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report
8th July 2009
Stop the ination or deation debate –we have both until ination prevails
The great debate between the inationists and the deationistsrages on. Most commentators fall rmly into one camp oranother. In fact, we
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re experiencing both ination and deationsimultaneously due to the extreme distortions created by thereckless policies of central bankers and politicians in the UK andUS. Ultimately, one of these forces will overwhelm the other andit will almost certainly be ination in response to a currency crisis.It should be fairly obvious now that if the UK and US economieswere left to their own devices (without the heavy-handedmeddling by the gentlemen referred to above), economic gravitywould dictate that they would both experience a prolonged periodof deation and depression.
Kondratieff cycles since the Industrial Revolution
Source: Ian Gordon/Long Wave Group
Here is the link to a full-screen version (see page 2 of thepresentation) of this excellent chart:http://www.longwavegroup.com/ash_pres.html
Contact/additions to distribution:
Paul Mylchreestpaul@thunderroadreport.com
This issue:
Stop the infation or defation
debate - we have both until
infation prevails
(“Badlands - getting close toa dollar crisis” Part 2)
 
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© Thunder Road Report - 8 July 2009
Stated simply, we are in the “Kondratieff Winter” part of the long wave economic Kondratieff cycle whichhas been repeating itself at least since the Industrial Revolution - and some would suggest even back tothe agrarian economy. As I showed in the Gold War report, the best illustration of these long wave cyclesis the chart created by Ian Gordon of the Long Wave Group above
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A Kondtratieff Winter typically lasts at least 10-15 years as the Japanese experience of the last two decadeshas shown. While extremely painful, it is necessary to repair the fabric of the economy, i.e. purge theexcessive debt built up during the Spring, Summer and (especially) the Autumn phases of the Kondratieff cycle, remove excess capacity and recapitalize the banking sector, etc. This takes time, but once completed,the economy is ready to begin a new long wave cycle. If we wanted to avoid the pain of the K-Winter, thebehaviour of politicians, central bankers, the banking system and consumers would have to change – butevery generation forgets the lessons of history, even when the evidence to the contrary is staring them inthe face – like it was with our dear leader. “And we will never return to the old boom and bust” 
Gordon Brown budget statement 21 March 2007 after the onset of the sub-prime crisis
If you understand the different phases of the K-cycle, you also know which asset classes tend to outperformin the different phases. So in a typical cycle, for example, you only buy gold in the inationary Summerphase and the deationary Winter phase (I am not a “perma gold bug”), the stock market and real estatetypically do best in the recovery Spring phase and the debt-driven bull markets of the Autumn, whileTreasury bonds do best (unless the value of the currency is destroyed) in the deationary Winter phasewhen everything else, apart from gold and cash, collapses.The downward “gravitational pull” of the K-Winter cannot be underestimated – look at what Japan tried –almost zero interest rates for years, massive decit spending and public works, quantitative easing - and itseconomy still didn’t escape deation and economic stagnation. While all these policy actions failed in Japan,they are being repeated in the UK and US. The risk we face is that Darling, King, Bernanke and Geithnerare guilty of Einstein’s denition of insanity: “Doing the same thing over and over again and expecting different results” The only intellectual justication they have for their policies is that Bernanke, the student of the GreatDepression and the Japanese deation, has argued that Japan responded too slowly and that its initialactions were not sufciently aggressive. The reality is that we are in uncharted territory – taking theeconomic equivalent of the trip up the Nung River with Captain Willard in Apocalypse Now.Back in 2007, I was arguing that we had been in a “distorted K-(Kondratieff) Autumn” since the beginning of the decade. What I tried to explain was that the US economy would have slipped into a purging deationaryrecession in the wake of the dot.com bust in 2000 if it wasn’t for Greenspan’s massive reationary actionat the time, e.g. bringing interest rates down to 1% and leaving them at that level for a year which ignitedthe real estate bubble. Debt/GDP in the US economy back then was about 270%, in line with the peakreached in the Great Depression. But it wasn’t just real estate. While Marc Faber didn’t call it a “distortedK-Autumn”, he grasped the unusual situation that prevailed before the current crisis: “…the feature most common to the previous investment booms was that a bull market in one asset classwas accompanied by a bear market in another asset class. Currently, looking at the ve important assetclasses – real estate, equities, bonds, commodities, and art (including collectibles) – I am not aware of anyasset class that has declined in value since 2002.” Thanks to Greenspan, what could have been a difcult, but milder, adjustment process was averted,but at what eventual cost? Now US debt/GDP is above 350% and attempting to reate the current bustis requiring measures that would have been considered beyond reckless not long ago. We are now in a “distorted K-Winter” where the lessons of previous economic cycles are important, but events might notplay out in the usual fashion.
