posterous kontent

Unannounced, quantitative easing has started in the US. The Federal Reserve is flooding banks with reserves, most of which are not required. Excess reserves now stand at over US$550bn (Exhibit 1). According to Morgan Stanley US economist David Greenlaw, the wind-down of the Supplementary Financing Program means that excess reserves will rise further over the next couple of months. (See Revenge of the M's, 18 November.)

Quantitative easing sees the Federal Reserve shift from targeting the cost of money to targeting the supply of money. In a market system, the central bank can control one or the other. Recent practice has been to set the price (the overnight lending rate between banks) and let quantities adjust; now the Fed wants the money supply to rise, and will let rates adjust to their own levels (but because the Fed now pays interest on the reserves, there is a floor). On a long view, this is a return (in very different circumstances) to the fashion of the late 1970s/early 1980s, when many central banks targeted monetary aggregates.

The Fed's move mimics the Bank of Japan's move to quantitative easing, starting in 2001. This was seen as an important turning point in Japan's recovery. In fact, the actual story is more complex, and colleague Robert Feldman argues that Japan's recovery resulted from getting a range of policies right. For details, see How Japan Got Financial Reform Right, 27 November.

A few comments from me:

First, just as interest rate changes take time to work, so too will quantity-based monetary regimes. Central banks have good control over rates in the short-term inter-bank market, but the degree of control ebbs beyond that. Likewise, central banks have good control over very narrow money supply measures, but their control fades as the money aggregates get wider.

The hope is, of course, is that just as control of the overnight cash rate ultimately filters through to other rates, flooding the banking system with reserves will filter through to broader money aggregates (Exhibit 2). But it will take time.

Second, quantitative easing will face several headwinds. The first is that the banking system itself is under pressure to reduce leverage. Money supply is banks' liabilities; what is required is for banks to expand their assets (credit). Over the long run, the two sides of the balance sheet - money and credit - move together. But there can be sustained divergence in money and credit growth when the banking system increases or reduces its leverage.

Japan illustrates this. Even before quantitative easing, money supply did not appear unduly restricted. The explosion in narrow money did not prevent bank credit from continuing to contract for an extended period (Exhibit 3). This is partly because QE did not address solvency problems in the banking system, and hence did not prevent institutional failure. (For details, see Takehiro Sato, Liquidity, NPL and Policy Responses, 9 October 2008.) The US has seen the reverse over the past 20 years: Credit growth has significantly out-paced money supply growth (Exhibit 4), as banks increased leverage. Of course, US banks are now, like their Japanese counterparts in the 1990s, reducing leverage.

A second headwind for QE is that the banking system is only part of the problem. Exhibit 5 shows the supply of credit by the financial sector in the US. Over the past 25 years, the banking system's share of total credit provision has fallen from 65% to around 30%. While QE liquefies the banks, non-bank credit providers also need assistance. The Fed recognizes this, and now directly provides support to some non-bank credit sources (by intervening in the commercial paper and asset-backed security markets).

A third headwind for quantitative easing is the 'leading horses to water' problem: Lenders may be willing to lend, but borrowers may not want to borrow. If the focus of, say, households turns to reducing leverage, then the cost (or availability) of credit may not encourage the usual take-up. The problem is the level of debt, not its cost.

In short, quantitative easing is no panacea. That, as Robby Feldman argues, is certainly one of the messages from Japan's experience. The Fed seems to understand this. Morgan Stanley US economist Richard Berner anticipates further aggressive policy action, on a range of fronts, as outlined in Aggressive Policy Actions Will Avert Both Depression and Deflation, 24 November. For what QE may mean for currency markets, see Stephen Jen, The Fed's QE Operations and the Dollar, 26 November.

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END OF RESEARCH ABSTRACT

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Disclosure Section
The information and opinions in Morgan Stanley Research were prepared or are disseminated by Morgan Stanley Asia Limited (which accepts the responsibility for its contents) and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z, regulated by the Monetary Authority of Singapore, which accepts the responsibility for its contents), and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H, regulated by the Monetary Authority of Singapore, which accepts the responsibility for its contents), and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services license No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley").
For important disclosures, stock price charts and rating histories regarding companies that are the subject of this report, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures, or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Equity Research Management), New York, NY, 10036 USA.

