Deflation Convyer Belt

Counterpunch has an article with a quote I like about the monetary system that is an excellent image of deflation at work:

"Imagine a 200 ft. conveyor belt with two burly workers and a mountain-sized pile of money on one end, and a towering bonfire on the other. Every time a home goes into foreclosure; the two workers stack the money that was lost on the transaction, plus all of the cash that was leveraged on the home via "securitization" and derivatives, onto the conveyor-belt where it is fed into the fire. That is precisely what is happening right now and the amount of capital that is being consumed by the flames far exceeds the Fed's paltry increases to the money supply or Bush's projected $168 billion "surplus package". Capital is being sucked out of the system faster than it can be replaced which is apparent by the sudden cramping in the financial system and a more generalized slowdown in consumer spending."

And a quote within the article:

"A year ago $20 million would have gotten Luminent Mortgage Capital Inc. access to $640 million in loans to buy top-rated mortgage-backed securities. Now that much cash gets the firm no more than $80 million. ... (Only) 6 lenders are offering 5 times leverage, while a year ago, 20 banks extended 33 times."

There have been a few debates about inflation/deflation and the definitions are all over the map and inconsistent with each other. There has already been way more "inflation" than we realize, yet the "price increases" due to the inflation have not worked through the system.

To me, inflation and price increases have been used interchangeably for so long, the concise difference is lost, much like many people interchangeably use minus for negative and vise-versa. In most cases it doesn't matter, people know what you are talking about.

You simply can not have a definition of inflation that includes money supply and price increases and have those definitions really describe what is happening in the economy. They mostly work together, but, the price increases are a delayed response to increased money supply and can be caused by other things. To better understand the common misuse of these words, give this a read.

The money supply has already increased to the point that we should all feel utterly sick about it, as the graph shows:



The developments over the past 10 years in the financial industry have effectively increased the rate of growth of the money supply. I am not sure where the mortgage bonds, etc., show up in the tally of the money supply, and they thwart the intention of regulations that required a level of reserves for credit. So regulations that were intended to control the increase of money supply through credit completely fail and we have the banks acting like Sammy Slimy with his printing press in his basement.

This gross level of increased money supply has only been showing up in a few areas, the cities with homes priced 5-12 times median wages, commodities like copper which was under $1 in 2002 but peaked at over $4 and has ranged between $3-4 since the peak. The same is true for all base metals, and it seems to me with their vast expenditures and need for raising capital to build new mines, well, they are first in the price food chain and responded to the increased money supply early. Sure there is also supply and demand, but the price increases of the 21st century are far beyond any reasonable historical increases and I would suggest the back room banking activities comparable to Sammy Slimy with his illicit printing press in his basement are responsible and the only real commodity that we use everyday and see in our home balance sheets that has adjusted to the increased money supply is oil.

There is no question there are going to be some fairly significant price increases coming, but these are in response to previous inflation, and aren't here yet due to the time delay in working increased money supply into the system.

The US has an increased delay for inflation to translate into price increases because of its status as a world reserve currency. The volume of US dollars sitting in foreign bank accounts effectively takes those dollars out of circulation and prices are as though they don't exist. Some say the US has effectively been exporting their "inflation" because of this practice... Just look at China's double digit inflation...

The trend of foreigners taking US dollars out of circulation is reversing and that's going to show up as price increases, but it is not an increase in the money supply. That has already happened to an extent far beyond the current pricing of goods. There are so many of those dollars out of circulation, well, it has resulted in a totally unrecognized degree of privilege in buying power, and a privilege that has been taken for granted and completely unrecognized as to where it comes from.

Those dollars head home, or the rate they are bought up by foreigners simply slows down or stops, and the privilege ends and the value of American output gets repriced towards the value the rest of the world gets for their output. The stagnant wages despite increases in the money supply suggest that that process has begun, although sectors with first access to the gross increases in money supply have seen wage increases far beyond other sectors of the economy over the last ten years, the financial sector and sectors related to home building would be examples.

And the people who work in the sectors that saw the largest benefit will be the hardest hit with the current deflation of the money supply. Their wages will decline the most and they will have the hardest time adjusting to the lesser lifestyle.

So, there will continue to be price increases due to the current money supply, but the money supply is deflating and there is a highly leveraged effect of this deflation. Right now I'd say the mortgage backed bond holders are taking the largest hit of the current deflation, followed by home owners in bubbled cities, and somewhere in there is the highly leveraged investor, either through direct personal choice, or indirect personal choice of a highly leveraged invest fund of some kind. These price decreases are a result of deflation, or a reduction of money supply due to credit contraction.

Update: Here's a good post, one I recommend having a read.

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2% inflation in one day

In one day or so the exchange rate for a dollar US went from $1.03 to $1.01 Canadian.

Today the US had 2% inflation on imports from Canada, or Canadian exporter to the US just saw their revenue drop by 2%. Either way, it is going to be ugly.

End of post.

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I'm a banking bear

Over on Motley Fool I was asked why I rated Citigroup, a banking stock that is paying a 4.2% dividend and has a P/E of 11.39 as under perform and I thought it a question exceptionally worthy of an answer.

I do not usually rate under perform for a stock paying a good dividend and having a low P/E, however, I do not believe any financial institution will ride out the subprime fallout very well and I think the consequences of the sub prime lending market will be felt for years. These mortgages have been repackaged and sold and repackaged and sold again. They are hiding everywhere in financial institutions and investors would be very hard pressed to figure out any individual institution's exposure to risk.


I think there will be more than one wave of people in trouble with their sub prime mortgages, estimated to be at about 30% of mortgages. First wave is those that are not meeting interest payments now. Their mortgages are essentially increasing every month as unpaid interest is added onto principal.

