The Case for a Global Deflationary Collapse and Its Impact on Hong Kong

Ok. This is going to be a long and detailed look at the case for deflation, rather than bombarding the HK property thread, I thought I create a new thread for those interested and perhaps can agree or refute the following arguments, because the case for inflation is so very logical and straight forward, any simpleton can side with that argument and easily overlook the case for deflation. The case for deflation is 3 fold, and I credit Robert Prechter for these insights:


1) This is a cartoon documentary "Money as Debt", you really have to understand how our debt based monetary system works in order to appreciate deflation.


http://www.youtube.com/watch?v=jqvKjsIxT_8


The fact is our banking system is one which is based on deceit, meaning the banks don't actually loan out your deposit, they counterfeit (legally), by lending out credit (money) they do not have, its called "fractional reserve banking". Credit (debt) only comes into existence when someone takes out a loan from the bank. Suppose you wish to borrow $10,000, the bank will pledge $1000 of its own money as collateral, and literally print the other $9000 into existence, under a capital reserve ratio of 9:1.


Again depending on the capital reserve requirement suppose 9:1, your $10,000 deposit can allow them to lend out $9000, and if the process is repeated ie $9000 re- deposited, ultimately you get close to 100 times the original amount, meaning that $10,000 could end up having thousands of people laying claim to it, hence the term "credit" or "IOU".


Whats this got to do with deflation? the takeaway from this is, if there is no borrower, there can be no money/debt, so when people say the Fed prints money, making credit available doesn't necessarily induce inflation, if suppose I had a printing press, and I dig a hole in the garden to bury that money, does that cause inflation in the economy? asset prices more often than not rise on the news. Furthermore, the consumers in the USA are all indebted to the limit, how much more debt can be taken on when their house is already gone? surely the end game is near, and when credit stops growing, it contracts because the economy would be slowing, driving people to save money and extinguish debt by paying them off. Look at the plunge at M3 from 2008 to 2010:


http://www.shadowstats.com/charts/monetary-base-money-supply



2) The idea the Fed can stop deflation is flawed. Despite QE1 and QE2, right now the Fed's balance sheet is a puny $2.9 Trillion of liabilities.


http://www.dailymarkets.com/stock/2012/09/21/us-fed-balance-sheet-to-grow-5-to-2-9-trillion-end-2012-cleveland-fed-study/


The US government right now, has a total outstanding debt of $60.9 Trillion, including all unfunded liabilities:


http://www.justfacts.com/nationaldebt.asp


Better yet, the total outstanding notional amounts of derivatives is around $600 Trillion, and this was back in 2007.


http://en.wikipedia.org/wiki/Derivatives_market


A quick glance at the figures, you ought to question, is the Fed going to be able to stop the deflationary collapse of credit by taking on close to $700 trillion or over 230 times its currently "oversized" $2.9 Trillion balance sheet? would the board members not object to this insane idea?


As a reminder, the Fed is ultimately a private banking cartel that would seek to preserve its own existence.


3) Assuming the Fed was crazy enough to monetize all the above debt, what would foreign bond holders do? they would dump bonds like there will be no tomorrow, interest rates would soar, the end outcome would still be deflation.


Furthermore, say a collapse in credit of $700 Trillion is immediate monetize by a newly printed $700 Trillion, (-700T + 700T) net ie 0, would still produce no inflation,

again absent borrowers, the new money cannot multiply as credit via its reserve ratio into the real economy.


The impact on Hong Kong and HK property is obviously deflationary, furthermore, given such extreme situation, hedge funds love to prey on these circumstances. I would hold USD cash notes, and not HKD because I fear like in 1997, George Soros may attack the HKD, the government can only defend the peg with its own FX reserves of USD, but if a bigger collapse than 08 is coming, most banks would scramble for USD, ie selling HKD for USD, the HKMA will do the opposite to defend the peg potentially unraveling the peg by exhausting the HKMA's own pool of USD reserves, and devalue the HKD denominated assets along with it, including real estate.

I almost stopped reading when you mentioned Robert Pretcher. Even people who gave their money to Madoff did better and you could have made a fortune by doing the exact opposite of Pretcher's recommendations over the last 25 years: http://www.erictyson.com/articles/20090616


Putting aside Pretcher's utter lack of credibility and incorrect emotive language like "deceit", the deflation argument is (partly) correct in that if fractional reserve banking goes into reverse because of the lack of new lending then the overall money supply will contract. However, it does not follow that this leads to recession (or worse) as the contraction could be largely directed at financial markets (such as derivatives) rather than into the "real" economy where goods and services are purchased. The opposite of this has happened with QEternity where much (most?) of the stimulus has ended up flowing into financial assets (equites and bonds) or foreign markets (food inflation in the third world) rather than into the "real" domestic economy. There is also the velocity of money issue to consider.


Conclusion? It could happen this way but it doesn't have to.

Late on my reply, just came back from overseas.


@ TI, you haven't addressed any of the arguments above. Character assassination isn't really an argument, on the contrary its weak.


