The deflationists often talk about the two historic showcases – The 1930′s US depression and Japan’s lost decade of the 90′s. In both of those cases, debt-fueled equity and real estate bubbles were gigantic and exceeded 100% of the GDP in size. The subsequent debt implosion caused 50%+ retrenchment in their respective equity and/or real estate markets.

While there are similarities in the cause of the bubble and immediate effect after the debt collapse, the long term economic outcome and survival can be very different. In this paper we will debunk the claim that US is facing an imminent 90′s Japanese style deflation.

The Cause And Effect Of Deflation

Fractional-reserve monetary systems are inherently unstable. Money is created out of thin air by the banks and lent to government, consumers and businesses. In order to service and replay those debts, the borrowers take on more debts. Collateralized asset prices are inflated, and the vicious cycle continues until the debtors are unable to borrow or the banks are unwilling to lend. At that point the system snaps, everything is sold off, asset prices dive and we have a financial crisis at hand. The classical definition of deflation is the decrease in money supply. Although at times the rate of increase in money supply may slow, the actual money supply has never decreased in the fiat-money world we live in since 1913. Therefore, technically deflation is not a possibility. For the sake of discussion however, we will define deflation as “the decrease in the general prices of goods and services”

Japan of the 90′s

Japan had an equity bubble and real estate bubble in the late 80′s fueled by easy credit and excessive borrowing. The bursting of Japan’s bubble economy in the early 1990s triggered an economic slump that has sometimes been called the “lost decade.” The Nikkei stock index declined by more than 70%, and commercial land prices in large cities fell 82% from their peak, creating stockpiles of nonperforming loans. Altogether such loans were estimated to be in excess of US$2-$3 trillion, which is more than Japan’s GDP.

Mortgage defaults and budget deficit in Japan
Throughout the crisis, the mortgage market was comparatively stable, as banks were willing to restructure the loans and defer payments. In Japan it is shameful to walk away from your home and mortgage, and fear of repossession kept default rates relatively low. In the 1990s, as interest rates fell default ratios did, too—from 2-3% to less than 1%. In 1990, Japan was running a balanced budget which created room for fiscal deficit spending. It wasn’t till 1997 that budget deficit ran into double digit of GDP.

http://www5.cao.go.jp/zenbun/wp-e/wp-je01/wp-je01-00301.html

Current Account and External Debt in Japan
Japan long enjoyed current account surplus since 1982, and has little external debt owed to foreigners. The positive current account enables the government to expand spending without fear of inopportune foreign attacks on the yen through debt and stock redemption.

Japanese savings rate, the Yen,

Japan’s national savings rate throughout the 90′s exceeded 30% which created demand for the Yen.
During the same period, Japan was world’s dominant creditor and the Yen was kept in high demand on the world stage. As shown in the chart below, the Yen appreciated 100% against the Dollar from 1990 to 1995. Purchasing power of the Yen was further enhanced through slow and painful deleveraging whereby world assets owned by indebted Japanese firms were sold to raise Yen to be repatriated.

Quantitative Easing in Japan

Quantitative Easing = Printing money to buy public and private assets (Treasury bonds, mortgage bonds, even stocks)

This is a direct attempt to prop up prices through money printing.
Faced with sluggish Japanese economy post-Nasdaq bubble, The Bank of Japan lowered the policy rate to zero in February 2001 and then went to quantitative easing the next month. It ended both quantitative easing and its zero interest rate policy only in 2006.

The size of the bond-buying operation became the policy tool to target the level of reserves rather than the policy rate, which was fixed at virtually zero. At its peak, reserves reached around Y35,000bn (US $300 billion) of which only around Y8,000bn were required.

Although a modest boost to GDP was observed through quantitative easing, the perceived growth came at the expense of the Yen. Indeed Yen lost nearly 20% against the dollar in just 12 months from the quantitative easing announcement. It doesn’t take an academic to figure out that money printing resorts to depreciating currency and inflation, it not a matter of if but when.

It’s interesting to note that Japanese understood the use of “quantitative easing” as last resort. Interfering prices so blatantly can cause irreparable damage to the currency, and the BOJ exercised this dubious demon power only some 11 years after initial debt bubble burst.

To summarize, Japanese lost a decade of progress in the 90′s as it struggled to pay down domestic debts that’s multiple times its GDP. The government began 1990 with budget surplus but expanded expenditures to eventually reach 10% budget deficit some 7 years later in 1997. 30% domestic savings rate coupled with positive current account balance provided support for the Yen, which enjoyed a formidable rise until 1995. The government didn’t toy with unconventional monetary policies such as “Quantitative Easing” until 2001, a decade after the initial bubble burst.

