Deflation and the Liquidity Crunch: Update 2001

August 24, 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

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