With regards to Mr Prechter, I could easily find links to support his case, such as this:


http://seekingalpha.com/article/227384-dow-1000-robert-prechter-thinks-so


Like I said before, if you Google any analyst enough, your bound to find negative comments, so lets focus on his arguments for deflation. For example, if you think he is incorrect, how do you refute it? I mean if the USA which has a debt of 60 Trillion will not have a deflationary collapse, how do you suppose they address their spending? do you expect them to continually get further into debt into infinity and beyond? and how do you suppose they would pay off the Chinese and the Japanese which holds 2 Trillion and 1 Trillion in US Treasuries respectively? if not by defaulting and hence deflation, how on earth do you expect them to pay it off if like you said "It could happen this way but it doesn't have to"??


With regards to the word "deceit" on our debt based monetary system, these are my words not Mr Prechters. Its not emotive, but it is factual. I don't know if you watched the "Money as Debt" doc link posted above, but basically it says if I have 1 ounce of gold, and I issue 100 receipts against the claim on the same 1 ounce gold, isn't that an act of fraud or deceit? that is exactly how our debt based system works under fractional reserve banking, albeit the claim is against the money deposited in paper, not gold.


Anyways, here is a video that drives the message home, "The Economic Collapse for Dummies":


http://www.youtube.com/watch?v=sKqWmI5AGto

I've seen some commentary from Dent... I think he's got it correct re: the macro picture in the US... the QE and other stimulus is just delaying the inevitable.

@ ltse - I agree that I focused on Dent's awful track record rather than the argument. However, it is very hard to take someone seriously who has been so wrong so often. The fact that peoplle who followed his advice would have lost 98% of their capital over a length time period when both bonds and equities gave investors positive real returns (see the link I provided above) just about says it all. Like any person who makes a living out of making predictions about the future and associated investment recommendations I will take a long hard look at their track record before I decide how much weight I shoud give to their advice. It would fo course be a mistake to focus on the few predictions he got right - make enough predictions (like Dent does) and you are bound to get a few right. You have to look at his track record as a whole.


To address the argument, the deflation case made by Dent (and many others) rests on one of two assumptions:


1. only the money printing by central banks has prevented deflation from occuring already. If they stopped printing we would have a deflationary collapse. This arguement can be safely dismissed - the chances of the cental banks stopping printing before a retrun to acceptable levels of unemploment or unacceptable levels of inflation is close to zero


2. the money printing by central banks is insufficient to overcome the deleveraging that is going on in the rest of the economy. This could happen. I have never said that delfation will not happen, only that I believe an inflationary scenario is more likely. A point which is often overlooked is that delevergaing is not an infinite process - it will come to an end at some point. In some countries, there hasn't actually been any deleveraging (yet).


As an aside, three points for deflation which are seldom mentioned are (i) advances in robotics which will reduce the demand for low and medium skilled manufacturing jobs and (ii) the possibility of increased barriers to trade being imposed as increasingly desperate politicians attempt to appease local voters and (iii) the adverse impact which higher taxes will have on consumer spending - higher taxes are, by definition, delflationary.


The counter arguements for rest on the following:


1. the world population is still growing. More people means more demand for goods and services

2. although still uacceptably high, global poverty levels have been falling for many years now. This means that more people are shifting from a "subsistance" level of economic existence to a point where they can and are spending money on consumer goods and services

3. the global middle class is growing (unlike the US and a few other places where it shrinking). The number of people who are able and willing to spend on better food and a variety of consumer goods and services is growing and is expected to keep growing for at least the next several years

4. many non-agricultural commodities are being consumed faster than the rate of new discoveries and the marginal cost of production has been rising rapidly. Also, many key resurces are in politically unstable places creating vulnerability to supply shocks. In effect #3 is rising demand and #4 is inelastic supply

5. in addition to the imapct of rising demand on food products, the impact of environmental degradation + limits in the potential for further crop improvement mean that the ability to increase food production to meet the rising demand is somehwat inelastic

6. central banks will keep printing money as long as there is a threat of deflation. More money in existance without a corresponding increase in the amount of real goods and services menas that the money is worth less

7. governments cannot repay the huge debts they are continuing to accumulate - their best chance of avoiding a collapse is to inflate away the real value of what they have borrowed. They will keep printing to achieve this.


There are a few other points on the inflationary side as well but the above are the main ones.


On the debt based monetary system, fractional reserve banking has nothing to do with multiple claims against the same asset. Factually, they have nothing to do with each other. The former is the consequence of money being circulated in the economy (aka the multiplier effect) and the latter is an act of fraud. They have nothing to do with each other. By making this claim, all Dent has done is demonstarte that he has zero understanding of how banks work. For the record, part of my job involves looking at the regulation of bank capital and what banks can and cannot do with the assets that they hold so I am very familiar with this issue at a professional level. The days of people like Andrew Dexter (who was one of the causes of America's first banking collapse) are long gone. Banks are regulated, audited and subject to inspection by regulators on a regular basis. Just like any business, they can and do fail from time to time but their ability to repledge the same assets multiple times is virtually nil.


As I have said on a few other posts, I don't rule out a deflationary scenario but believe that for the next few years at least, inflation is more likely. And, of course, just like anyone else, I could be wrong so I am not betting my life savings on one particular outcome.