USA Today

Avoiding this paper turning into Ph.D dissertation in length, let me summarize the USA section by saying that post bubble condition today in the US has almost nothing in common with that in Japan in the 90′s.

Japan entered into the crisis with a balanced budget, while US 2009 budget deficit is projected to be 12% of GDP. Such daunting budget gap is reserved mostly for 3 rd world countries. For example, during Argentina financial crisis in 2002, the country’s budget deficit was only a “modest” 4.6% GDP.

What’s most alarming – the US 12% budget deficit is only the beginning of a trend. Seeing all levels of government severely short on tax receipts, most analysts project the deficit to worsen further into future years.

In the 90′s Japan was world’s top creditor nation whilst US today is the world’s largest debtor nations with over $12 trillion owed to foreigners.

The following list from CIA shows US owing over $12 trillion to foreign residents as of June 2007.

1    United States $ 12,250,000,000,000
2    United Kingdom $ 10,450,000,000,000
3    France $ 5,370,000,000,000
4    Germany $ 4,489,000,000,000
5    Spain $ 2,478,000,000,000
6    Netherlands $ 2,277,000,000,000
7    Ireland $ 1,841,000,000,000
8    Japan $ 1,492,000,000,000

https://www.cia.gov/library/publications/the-world-factbook/rankorder/2079rank.html

In 2008, the US imported $670 billion more than it exported. The country requires foreign trading partners to re-invest all of that $670 billion to keep the dollar afloat. This means external debt would have to increase at least by similar amount just to keep the status quo.

China so far invested in $800 billion US treasury. What if they want to withdraw? Who can buy $800 billion worth of US treasury?

Quantitative Easing Revisited

“Who can buy $800 billion US Treasury notes from China?”

The Federal Reserve Bank is our savior and lender of last resort. The Fed is generous and has offered to buy US notes of all kinds.

To quote directly from Mr. Bernanke, chairman of the Fed

“U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

I find it amusing that the deflation camp still exists after such statement. Since 2008 the Fed has bought over $2 trillion of soured notes issued by AIG’s and the alike. To pick up the slack from wary demand of US assets by foreign creditors, the Fed recently affirmed the commitment to buy additional $1.7 trillion worth of MBS and US Treasuries.

It took 10 years after the bubble burst in Japan to take on quantitative easing. The US entered into financial crisis in 2008 and Mr. Bernanke is already prepared to print upwards of $4 trillion by the end of 2009.

How did the dollar react to the news? The dollar chart below shows a distinct bearish trend.
Often times, prediction arrives through the process of elimination.

By now, it should be crystal clear that the immediate US path is NOT Japanese style deflation of the 90′s. The path of concern is Argentine style hyperinflation of 2002. The chart below shows that the impaired peso was permanently devalued after the crisis.
The Savers Camp vs Borrowers Camp?

An average American family carries

- $9,000 in credit card debt,
- $18,000 in debt and loans inclusive of credit cards, auto, and education
- $70,000 in mortgage debt

Then there is borrowing by Uncle Sam. The $11 trillion national debt equates to over $31,000 per U.S. person.

If one sums up all recognized debt of federal, state & local governments, international, private households, business and domestic financial sectors, including federal debt to trust funds, the t otal Debt in America is over $57 Trillion, or $186,717 per U.S. person.

The foreigners own over $5 trillion of the national debt and over $12 trillion of all US debts. Even at 10% savings rate, it will take a full decade for US citizens to pay its foreign obligation.

With hundreds of $billions added to the external debt clock every quarter and a national savings rate of less than 7%, the fat lady may never sing and foreigners may never get the payback in full, in today’s dollars anyway. With those stats in mind.

It’s completely rational and clearly in the best interest of America to repudiate foreign debts and subject the dollar in harms way.

Foreigners don’t have political representation in the US, so why would an average Joe work to pay foreigners? It’s far easier to debase the currency.

Conclusion

Buffet was quoted on May 2, 2009
–
Buffet warned that efforts such as the Treasury’s $700 billion Troubled Asset Relief Program and the $787 billion fiscal stimulus plan passed this year by Congress will have to be paid for, one way or another. The biggest losers in a surge of inflation, Buffet added, would include holders of bonds and other fixed-income assets.

