Guest Author: Jeffrey Dow Jones is a registered investment advisor with Jones & Company which has managed a family of hedge funds for 27 years. Their flagship fund, High Sierra Partners, is currently the #1 ranked fund of funds with a track record greater than ten years in the HFN Multi-Factor Ranking Database. Jeffrey is also a partner at Draco Capital Management and publishes a free weekly investment newsletter, The Draconian. This article is the first of a three-part series. Read Part 2 and Part 3.
The Legend of El Chupacabra
A lot of us folks in Nevada are of Mexican or Latino descent and so around these parts we grow up with our own unique mythologies. All you readers from back east, up north, or overseas may have to indulge us for a moment as we dip into some ghost stories you might not be familiar with.
Every farmer throughout the Southwest and Latin America is familiar with the legend of El Chupacabra. Possibly originating in Puerto Rico, El Chupacabra has haunted the desert hills and tropical jungles for generations, preying on farmers’ herds. Reports of Chupacabra differ. Some people claim he hops on two legs and others say he prowls on all four. Some say his skin is scaly like a reptile and others claim it’s smooth and furry like a panther. Theories on his origin are equally diverse with some folks believing him an extra-terrestrial or alien-hybrid while others claim he is descended from wild beasts.
While his appearance and heritage vary from story to story, a few things do not. The undeniable common denominator is slain livestock – goats and cattle riddled with with puncture marks and drained of all their blood. El Chupacabra literally means “the goat sucker” in Spanish, and whether the creature is imaginary or not, these slayings are very real. What’s also very real is the fear he leaves in his wake, even while his existence is left up for debate.
Today a similar story is being passed around the marketplace, frightening participants that massive future inflation is in our country’s future. Given the unprecedented recent government intervention, stimulus programs, bailouts, and good ol’ fashioned money-printing, it’s hard to make a case that all this won’t have a severely inflationary effect. “Future Inflation” is almost certainly the consensus view at present, and that view has generated undeniably tangible fear.
But like Chupacabra, the real picture is a lot less straightforward.
A brief, non-academic primer on inflation, deflation, and the effects thereof
Inflation in the classic, economic-textbook sense means “too many dollars chasing too few goods.” In a literal sense, it’s what happens when there are too many dollars in the system. But the way it makes itself apparent is through observably higher prices. Inflating prices means that the value of an individual dollar erodes. There was a time when I could buy a box of Rice-a-Roni for a dollar. Today it costs me quite a bit more.
Like the Chupacabra, inflation sucks out all the value from your stack of dollars. And just as the the Chupacabra gives frightened goat farmers motivation to swap their herd for a field of alfalfa, immune to the dangers of the night, inflation creates an incentive for consumers to exchange their dollars for hard assets – stuff like real estate, gold, commodities, and physical goods – that are immune to the effects of inflation. Their price goes up to compensate for cheaper dollars.
In a monetary sense, it dissuades people from lending money because in the future, they will be getting paid back with cheaper dollars. So lenders expecting ever-higher prices only want to lend at high interest rates.
Deflation is the opposite, where the value of each of your dollars increase relative to other assets. More valuable dollars might sound really cool, but the problem with dollars that become more valuable is that the price of everything else is going down. It takes fewer dollars to buy a house, to take your wife to dinner and a movie, or a stock your dorm with boxes of ramen noodles.
Falling prices create a major incentive to hoard money – why buy that new car today when it will be cheaper a few months from now? Stock prices go down too, wrecking the balance sheets of things that hold stocks like investors and pension plans. Real estate prices fall, straining personal balance sheets and creating a precarious situation for the banks that have collateralized these properties. Loaning money can be really great in deflationary environments because as time goes by you’re getting paid back with more valuable dollars. Awesome! The problem, of course, is that interest rates have to be low for borrowers to take that deal.
Since we moved off the gold standard, the policy pursued and the reality that we’ve witnessed in the U.S. should be described as “generally inflationary”:
The deflation that we have seen over the last year is the first time significant deflation has crept into the system in the last 55 years. As you can see, it doesn’t happen very often, especially with the modern Fed at the wheel of the monetary policy bus. Since the creation of the Federal Reserve in 1913, the value of one U.S. dollar has decreased by about 95% relative to the basket of goods it can purchase. In the year 2113 when robots are not just vacuuming our floors but driving us to work and baking us meatloaf for dinner, count on your dollars being (at best) 95% less valuable than they are today.