There are lots of people who have bought on plans that offered lower interest rates the first 1, 2 or 3 years. These people are at risk as their interest rates readjust.

There are people who were barely able to make their payments and may be increasing credit card debt every month right now just due to the increase in the price of gas alone, and so many other costs have gone up. Expenses are increasing faster than wages and they lack any buffer zone in their income.

There are people who have been living off equity, borrowing more as their equity increases. If they've put the money into other investments they'll probably be ok. If they've been doing this to pay off their credit card debt that gets out of control every 2-3 years, well, obviously they already have money management problems and this is going to be big trouble for them.

Many have variable mortgage rates and coming into the market at a low rate and then finding the rate increases is an enormous negative leverage for the household budget. I worked out that each $100,000 of mortgage costs $474.21 per month at 3% for a 25 year mortgage. It costs $527.84 at 4%, or an increase of $53.63/month per $100k of mortgage, and that is an 11.3% increase in mortgage payment. I don't know about you, but that eats up 4.5 years of wage increases for me.

I do not believe that any banking institution will ride this out without taking some pain, as will the shareholders of banking stocks.

I would also like to point out what I believe to be a difference between Canadians and American because of public policy. In Canada you can not deduct mortgage interest from your taxes and if you buy a home with less than 25% down you must pay up to 2.5% mortgage insurance.

I believe that you are ultimately better off by paying off debt even if you get a tax exemption on interest paid, but I think there is a perception of getting something for nothing, or getting more if you have more debt, almost stick to the government, taxes are so ultimately evil and I figured out how to pay less. That's probably an exaggeration, but ultimately this policy that allows you to deduct interest has lead to a higher acceptance of debt and even a strong shift towards public perception that a level of debt is ok and perhaps even a level of debt relative to assets is wise... (Ekkk!!!!...)

Canadians are more motivated to pay off debt as there is no perceived benefit from holding debt and they are also much more motivated to try and have a larger down payment. That isn't to say they manage the 25% down, but what will typically happen is they might come up with say 15%-20% down, find another 5-10% through short term debt and finance their first home with a highly aggressive debt repayment plan for the first 5 years or so as they work to pay back that 5-10% in a short term. If they can only come up with 10% down they just fork out that 2.5% insurance because they don't have hope of paying back that short term debt in a reasonable time line. It is difficult to get a subprime mortgage with Canadian law. You have to have 5% down and have to pay that 2.5% insurance.

I don't believe the differences in behaviour is universal, no people or countries are monolithic in all things and I didn't say this is a universal thing, but I do believe that if you look at the facts you would find a greater percentage of Americans borrowing against their equity than Canadians, and this is one of the ways that public policy affects behaviour to the detriment of the economy as a whole.


And even another point, the policy of allowing interest to be deducted has leveraged an ever higher level of hyperinflation in the housing market, but that's another topic.

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Why Aren't You Saving -- The Death of a Bedrock Belief

The purpose of Low Interest Rates - As Destructive as Usury was to show how much less empowered people have become in their ability to get ahead by paying down debt through two mechanisms:

1. Grossly reduced leverage of benefit of reducing total amount to be paid back from increasing payments.
2. Low interest rates are because theoretically inflation is low, so wage increases are also low further disabling the ability to increase mortgage payments.

A third problem is revealed in Making Less Than Dad. The study points out that American men in their 30s are earning less than their father's generation, a 12% drop.

A significant point in the article states that American families had a 32% increase in income levels between 1964 and 1994. Move that forward by 10 years, from 1974 to 2004 household income growth slowed to 9%.

A "truth" I was repeatedly told when I was growing was that each generation does better than the generation before them, and article suggests the death of this bedrock belief, but I would suggest that belief has been dead a long time, through reduce earning power, as the article above shows and increased taxes that disproportionately burden younger people.

I became highly aware of the degree of the declining buying power when I was involved with the 1997 Census. I was shocked to often see 3 young adults sharing a one bed room apartment out of necessity.

That was not happening with my peer group when I was a young adult. You could afford to share a reasonable 2 bedroom or even a dumpy one bedroom on minimum wage. I worked in a bank so I saw what all occupations were paying and my wage was at the lower end of the wage spectrum. Sharing a two bedroom apartment cost me 15% of my gross income. I could fill my economical car's gas tank with one hour of wages. I had a girlfriend who supported herself in grade 12 renting a basement suite on working 20 hours per week.

I often bring up the declining buying power of minimum wage with students. "When I was a young adult minimum wage was $3.65 and my share of a two bedroom apartment was $112.50," I tell them and I get them to calculate how much minimum wage would have to be today to keep up. They will come up with about $13/hour.

I continue, "A course at Simon Fraser University cost $54 and today it is $453.30," and they calculate $31/hour.

And never mind the grossly reduced buying power, look also at the grossly increasing tax burden.

"You would have to pay $111 per year towards Canada Pension Plan, and you'd be at 57% of the maximum pensionable earning, today those at 57% of the maximum pensionable earnings pay $1066." Minimum wage would have to have gone up to $35 to have the same proportion of wages going to Canada Pension Plan. But, even on another issue, maximum pensionable earnings was 1.73x minimum wage and it is now 2.63 times minimum wage. At the very least, if minimum wage went up as much as the maximum pension amount it would be at $12/hour, but they be taking home way less because of the gross increase in pension contribution for low wage earners.

There is no question making less than dad grossly impacts on ability to work toward financial security, but I question how much the study corrected for how the tax system grossly favours the old over the young.

And they go on and on about the reduced savings rate...

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