Special Report
Deflation And The Liquidity Crunch:
Update 2001
Part I
Unbeknownst to a new generation
of be-boppin' baby-boomers, the seeds were being sown for their
new-millennium experience with deflation and a collapsing speculative
bubble before they were even born.
When most were mere teeny-boppers, many would
demonstrate against the possibility that decisions by the powers that
be.similar to those that led to wars of the past.could, in turn, be made
again, helping sow some seeds for their heretofore unknown 2000s
experience. And in the 1970s, another major decision was made
that would later affect the lives of those baby-boomers, and every
consumer on the globe: the gold exchange standard was
dropped.
Today, this generation relearns two of history's
greatest lessons.lessons that will affect their lives and the lives of
their children and their grandchildren in ways that are still being
defined by the market's everyday action: the lessons of the bursting of a
speculative bubble, and yet another cycle of global deflation.
Again, it was thought in this modern age by yet another
generation of humanity that neither deflation nor a speculative bubble
could occur, let alone result in a financial market bust that would cause
the steepest plunge of any stock index in history (70% in the NASDAQ
Composite Index through April 4, 2001). Even now, with Japanese
Finance Minister Miyazawa announcing in March that he feared his country's
economy.the second largest behind only the United States.was on the verge
of a deflationary collapse, many deny that deflation exists now or will
ever exist.
What is this ugly monster called "deflation" that
sends people into to much denial that the very denial of entire societies
actually execrates the problem they fear? I have addressed this
issue several times in special reports during the past twelve years,
beginning in December 1988 with a report called "1989 And Beyond."
Since then, even as we had forecast a great bull market in stocks and
bonds to take place in the nineties (see February 1991 issue of The
Global Market Strategist.), I would send periodic updates regarding
the great deflationary collapse that would follow the megabull, and the
reasons behind it.
The chief reason? The world dropped the gold
exchange standard and launched all of humanity on the first peacetime
experiment on a fiat currency (not backed by a monetary commodity)
system. Never before had a country or the entire globe been on a
paper currency system for an extended period of time that did not involve
war. Research back into the Roman Empire reveals that a
gold/commodity standard, and in the times to which we have now chosen to
call "Before Common Era," has always existed except in wartime.
The resulting fiat currency system devised in 1971 has presented central
bankers with more discretion than they can feasibly manage, creating
structural problems within the global monetary system that is contributing
to the modern day version of deflation and currency collapse.
Post-war reconstruction comprises another key reason
this latest episode of global deflation is occurring. The so-called
Western economy was created on the foundation of the U.S. dollar as the
world reserve currency, and on U.S. economic constructs that are difficult
for emerging economies to manage in this unifying global economy.
Thirty years after the gold standard was dropped, this paper foundation is
ripping.
Now, in April 2001, we update the situation in the
days after Japan narrowly made it past their March 31 fiscal year and its
new laws for valuing assets of its banking system. Despite evidence
of a global stock market recovery, the world stands on the brink of a
serious deflationary spiral and collapse of the monetary
system.
Part II
What Is
Deflation?
In our fall 1997 report, "Forecast 98: The Global Meltdown of
1997.What Is Happening and Why," we detailed the progress the globe
was making in its efforts to integrate the global economy and to
unify. Because of the diversity of component economies, governments,
and degree of experience in managing a fiat-currency based monetary
system, the global economy has run into severe structural problems that
actually began with the creation of the post-WWII economy and the
rejection of the Gold Exchange Standard in 1971. Basically speaking,
it is the currencies of each country that form the common link the
individual countries of the newly integrating global economy have to each
other. Countries of the world cannot unify their economies, and therefore
cannot participate in increased prosperity through world trade, unless
they properly manage their currency, and the structural problems are now
manifesting themselves in a big way.
The following was written in the fall of 1997 from our Forecast '98
Report, and remains a good illustration of what is happening now:
The problem the global stock market crash of 1997
exposed can be described, perhaps at the risk of oversimplification, as
one of overlending and excess speculation brought about by investor,
corporate and government complacency. As we discuss, the resulting
"adjustment" of the financial markets is deflationary and a very serious
threat to the prosperity of the countries involved, and is typical of
the end of the Kondratieff Long
Wave economic cycle of boom and bust.
I have long written on the pages of The Global
Market Strategist this decade, and before that for The Elliott
Wave Currency and Commodity Forecast, that the problem as we
approach the 21st century will be global deflation and debt default, not
the fear of inflation expressed by most people. For them, memories are
too short to remember the deflation of the 1930s, or even the deflation
of the 1990s that has plagued Japan. The problems the world now sees in
Asia are more like those of the 1930s, not of the "salutary" effect of
the Crash of '87.