With the Fed and their moderately-inflationary mindset at the helm of monetary policy, inflation seems like a pretty safe bet for the future, right? Especially given the epic debt issuance and heroic government spending measures of late, right?
Well, not so fast.
Making Sure ‘It’ Doesn’t Happen Here
To the uninitiated, the “it” refers to “deflation”, and that phrase above was the title of a now-famous and oft-cited speech that current Fed Chairman Ben Bernanke gave to the National Economists Club back in 2002 about how to avoid the perils of deflation and the mistakes of Japan.
Almost to the paragraph, that speech has served as the roadmap for current U.S. policy making, describing all the tools available to fight inflation should the Fed Funds rate go to zero; it’s almost eerie to go back and re-read that speech today.
You may or may not be aware that in the late 1980’s Japan had a gigantic bubble in their stock market and also a gigantic bubble in their real estate market. Growth in Japan was initially driven by real developments in technology and revolutionary new methods of manufacturing, but eventually credit became incredibly easy to obtain and speculation would run rampant as seemingly everybody in the world wanted to invest in Japan. Anybody remember when the imperial palace in Tokyo was worth more than all the real estate in California? Or when large, horizontally and vertically integrated banks and other conglomerates, known as keiretsu, dominated the economic landscape? Everybody wanted to be like Japan.
But as bubbles do, theirs inevitably burst. And heavy-duty deflation was what they had in the wake of those bubbles bursting. The Bank of Japan (their version of the Federal Reserve) slashed rates to zero percent, bailed out all their failing banks, adopted a policy of quantitative easing, and tried a bunch of other creative stimulus measures.
Any of that up there sound familiar?
It should, and it should give you the willies because while everybody wanted to be like Japan, nobody wants to wind up like they did:
The red line is their stock market and the blue line is their inflation rate. That’s twenty years of “zeroflation” and a stock market now worth one fourth of what it once was. That chart may look unremarkable out of context, but consider that for the last twenty years, Japan has been doing everything it can to ignite a little inflation and get its real estate and stock markets back up again.
But nothing that they’ve done has worked. None of it was enough. Low interest rates didn’t re-stimulate lending. The bailed out banks who couldn’t be allowed to fail just became “zombie banks” that had no business being in business but stayed alive through the government’s backwards alchemy of support. And neither the quantitative easing nor the stimulus measures encouraged the population to do anything more than save their money and pay off their debts.
There’s a chance that a few years from now this might sound pretty familiar to us as well. I certainly hope not. Could you imagine a stock market worth half of what it is today? Or your house, already half the value it once was, cut in half again?
In Bernanke’s speech, he faults “Japan’s massive financial problems in both the banking sector and private sector, the large overhang of government debt, and the longstanding political debate about how best to address Japan’s overall economic problems.” At the time Bernanke gave that speech, none of those risks were present in the U.S., and thus it was believed that his inflation-fighting toolbox would enable the U.S. to succeed in any potential battle against deflation. But as you can see now, with our massive private-sector financial problems, our gigantic wad of government debt, and our an increasingly contentious debate about how to get the economy rolling again, we’re a whole lot closer to circa-1992 Japan that we ever thought we’d find ourselves.
Deflation in the U.S.?
The U.S. Treasury and The Fed have acted the way that they have, stimulating the economy and forcing money into the system in order to stave off deflation, the true economic nightmare. If inflation is the Chupacabra, sucking the value out of each dollar in the system, deflation should recall Lovecraft’s Cthulu, a beast far more terrifying, far more destructive…and far more difficult to imagine actually being real.
In the midst of their liquidity trap Japan was getting plenty of unsolicited advice from economists around the world, especially the U.S. One of the most notable voices at the time was that of Princeton University’s Paul Krugman (recently a recipient of the Nobel Prize), and his novel suggestion had less to do with actual policy measures than the proper attitude for the government to adopt, one more focused on the future than the present.
In short, the Krugman argument was that despite all the theoretically-inflationary measures employed by the government and BOJ, the Japanese kept saving because they doubted the long-term commitment to inflationary policy making. The mindset was, “why spend or invest money now, trading our Yen for real assets, when the government will just stamp out inflation as soon as it reappears, possibly throwing our country back into deflation and wiping out the value of the real assets we purchased?”