“I haven’t had my taxes raised,” said Buffett, who has run Berkshire for more than four decades. “My guess is the ultimate price will be paid by a shrinkage of the value of the dollar.”

http://money.cnn.com/2009/05/02/news/newsmakers/warren_buffett.fortune/index.htm?postversion=2009050213
–
Greenspan was Quoted on June 26, 2009
–
Inflation is a special concern over the next decade given the pending avalanche of government debt about to be unloaded on world financial markets. The need to finance very large fiscal deficits during the coming years could lead to political pressure on central banks to print money to buy much of the newly issued debt.

The US is faced with the choice of either paring back its budget deficits and monetary base as soon as the current risks of deflation dissipate, or setting the stage for a potential upsurge in inflation.

http://www.ft.com/cms/s/0/786355f2-61ea-11de-9e03-00144feabdc0.html

The following gold chart speaks the same terms and seems ready for the next advance.
If you are in the savers camp, it’s not too late to diversify out of dollars. Subscribe to our network and read letters from independent thinkers such as Aden Sisters, Lawrence Roulston, and Ron Struthers on how you can protect yourself from the imminent dollar crisis.

John Lee, CFA
http://www.goldmau.com
jlee@goldmau.com
1.800.965.6404

ABOUT THE AUTHOR
John Lee, Mau Capital Management

John Lee is the founder and principal of Mau Capital Management and the portfolio manager of a mining equity hedge fund. He is a CFA charter holder and has degrees in Economics and Engineering from Rice University. Mr. Lee has a keen interest in the history of money and economics, and has previously studied under Mr. James Turk, a renowned authority on the gold market.

If you would like to receive subscription of Mr. Lee’s Stock Chart of the Week and 4 other famous newsletters for the price of $89.95/3 months, click here to find out more. http://new.goldmau.com/stockchartsubscribe.php

1998 Russia

Declining productivity, an artificially high fixed exchange rate between the ruble and foreign currencies to avoid public turmoil, and a chronic fiscal deficit were the background to Russia’s financial meltdown in 1998. The economic cost of the first war in Chechnya that is estimated at $5.5 billion was also a cause.

Prior to the culmination of the economic crisis, the government-issued GKO bonds policy had been described as similar to a Ponzi scheme, with the interest on matured obligations being paid off using the proceeds of newly issued obligations.

Two external shocks, the Asian financial crisis that had begun in 1997 and the following declines in demand for (and thus price of) crude oil and nonferrous metals, impacted Russian foreign exchange reserves. A political crisis came to a head in March when Russian president Boris Yeltsin suddenly dismissed Prime Minister Viktor Chernomyrdin and his entire cabinet in March.

The Asian crisis and political event rattled investor confidence caused foreign investors to sell off Russian stocks, bonds, and took a flight out of rubles.

The amount of GKO at some $150 billion was not a cause of concern for a $1 trillion economy. But with over 30% of GKO owned by foreigners, the foreign selloff caused havoc in equity, bond and the ruble.

Russian broad equity index down 90%+ from late 1997 to October 1998

Ruble went from 5 to 1 USD to 30 to 1 USD in June 1999

After the equity panic bottom in October 1998, Russian equity index, measured in rubles rebounded strongly in part thanks to the depreciating ruble.

However, measured in US dollars, Russian stocks didn’t make full recovery till some 5 years later.

2001 Argentina

In 1998, Argentina officially entered a recession, which lasted for three years and ended in a collapse as fears of the devaluation of the peso led to bank runs. This brought about grave amounts of protest and violence affecting many people and companies, causing several deaths.

In 2001 Argentina had US $100 billion of national debt, which is approximately 40% of its GDP. While the amount is containable relative to its GDP, the Argentines made a mistake of denominating its debt in US dollars. With shrinking current account surplus, the country wasn’t able to raise dollars to pay debt principal and interests in 2001 and eventually repudiated on the foreign debts. The fixed exchange rate was removed and the peso was quickly devalued. The exchange rate was then left to float, causing further devaluation (about 4 pesos per dollar)

Argentine equity index dived 60% in 2001

Peso went from 1 to 1 USD to 4 to 1 USD in early 2002 after the government allowed the Peso to float.

Although Argentine Equity Index recovered fully in 2002 in nominal terms, it wasn’t till 2004 before the stocks come back to pre-crisis level in US dollar terms.

