Saturday, December 10, 2005


Low Interest Rates Mask Deflation, Overcapacity

One trader makes the case that deflation is already here. "I’m more convinced than ever that deflation is inevitable. This is partly the result of some very interesting conversations I have had recently with colleagues. One highly experienced former broker said..the US economy is producing unbelievably strong numbers. Why did he think it is working so well? It’s all about supply and demand, he said, and India and China are producing large quantities of cheap goods."

"Isn’t that going to be deflationary, I asked? No, was the answer, because there are vast numbers of people in India and China wanting to join the industrialised world and they will become the new consumers. So it appears that this is why the City is so bullish in the face of this huge expansion in global production capacity, which, on the face of it, by simple arithmetic, must be deflationary."

"In my view, you’ve only got to think about it for a moment to realise it can’t possibly be true. They simply aren’t paid enough to buy the goods they are going to produce at western prices. The theory that they will be able to do so seems to me to be a utopian dream, born of optimism and complacency because things have gone well so far."

"And it’s not just low wages which are keeping production costs down; it’s mechanisation and computerisation as well. You don’t need that many human beings these days."

"Skilled labour costs in China are between one-sixth and one-eighth of those in the west. Unskilled labour, I have read, may be as little as one-tenth of the cost in the west. And ­Chinese workers work more hours. There are also becoming far more of them, that too must be deflationary. Chinese universities turn out nearly 400,000 skilled engineers a year, whereas in Germany it’s about 40,000. Indian universities produce about 300,000 a year."

"I think we already have severe deflation right now, but it’s being masked. The Dow Jones AIG Commodity Index, which reflects the underlying price movements of a very broad range of commodities: energy, petroleum, precious metals, industrial metals, grains, livestock and softs (cocoa, sugar, coffee, cotton etc)..has increased by 142% since February 1999. US house prices have doubled since 1991, increasing 48% since June 2000 alone."

"So why is there no inflation? Doesn’t this strike you as odd? Could this, by any chance, be related to the fact that last year Alan Greenspan’s Fed had to drop interest rates to the floor in a desperate bid to stave off deflation? You bet it is."

"They have pumped up demand with the most inflationary interest rates since the early 1950s, yet inflation has remained meek and mild. But they haven’t cured deflation. They have masked it. The result, of course, is an ideal boom, with no inflation, and that’s why my friend is so contented. But it’s a complete illusion."

"When this economic cycle turns down, and the demand for fuel, houses and commodities wanes, and the debt which has been incurred to finance it has to be repaid, there will be nothing left to disguise the deflation, because the excess production capacity will still be there."

In these confusing economic times, I lean towards this position. Why didn't gold take off when liquidity was created like mad in 97, 98, 99, 2001?

Are we really to believe there can be such a thing as a jobless recovery? Corporations are flush with cash because they are increasing profits via M&A's, outsourcing and off-shoring, which they can finance with near negative rates. But these actions add to deflationary pressures.

Throw in globalization and it's no wonder real incomes are falling in the US.

The key is that the central banks have now created too much credit, which as the G7 meeting revealed, has resulted in unprecedented risk in global markets. As the CB's are forced to draw down this liquidity, as the writer notes, the deflation should be exposed. These are historic times and I can't wait to find out how it unfolds.

I'm interested to hear an inflationary case from anyone who cares to take the time.

I see both high inflation (commodities, etc.) and deflation (assets, wages, etc.). It's the worst possible combination -- the things you need skyrocket just as the things you want plummet. As in the depression, people will fire sale assets just to feed themselves.

Rogers thinks that even though the metals will rise substantially, that more money can be made in basic commodities (e.g., sugar). Isn't that scary!
These are extraordinary times, and anything could happen. The 'stagflation' surprised almost all economist and some replay of that could happen. I like the approach that Jim Rogers has taken; looking at scarcities and population trends in regard to commodities. BTW, eventually the US dollar will give up the ghost and these global imbalances will be resolved.
Rogers thinks that even though the metals will rise substantially, that more money can be made in basic commodities (e.g., sugar). Isn't that scary!
# posted by TJ & The Bear : 10:17 AM

I tend to agree with Jim Rodgers, I love PM's but you can not eat or drink them. Just like the middle East they have oil & gold but a very large water problem. If you are dying of thrist you would rather have a glass of water over a barrel of oil. As to inflation or deflation. I would not rule out stag-flation. Which ever road we end up on it all leads to deflation and I think the dollar in time will end up on the rocks...
Ben thanks for your sites: here is one of the best written cases for inflation that I have seen (sorry but for some reason my computer will not hyperlink on your blogg); go to guest commentary article and read the longish article by David Jensen titled Deceptive Warnings: Nearing Economic Disruption, the Fed Distorts Perception. There is also another article in the archives on July 7 by Shadow Governemnt Statistics that calls for the jump in gold that we are seeing currently as a warning of a US dollar adjustment.

With a very limited supply of gold in the world even a small reallocation out of financial assets by hedge funds, momentum and trend following traders, foreign governments and the puplic will send the price soring. Most of this action I feel is predicated on the future expectation that under B-52 Ben our Fed will have to monetise the US debt as the slowing housing market will directly contract tax revenue, GDP and incomes for the final Qrtr of 05 and into 06 and for who knows how long.

For those looking to buy some gold, I feel we will see some sort of a trading correction after the Fed meeting tomorrow. If there is no correction and someone wants in start buying maybe 1% of portfolio a week until they get to a allocation level they have selected. And as a further suggestion to prospective buyers of precious mentals, buy and hold the physical metals as a core position and hedge against something bad, trade gld on the stock exchange or trade the futures. Happy Holidays.
Marc Faber on gold
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