Inflation is a monetary phenomenon and
occurs.again at the risk of oversimplification. when too much money
is created and prices rise. Money can be created not only by an
expansion of the monetary base by a central bank through its open market
operations, but through an increase in bank lending. In other words,
every time a bank lends money, the total money in circulation in that
country increases since, in the U.S. for example, Federal
Reserve-dictated bank reserve requirements typically require a bank to
have on deposit in its vaults only 10% to 15% of the amount of a loan
that is created. The rest did not exist before the loan was created.
When long-term prosperity has been experienced, overly optimistic
(irrationally exuberant?) banks tend to lend too much money to
customers. Thus, inflation is not just a situation in which commodity
prices rise, but a situation that occurs within the monetary base of a
country.
On the other hand, deflation occurs after too much
money has been created by excess lending and borrowers cannot pay
back their loans. The resulting defaults are, therefore, deflationary
because the money that the bank created through its loans was not paid
back, and money circulating in the monetary base is destroyed. Thus,
bank loans and inflation create money, and debt defaults and deflation
destroy money. When money is destroyed, it is literally taken out of
circulation-the opposite result from that of loan creation.
As we have proven in our report, Gold In A Deflationary
Economy, there have been just as many deflationary cycles as
inflationary cycles over the past four centuries. The forces
powering inflation and deflation in their respective cycles are global
in nature, and therefore, each time the deflationary cycle comes around,
most countries not initially caught in the commencing downward spiral
don't feel they will be affected since there is not yet much open
evidence that deflation exists in those countries.
To the imploding countries, the deflation is very real,
and it typically occurs in three major phases, each squeezing its hold
on an economy more than the last:
- Asset Price Deflation
- Commodity Price Deflation
- Monetary Deflation--the destruction of the monetary
base
For more on this, see the section of this report
entitled "Pacific Rim.
The problem in Asia began in Thailand, when excess
lending and speculation began to result in a structural breakdown in the
economy such that investors lost confidence and market prices began to
fall. Banks in Asia, Indonesia, and Hong Kong had reportedly increased
the number of 100% real estate loans in the recent past, transferring
the risk from the real estate buyer to the bank and thereby making the
bank the speculator instead of the buyer. When real estate values
decline, so do the assets of the lending bank. Thus, a $100,000 loan on
a property that is falling in value to, say, $70,000, puts a $30,000
direct loss on the bank. This means the property is
under-collateralized, and the bank must call the loan. Most often, the
buyer defaults, and the bank must try to liquidate the property in a
plunging market at a deep loss, threatening the solvency of the bank.
When this occurs on a large scale, and when global investors lose
confidence in the financial markets of a country that has thrown caution
to the wind, currency and stock markets plunge, further exacerbating the
situation.
When Thailand began to melt down in July 1997, pressure
on neighboring Asian countries sent currency and stock prices reeling.
The problem spread to other countries with marginal abilities to
prudently manage their fiscal affairs, and when global investors and
financial concerns realized that overlending and excess speculation had
occurred in Hong Kong, too, the Hong Kong dollar also came under
pressure. As we have written many a time, when a country's currency
destabilizes, a ripple effect destabilizes its other financial markets
and a flight capital episode occurs during which global investors seek
to head for the exits before a meltdown occurs. Thus, Hong Kong's stock
market collapsed, too, as the memory of Japan's similar bubble-burst
meltdown of earlier this decade reminded investors of what it is like to
overstay their welcome in a financial market that is simply
overpriced.
Add to all of this the fact that Hong Kong had just been
assimilated into a new government, the Chinese, and the uncertainty of
how a centrally planned government like China new to the wild gyrations
of a western-type financial system would handle such a thing, and the
formula for a genuine crash of 1930s proportion existed come October
1997.
Although the American and European stock markets will
very likely survive this bout of Asian meltdown by eventually making
record highs without breaking their October 1997 lows, the global
deflation/meltdown problem and the challenges of global unification are
far from over (and, as we've maintained, are far worse than the American
government and media are portraying). The next time the U.S. market
crashes, it will not come back so readily, and many, many investors who
remain in denial or who refuse to inform themselves of exactly how the
financial markets operate and fluctuate, will be hurt very badly. Until
then, between now and the 4-year cycle low due at the end of 1998, the
fiscal, monetary, and lending policies of every country on this globe
will be closely scrutinized and marginal countries will see the flight
capital episodes much like Mexico 1995 and Asia 1997 again. We have not
seen the last of economies that will melt down. We can only express a
certain degree of sorrow over the "irrationally exuberant" method of
investing that stock market investors of the late 1990s have chosen to
manage their investment strategies. As we have indicated in the recent
past, it is much better for a market to back and fill, and stage
"normal" corrections along the way toward years of bull market record
highs than to invest for the sake of investing without maintaining a
systematic strategy to manage the risk/reward equation in one's
portfolio.
...continued
Dan Ascani
©2001 Ascani's Global Market Strategists, Inc.
P.O. Box 5309, Gainesville, GA USA 3
http://www.gmstechstreet.com
24 August 2001
Printer Friendly Version
Email this Article