Today USA

The US just experienced the biggest debt blowup known to man. Trillion dollar plus mortgage debts had to be bailed out. Lehman Brothers, Merrill Lynch, Bear Stearns, Countrywide, Fannie/Freddie’s have all become history. Even the American icon Citibank was brought to its knees at $1 before the government bailout. S&P500 was halved in 12 months.

America is privileged to have its dollars serving as the world’s reserve currency. America’s debt is denominated in dollars, which can be printed at will by the Fed. And printing is what the Fed did.

The Fed has printed over 1.5 trillion dollars to bail out various groups.

S&P 500 responded positively to monetary easing as it rose 40% since March in nominal terms. It shouldn’t be surprising to see the index recover to pre-crisis level. Equities have to rise as in Russian and Argentine cases, when currencies had been massively devalued.

In real terms however, when S&P 500 is measured in gold in the chart below, it likely takes many years before the index recovers.

Where does the dollar go from here?

When foreign investors took flight from Russian rubles and Argentine pesos, the dollar was the beneficiary. When global investors took flight from the dollar, which currency benefits?

Gold is the ultimate antithesis to the dollar. Gold is liquid, universally recognized, limited in quantity. Just like Russians and Argentines trying to anchor their currencies to the dollar, the US government devised various ways to slow down the rise of gold prices to maintain dollar’s soundness. However the massive money printing by the Fed and fast-eroding confidence in the dollar by international investors might just be the key to drive gold past the all illusive $1,000/oz level and not look back.

As we saw in the past crisis in Russia, Argentina, Thailand, and Brazil; equity markets eventually do return while the devalued currency never regained strength. The US case is no different. Further rebound by the equity market in nominal terms can be seen albeit with extreme volatility, and we will likely witness a 4-digit gold price in 2009 that will never look back. As the Chinese saying, crisis is spelled danger + opportunity. There is still time to diversify out of dollars before the world recognizes the dollar’s permanent debasement and demotion of status. Visit goldmau.com and sign up for our free market and stock updates.

John Lee, CFA
http://www.goldmau.com
jlee@goldmau.com
1.800.965.6404

ABOUT THE AUTHOR

John Lee, Mau Capital Management

John Lee is the founder and principal of Mau Capital Management and the portfolio manager of a mining equity hedge fund. He is a CFA charter holder and has degrees in Economics and Engineering from Rice University. Mr. Lee has a keen interest in the history of money and economics, and has previously studied under Mr. James Turk, a renowned authority on the gold market.

If you would like to receive subscription of Mr. Lee’s Stock Chart of the Week and 4 other famous newsletters for the price of $89.95/3 months, click here to find out more. http://new.goldmau.com/stockchartsubscribe.php

There are countless tips on how to make money. This article is not about that. Rather, we examine the definition of money, what makes good money, and how some bad monies stay bad while others have become acceptable through new ideas and technology. In the end we will talk about how money and currency will evolve in the future.

Definition of Money

Money is anything that is generally accepted as payment for goods and services and repayment of debts. The main uses of money are as a medium of exchange, a unit of account, and a store of value.

Aristotle on good money

Aristotle (384 BC – 322 BC) was a Greek philosopher, a student of Plato and teacher of Alexander the Great. Aristotle discovered, formulated, and analyzed the problem of commensurability. He wondered how ratios for a fair exchange of heterogeneous things could be set. He searched for a principle that makes it possible to equate what is apparently unequal and non-comparable.

Aristotle says that money, as a common measure of everything, makes things commensurable and makes it possible to equalize them. He states that it is in the form of money, a substance that has a telos (purpose), that individuals have devised a unit that supplies a measure on the basis of which just exchange can take place. Aristotle thus maintains that everything can be expressed in the universal equivalent of money. He explains that money was introduced to satisfy the requirement that all items exchanged must be comparable in some way.

Within such frame work, Aristotle defined the characteristics of a good form of money:

1.) It must be durable. Money must stand the test of time and the elements. It must not fade, corrode, or change through time.

2.) It must be portable. Money hold a high amount of ‘worth’ relative to its weight and size.

3.) It must be divisible. Money should be relatively easy to separate and re-combine without affecting its fundamental characteristics. An extension of this idea is that the item should be ‘fungible’. Dictionary.com describes fungible as:

“(esp. of goods) being of such nature or kind as to be freely exchangeable or replaceable, in whole or in part, for another of like nature or kind.”

4.) It must have intrinsic value. This value of money should be independent of any other object and contained in the money itself.