That individual mindset wound up being a self-fulfilling prophecy for Japan, and this is a risk for the U.S. right now, too. Americans might say that these massive government stimulus measures will bring about inflation, but they aren’t currently acting in accordance with that belief right now and there’s a very good chance they may not in the future.
So why not? The answer lies in our psychological anchoring to the recent past. It’s been almost 80 years, nearly four generations, since we’ve had a genuine deflationary crisis. Deflation is, for most Americans, a largely academic and imaginary problem, not unlike Cthulu. But we haven’t yet forgotten the inflation of the 70’s. It wasn’t that long ago that we actually lived through it, and today we still hear stories handed down from that era just as our cousin’s wife’s grandfather’s ranch hand actually saw El Chupacabra in the hills above his goat farm! (Assume, ye non-believers, for the simple sake of argument that Chupacabra is real.)
Perhaps even more importantly, and more relevant to the debate at hand is is the fresh memory of the unforgettable lesson that Paul Volcker taught us: we can stop inflation if we want to. High interest rates and tight monetary policy whipped inflation right out of the system in the early 80’s but it cost us a nasty W-shaped recession and the highest level of unemployment since the Great Depression. The period since that discovery has been dominated by expectations of moderate inflation, and until the Fed actually demonstrates that it can’t stop inflation or abandons its commitment to aggressively fighting it, future inflation expectations should remain permanently modest.
Inflation is coming! Inflation is coming!
We all might run around and squawk “Inflation is coming! Inflation is coming!” But none of us are acting as though we really believe it because deep down, we know that once inflation starts to heat up, the Fed will raise rates and reign in all these inflationary measures. Generally, nobody is seriously panicked about all this massive government spending and stimulus because we believe Bernanke, Geithner, & Co. when they tell us that they have an exit strategy and will make the proper adjustments to correct the negative long-term effects of their current policy.
So why not keep saving and paying down debt? Ultimately, we do believe that the value of these dollars relative to other assets will be protected over time and inflation won’t get out of control. No need to exchange all these dollars for hard assets. The Fed’s commitment to long-term, stable monetary policy is unfortunately working against them at present, stunting the effect of these historic recent measures, all geared to reignite credit and get people spending money again.
The U.S. isn’t taking its own advice, the same advice it gave Japan as it was struggling with deflation. Namely, that the government should explicitly signal to the public that they’re open to allowing inflation to run a little hotter and for a little longer than they have historically allowed in an effort to re-inflate the price level back to where it would have been under a normal, moderately inflationary environment.
That’s an immensely powerful concept. It’d get you exchanging your dollars for physical assets in a hurry, wouldn’t it! Under that framework, halting deflation in theory seems almost as easy as halting inflation in practice.
Myth or Reality
The next time you make the seemingly-obvious claim that a bunch of inflation is in our future, try and find a way to reconcile that statement with your knowledge that there are central bankers around the world who toss and turn every night with spooky inflation nightmares – these are guys that truly believe in El Chupacabra – and are eager to beat back, Volcker-style, any inflation that gets a little beyond control. If you need a little more convincing, go back to last month and read the minutes of Chairman Bernanke’s semiannual testimony before congress. He iterated and reiterated not only The Fed’s commitment to fighting inflation, but again talking up all the clever tools they have to win that fight.
A few weeks ago, you may have been scratching your head as to why long rates remained under control and why the TIPS/Treasury spread is pricing in only 2% annual inflation growth for the next decade. This is why. The bond market is really, really smart. Listen to it. Right now it’s telling you that deflation is still a present reality and a future risk, and should inflation crop up during the next decade, there is faith that it will be kept under control.
We might claim that we’re worried about the Chupacabra coming to eat our goats and we might claim that we’re worried about future inflation. But we don’t believe in either. Not really. We keep farming goats and holding dollars. The inflation Chupacabra at present remains a myth, a scary story that we share when we huddle around the campfire on moonless nights. As everybody knows, the best ghost stories are the really believable ones, and it’s possible we’ve given ourselves one heck of a fright. Right now, out-of-control inflation, however eerily believable, could turn out to be nothing more than a ghost story.
Inflation and Deflation, Part 2: Captain America and the Bond Vigilantes by Jeffrey Dow Jones
Inflation and Deflation, Part 3: A Blueprint for Disinflation by Jeffrey Dow Jones