Thursday, October 23, 2008

Deflation vs. Deleveraging

There has been a lot of talk in the news recently about the new deflationary scare taking hold of the markets. As the stock market began to crash in 2000, many people were having the same conversations. In order to respond to this crisis, our former financial leader (who happens to be taking the stand today) Alan Greenspan decided to lower interest rates to 1% and hold them there for years. This took care of our "deflationary" problem.

Unfortunately, no one understands what they're talking about before they even start the discussion. The definition of:

Inflation = An increase in the money supply

Deflation = A decrease in the money supply

Prices rising is not inflation, it is a symptom of inflation. Prices can also rise because the value of a currency falls, causing imports to be more expensive. Prices can also rise because the supply of goods falls relative to the amount of currency in the system.

Prices falling is not deflation, it is a symptom of deflation. Prices can also fall because the value of a currency rises, causing imports to become cheaper. Prices can also fall because the demand of goods falls relative to the amount of currency in the system.

What we are seeing today is an explosion in the money supply. The Federal Reserve teamed with our government, are printing money at an unbelievable pace. The following chart shows the year over year increase in the money supply:



As you can see the percentage increase of dollars entering the system is rising at an unbelievable rate, about 12.5%. (M3 shows total money entering the system, it would take me a while to explain the difference between the three M's and I'll do so at some future point)

But why are prices falling? Is is because of deflation? No, it's because of deleveraging. Right now banks, hedge funds, a few companies, and some every day people are having to sell everything possible to stay solvent.

Hedge funds leveraged themselves up 30 to 1 over the past few years with mortgage securities. They have to keep a certain percentage of equity to assets or they are considered insolvent. The best way to think of this is to imagine that you bought a $500,000 house with no money down. The bank then calls and says they need to see that you have $50,000 in cash in order to keep your mortgage. You have no money saved because you were not planning on getting that phone call. So what do you do? You can either declare bankruptcy, or you can sell everything in your 401K, your gold, silver, commodity stocks, cars, clothes, children, and pets.

That's what the hedge funds and banks are doing right now and it's driving the price of EVERYTHING down. There is no market for mortgage securities right now. (Except for what the government and the Fed are putting on their books) The marketplace will not buy them at any price. In order to stay solvent and cover the losses, they have been forced to irrationally sell everything they have, including their best assets.

This is giving the Fed the opportunity to print money in amounts unimaginable only a year ago, and it is allowing the government to go into debt at a blistering pace. This, they say, is all to protect the country from the horrible prospect of deflation.

Trades are settled in the short term into cash positions because *right now* the dollar is the world's reserve currency. Also, a tremendous amount of money has come out of the markets and gone into cash as part of the deleveraging process for companies and individuals. This has irrationally pushed the dollar's value higher in the short term and irrationally pushed the dollar value of many assets lower in the short term. It has given what could be one last amazing opportunity for investors to exit the dollar before the currency begins its final collapse.

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