Money, 1,000 years ago

Only humans satisfactorily solved commensurability with the idea and practice of money. Throughout history, we have seen the adaptation of various forms of money. Here are some examples with relative merits denoted.

One couldn’t treat oil as money since it was not exactly durable and portable. Neither could one use a business (such as a restaurant) as money since it is hardly divisible and ever lasting. Gold has been the choice of money for over 5,000 years because it is valuable, durable, divisible and relatively portable.

Trading assets on paper

A thousand years ago, the ownership title of a land parcel or a business is merely a piece paper for decorative purpose and a registry for the tax collector. The oldest existing stock certificate was issued in 1606 for a Dutch company (Vereinigte Oostindische Compaignie) seeking to profit from the spice trade to India and Far East . Though very profitable in its day, when the company was dissolved in 1799, it was some 10 million Dutch guilders in debt.

American Stock exchanges were introduced in the early 18 th century and wasn’t prominent until the 19 th century, where we saw globalization expanded massively with computer technology, air travel, transcontinental pipelines, and giant cargo ships. Today over 50% of US households own stocks collectively worth over $10 trillion. It’s only in the last 15 years that an average person can access instant world news and buy stocks with few computer clicks thanks to the internet. Hundreds of millions of people around the world own publicly traded stocks collectively worth over $40 trillion. Over 5 trillion dollars worth of US mortgages have been securitized and owned by world citizens. Title certificates to commodities stored around the world are changing hands valued in the hundreds of $billions on various commodity exchanges.

Money, today

Oil, which has always carried intrinsic value but difficult to store and exchange for other goods, all of a sudden becomes a viable medium of exchange and store of value through the advent of Oil ETF. Oil is stored in a warehouse and your digital ownership certificate is tucked safely in your brokerage account, which you can practically instantly exchange for anything else you want, whether it be Microsoft, gold, wheat, air ticket, hotel room, for less than 1% of commission. Granted, we rely on dollars to calculate the exchange ratios but the role of dollars has diminished greatly in the process as we used it only as an exchange reference (and a lousy one at best) and never kept dollars.

Like oil, various assets once thought to be non-divisible, non-portable, and non-durable are gaining popularity and being saved in lieu of traditional money such as gold and dollars. REIT ETF allows you to “store” real estate around the world and sell in any increment you like, S&P spider ETF allows you to own a piece of America’s 500 largest companies with auto rebalancing. You can own Japan , Banks, Wheat, Motion Picture, anything you desire with transparency, liquidity, and low transaction cost.

Those assets are becoming more attractive as store of value with enhanced trading volume, portability, durability and divisibility.

Fiat Currency

Money must be a good store of value by definition.

Fiat paper currencies are popular at times since they are convenient and can be created at will to please the public. However fiat money fails the all important “intrinsic value” test, as its value is solely derived from legal tender laws. The compliance of such law rests on the credibility and strength of the issuing authority. As we know government and political factions can rise and fall faster than pop stars in some cases. It’s no surprise that no fiat money has ever survived through time, and they can never be viable money regardless of technological breakthroughs or other human advances.

The value of a dollar

To Recap

What Aristotle described as good money 2,000 years ago has not changed, sound money must be a good medium of exchange as well as a store of value. Assets such as oil or land once weren’t considered to be good forms of money due to poor physical or liquidity constraints, have received renewed interest thanks to novel ideas and innovative technology. The internet and various pooled products (ETF) on world markets enabled those once immobile and/or illiquid goods to be transacted with ease, speed, transparency and low cost amongst world buyers and sellers.

The role of fiat money is vanishing. This morning, I sold Newmont Mining to book a hotel in Hong Kong without owning dollars for long. I don’t own many dollars, or euros or yuans. Fiat money carries a hefty premium for being a good currency but bad store of value. There is no reason to keep any money without intrinsic value.

My view on gold from this evolution is mixed. On the plus side, gold will crowd out inferior fiat currencies at a faster pace. On the minus side, the choices of store of value have expanded vastly, reducing gold’s role to being a fair medium of exchange. Consequently I don’t see the combination of a $2,000/oz gold price, a crashing stock market and $30/barrel oil. If that happens, I’d be selling gold, storing oil, and paying with oil.

How can I pay with oil? One can already make payments with digital gold via www.goldmoney.com , I wouldn’t be surprised if one invents a way to pay merchants with a share of Disney, or a slice of someone else’s mortgaged backyard through a digital land token!

John Lee, CFA
jlee@goldmau.com
1-800-965-6404

John Lee

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