 
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© Thunder Road Report - 8 July 2009
That said, given “economic gravity” and historic experience, it is understandable why so many experiencedmarket participants are in the deation camp. For example, Absolute Return Partners, a London-based (bythe river in Richmond, lucky them) hedge fund, writes an interesting monthly newsletter. The July issueis titled “Make Sure You Get This One Right”. After quoting Robert Prechter “You can’t beat deation in acredit-based system”, ARP argues: “We are faced with another one of those ‘make or break’ decisions which will effectively determine returnsover the next many years. The question is a very simple one: Are we facing a deationary spiral or willmonetary and scal stimulus ultimately create (hyper) ination?” The ARP authors come down rmly on the deationary side (ination is not a concern to them for “severalyears”) and their main arguments are:- The massive liquidity created by central banks is being hoarded by the banking sector, rather than ndingits way into the economy - Agree;- The output gap, i.e. the low level of capacity utilization across the economies - Agree (n.b. in BenBernanke’s “make believe” world, this is about the only thing he looks at with regard to ination risk); and- A counter-intuitive argument that rising commodity prices (due to demand growth in emerging economies,rather than the developed world) could be deationary, rather than inationary - Disagree.Regarding the third point, ARP specically argues that rising prices for price inelastic commodities like “basic necessities such as heating oil, petrol, food, etc.” leads to less demand for discretionary goods andacts more like a tax hike. Demand for other goods is therefore weak contributing to deation. I agree thatthe rising price of basic necessities acts like a tax hike because there is limited ability to reduce energyand food costs. But it’s precisely because of this, and the heavy weighting of these items in consumerexpenditure, that higher food and energy prices ow so readily through to ination. Tricksters like Bernankeand other central bankers might want to focus on their ludicrous concept of “core” ination, excludingfood and energy prices, but this misses the true ination faced by households. While there may be lessdiscretionary spend for other goods, higher energy prices, also ow through the entire cost structure of alldomestically produced and imported goods. In some areas, they are likely to be passed on to consumerswhile in others, the hit might be taken by the manufacturing and distribution sectors in their margins.I really don’t mean to have a go at ARP and it is worth noting that they are in very good company. Thesuccessful London fund manager, Hugh Hendry, was spreading the deationary gospel only last week onCNBC. Hendry’s current view fascinates me, since it was an article written by him several years ago whichmotivated me to read about John Law and what he did to the French economy in 1720. Hendry is probablywise enough, however, to realize that he will need to turn from deationist to inationist on a sixpence atthe appropriate time and, given his record, he might nail it. Further in ARP’s defence, the fund managersalso recognize that the coming years will be vastly different from the last 20-30 in the investment world andthey correctly, in my view, see pronounced volatility in the years ahead (This is the “global end of normal”,baby).While there is evidence of deation all around us – year-on-year the stock market is down, house pricesare down, industrial commodity prices are down and some non-food retailers are cutting prices, the overallstory is more complex. In the UK, Halifax (now part of the Lloyds Banking Group) not only tracks houseprices, but also the overall cost of owning and running a house. The comparison between April 2009 andApril 2008 is shown below:
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