wrote an interesting article entitled Credit
Contraction, Economic Bust, and Deflation. Inquiring
minds will want to take a look.
Saville: Members of the deflation camp
assert that the large-scale contraction of credit happening within the
banking system means that deflation is upon us, even if the money supply is
expanding. At the same time, another camp is pointing to the breathtakingly
rapid growth in M3 money supply as evidence that hyperinflation is a
near-term threat. In our opinion, both camps are wrong*.
The argument of the first camp can, we think, be summarised as follows:
Inflation is an expansion in the total supply of money AND credit, whereas deflation
is the opposite (a contraction in the total supply of money AND credit). At
the present time the money supply may well be expanding, but this monetary
expansion is being more than offset by credit contraction.
Mish: So far so good. That is nearly my
exact argument. The only thing I want to add is that credit needs to be
marked to market, as opposed to some inflated book value.
Saville: The flaw in the above argument can
best be explained via a hypothetical example. Consider the case of Johnny, who
wants to borrow $1M to buy a house. If Johnny borrows the money from his
friend Freddy then the transaction results in a $1M increase in the amount of
credit within the economy, but no inflation has occurred. All that has
happened is that $1M of purchasing power has been temporarily transferred
from Freddy to Johnny. By the same token, when Johnny pays Freddy back there
is a contraction of credit, but no deflation. There is also no deflation even
if Johnny defaults on his loan obligation to Freddy. In this case Freddy will
have made a bad investment, but the money he lent to Johnny will still be
somewhere in the economy. The point is that credit expansion is not
inherently inflationary and credit contraction is not inherently
Mish: The flaw in Saville's
analysis is that I agree with him! The reason is that he is ignoring the word
"net". When Johnny loaned his friend $1M, money supply (savings)
decreased by $1M but credit expanded by $1M. In Saville's
example there was no "net" expansion of money (savings) or credit. As
I see it, we are in "violent agreement".
Saville: But what if Johnny, instead of
borrowing the million dollars from Freddy, takes out a loan at his local bank
and the bank makes the loan by creating new money 'out of thin air'? In this
case inflation has certainly occurred. Nobody has had to temporarily forego
purchasing power in order for Johnny to gain purchasing power, but the total
existing supply of money has been devalued to some extent.
Mish: Bingo! That is inflation. No argument
in this corner.
Saville: The critical difference is that
when Johnny borrows from a bank the transaction leads to an increase in the
supply of MONEY. Inflation is the increase in the supply of money that
SOMETIMES results from credit expansion; it is not credit expansion per se.
Mish: In my opinion, the critical difference
is that Saville misses the word "net",
conveniently looking at credit all the time, while ignoring money supply the
rest of the time.
Saville: This leads to the question: is the
money supply currently expanding? The answer is yes, but not anywhere near as
rapidly as many people think. The chart at http://www.nowandfutures.com/key_stats.html
reveals that M3 has grown by a mind-boggling 19.5% over the past 12 months,
but as was the case during the early 1990s it appears that this broad measure
of money supply is currently giving a 'major league' FALSE signal.
Mish: I 100% agree with the notion that M3
is giving a false signal. That is the very premise behind my post MZM, M3 Show
Flight to Safety.
Saville: Our preferred measures of money
supply are TMS (True Money
Supply) and what we call TMS+ (TMS plus Retail MMFs). TMS and TMS+ currently have year-over-year (YOY)
growth rates of around 3% and 6%, respectively. In other words, our
assessment is that the current US inflation (money-supply
growth) rate is 3-6%. Inflation is still occurring, but at a much slower rate
than it was during the early years of this decade.
Mish: I do not agree with adding MMFs to TMS as Saville does. I
agree with the formulation of TMS and gave my reasons in Money Supply
Furthermore, and it is hard to say who is right or wrong given massive
backward revisions in some Fed reporting and delays in other Fed reporting,
but the latest M'/TMS numbers that I come up with (more accurately Bart at Now and Futures
on my formulation) are as follows.
The above chart is as of April 18, 2008 as reported in MZM, M3 Show
Flight to Safety.
Presumably it is the same as TMS. If it's not, one or more data series
discrepancies may be at play, and given numerous backdated changes by the Fed
as well as delays in reporting sweeps, I am not going to assume which series
is correct. Close analysis will show near perfect correlation over time.
Finally, and this is key: Saville
failed to mark credit to market! It is the marking to market process by which
I state that deflation is here and now.
Please see Deflation In A Fiat Regime? and Now Presenting: Deflation! No one has rebutted the arguments presented in those links.
Saville: On a side note, the wrongness of
M3's current signal is validated by the happenings in the financial world. Inflation-fueled booms generally continue until there is a
deliberated or forced slowdown in the inflation rate, that is, the booms
continue until the central bank takes steps to rein-in the inflation or until
inflation slows under the weight of market forces.
Mish: I agree. Those looking at MZM are
barking up the same incorrect tree.
Saville: It is also worth noting that
although inflation is a major driving force behind the commodity bull market,
commodity prices are generally still very low in REAL terms. Therefore, while
we are anticipating a commodity shakeout over the next few months we think
the long-term upward trend in the commodity world has a considerable way to
Mish: I fail to see how this fits into the
debate. Commodity prices may indeed be very low in real (CPI adjusted) terms.
Exactly what does that have to do with credit contraction/expansion other
than perhaps propose the next bubble may very well be in commodities? If that
is indeed the point, then I agree.
Saville: In conclusion, it is clear that
inflation is still occurring in the US (and pretty much everywhere
else, for that matter), albeit at a reduced rate. Furthermore, if it hasn't
already done so it is likely that the inflation rate will bottom-out over the
coming few months and then embark on its next major upward trend. It is
possible that consumers are 'tapped out' and that the commercial banks are
about to reduce the rate at which they lend, but the government will never be
'tapped out' and the central bank will always be able to monetise debt.
Mish: In conclusion, I do not see evidence
supporting Saville's conclusion!
I feel he's failed to mark credit to market, to state why credit will not
contract greater than central banks' attempt to inflate, to account for
global wage arbitrage, walk-aways, boomer
retirement and a shift away from consumption, $500 trillion of derivatives
that can never be paid back and a secular shift from consumption to saving.
I see no explanation of how consumers and businesses are going to pay back
debts in a world of declining real wages, wealth concentration at the extreme
high end of the spectrum, global wage arbitrage, declining home prices,
rising unemployment, overcapacity at every corner, and insane overbuilding of
both commercial and residential real estate.
On the other hand, my thesis is simple: The Fed can address liquidity issues
not solvency issues, and we are facing a solvency issue. And because of the
enormous amount of debt in relation to the pool of real savings, there is no
way that debt can be paid back. Debt that cannot be paid back will be
Economic Trend Analysis
Thoughts on the great
inflation/deflation/stagflation debate as well as discussions on gold,
silver, currencies, interest rates, and policy decisions that affect the