don’t. They can seriously impair the bank’s ability to keep lending new money, but the money that was lent before is already loose in the real economy. Default means that the loan will never be paid back, and thus that loan money will never be destroyed by the normal mechanism of debt repayment to the bank.

In the end, we don’t really need to answer these questions. Instead we can look back at the charts of money supply, goods supply, and general price levels to see if the gargantuan defaults and credit destruction of 2008 was deflationary. If money and credit are the same thing, we should find that the money supply, since it doesn’t include the credit part of the equation, was a terrible predictor of general price levels in the economy. But that’s not what we found. Prices are still rising, in general, except on assets that are bought with leverage, like houses and stocks and commodities futures contracts.

Money Velocity

Many people focus on money velocity, and I agree that it is important. The idea here is that if people have money but don’t spend it, then the economy behaves as if people didn’t have as much money as they do. So, this is a multiplier effect on how much money is in the economy.

This, in turn, is why people focus on “inflation expectations” — if people think something will be more expensive tomorrow, then they buy it today, but if they think it will be cheaper tomorrow, then why not wait? If all the money in the economy turns over 5 times a year, then we need five times as many goods and services than we would if the money turned over once per year. If it turned over that fast but we didn’t have the extra goods and services, then prices would probably rise as a result.

People that think we are in a deflation focus on the slow movement of money in our economy and claim that these forces are larger than the bailouts and the 8 trillion dollars of new programs the Fed and Treasury rolled out this year. And I would argue that these factors certainly have slowed inflationary outcomes quite a bit, which we can easily see by looking at the plunge in the CPI this past Fall.

The trouble with the money velocity analysis, in my mind, is that it only prevents an inflationary outcome as long as the money velocity can stay low indefinitely. The root inflation problem, however, is that the money got printed in the first place and set loose on our economy.

The deflation theorists claim that hoarding of cash prevents the inflationary outcome, but my rebuttal is to ask, “for how long?” Sure, money can be hoarded today, but the purpose of money is to buy stuff. Someday people who hoarded money WILL spend it, and that’s when the previous money printing will matter again. When is that day? I’m not sure, but I’m afraid we’ll find out in the next year or two.

The International Aspect

Our structural deficits with China and oil producers have a huge impact on our daily lives, even though most of us don’t realize it. The reason we’ve been able to overconsume and underproduce for so long is that our currency is still the world reserve, and no viable alternative has been identified yet. It may also be due to China’s reliance on food imports to feed their massive population.

Essentially, we’ve imported goods from China, and exported inflation to China. Is that sustainable? What if China decided they can do without our food exports? What if their economy collapses and they can’t afford to buy our paper to keep the U.S. Treasury bubble going? Can this imbalanced situation last forever, or has something got to give? And if the latter, what will happen when something does give?

Really, this turns out to be the same kind of thing that we saw with money velocity. China is adding goods to our economy, and sucking money out of it. This is a powerful deflationary force on the U.S. in the present, but the dollars are being pent up in the Chinese central bank (and other nations, notably energy exporters). Those dollars don’t disappear, they just sit there and wait.

Importing deflation to mask heavy inflation

In other words, the U.S. economy has been inflating like mad all this time, but only seeing small price increments in comparison to the true structural deficits of our domestic economy. Deficits DO matter because they indicate that we, as a nation, consume way more than we produce. The only reason they haven’t appeared to matter is because China and other nations have been able and willing to allow us to export our inflation to them. Will that last forever? It is hard to believe it could.

The trouble with the financial crisis of this past Fall is that it might lead to a serious disruption or complete breakdown of the dollar standard and the international banking system. At that point, countries might become unwilling or unable to finance our continuing deficits. If that happens, we’ll begin to actually experience the current inflationary effects of our deficit-financed lifestyles, but we also may see all that foreign central bank cash flowing back to our shores in a run out of the dollar.

So, have We Experienced Deflation?

So, the answer to this essay’s question is “no”, we have not seen deflation. Yes, asset prices have fallen as people hoard the new cash that is being printed and scramble to cover their terrible and highly leveraged bets. Yes, money velocity seems to be a bit lower as people who can save or cut debt have started to do so. We may even see a bit of deflation in the future, depending on whose numbers you believe. But, so far the money supply is still growing, domestic output is not increasing, exports are shrinking, imports are also shrinking (but not as fast), and the general price levels are still rising, even by the understated government reports.

Deflationists like to pretend that in order to have inflation, we absolutely must have the 1970’s wage-price spiral, or that we could only have inflation if the stock market is rising, or something else. They argue that printing money can’t create inflation without a special “mechanism” to get it out into the economy. Well, there are a pair of special mechanisms. The people who get the printed money can just SPEND it or LEND it. While neither is happening in overwhelming amounts today, there is no reason to think they will never happen in the future.

Part of observing a collapsing financial system is to understand that some of the old models are going to break or give false readings. The economic models we’ve used for the last 100 years were designed and tested during periods of increasing resource availability. The only time America didn’t have increasing resources was during the 1970’s. This was after the U.S. peaked in oil production and but before the globalist response started to bring foreign resources to America in exchange for dollars. As that globalist system breaks down due to scarce resources everywhere, the models built against the backdrop of growth will keep giving false readings like the ones deflationists are getting today.

The real danger is still inflation. The problem isn’t that we might hyperinflate our currency in the future, it is that we may have already done so — that we’ve abused our dollar’s reserve status so much in the past (especially the recent past!) that a hyperinflationary outcome may have already been guaranteed. We could stop it if we found a new and plentiful resource of real wealth to match the dollars we already printed and stashed in the world’s central banks, but the meaning of peak oil is that such a find is not going to be possible.

It is hard to predict what will happen with China and our oil supplier nations, but it does seem unlikely that they will continue to give us something for nothing. There is an old saying that when goods don’t cross borders, armies do. At this point, war may be the only way to extend the dollar’s reign as the world’s reserve currency and avoid a hyperinflationary collapse of the dollar.

There is a lot of talk about deflation out there, and I think lots of people in our group take that seriously — and I do too, as one must during crisis times — but our special understanding of the oil based economy allows us to come to different conclusions about the global financial situation. Dollar hegemony is based on the petrodollar system because with a weak U.S. economy and no gold backing, there is nothing else for that hegemony to stand on. This is why we stopped food-for-oil, why we are in Iraq/Afghanistan, why we do much of our foreign policy.

Global dollar hegemony is the method we use to collect our empire tax from the rest of the world, and the petrodollar system is what makes it possible.

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