Analyst Certification
The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Gerard Minack.
Unless otherwise stated, the individuals listed on the cover page of this report are research analysts.

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Morgan Stanley Research has been published in accordance with our conflict management policy, which is available at www.morganstanley.com/institutional/research/conflictpolicies.

Important US Regulatory Disclosures on Subject Companies
The research analysts, strategists, or research associates principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues.
Certain disclosures listed above are also for compliance with applicable regulations in non-US jurisdictions.

STOCK RATINGS
Morgan Stanley uses a relative rating system using terms such as Overweight, Equal-weight, Not-Rated or Underweight (see definitions below). Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold and sell. Investors should carefully read the definitions of all ratings used in Morgan Stanley Research. In addition, since Morgan Stanley Research contains more complete information concerning the analyst's views, investors should carefully read Morgan Stanley Research, in its entirety, and not infer the contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations.

Global Stock Ratings Distribution
(as of October 31, 2008)
For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equal-weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively.

	Coverage Universe		Investment Banking Clients (IBC)
Stock Rating Category	Count	% of Total	Count	% of Total IBC	% of Rating Category
Overweight/Buy	869	39%	275	42%	32%
Equal-weight/Hold	983	44%	286	44%	29%
Not-Rated/Hold	22	1.0%	6	0.9%	27.3%
Underweight/Sell	403	18%	89	14%	22%
Total	2,277		656

Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley or an affiliate received investment banking compensation in the last 12 months.

Analyst Stock Ratings
Overweight (O or Over) - The stock's total return is expected to exceed the total return of the relevant country MSCI Index, on a risk-adjusted basis over the next 12-18 months.
Equal-weight (E or Equal) - The stock's total return is expected to be in line with the total return of the relevant country MSCI Index, on a risk-adjusted basis over the next 12-18 months.
Not-Rated/Hold (NA or NAV) - Currently the analyst does not have adequate conviction about the stock's total return relative to the relevant country MSCI Index, on a risk-adjusted basis, over the next 12-18 months. Please note that NA or NAV may also be used to designate stocks where a rating is not currently available for policy reasons. For the current list of Not-Rated/Hold stocks as counted above in the Global Stock Ratings Distribution Table, please email morganstanley.research@morganstanley.com.
Underweight (U or Under) - The stock's total return is expected to be below the total return of the relevant country MSCI Index, on a risk-adjusted basis, over the next 12-18 months.
Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.
For Australian Property stocks, each stock's total return is benchmarked against the average total return of the analyst's industry (or industry team's) coverage universe, instead of the relevant country MSCI Index, on a risk-adjusted basis, over the next 12-18 months.

Analyst Industry Views
Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below.
In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below.
Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark, as indicated below.
Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index.
.

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Morgan Stanley produces a research product called a "Tactical Idea." Views contained in a "Tactical Idea" on a particular stock may be contrary to the recommendations or views expressed in this or other research on the same stock. This may be the result of differing time horizons, methodologies, market events, or other factors. For all research available on a particular stock, please contact your sales representative or go to Client Link at www.morganstanley.com.
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Good and bad news on the earnings bubble. The good news is that, on one measure, the earnings bubble is gone. The bad news is that earnings are almost certain to overshoot as corporates face one of the worst downturns since 1945.

Exhibit 1 shows S&P EPS relative to trend (both inflation-adjusted). By late last year, earnings were 70% above trend, the largest earnings bubble since 1916. Now, earnings are back to trend.

There are two bits of bad news. First, EPS always fall below trend in a recession. For reasons that are not clear, the inflation-adjusted EPS series in the US has fallen to a similar level in each recession since 1970. That level is around 45% below the current trailing 12-month EPS level.

Second, while EPS are at trend, total earnings remain elevated. EPS have fallen farther than earnings because of dilution (as new equity was issued, largely by the financial sector). Consequently, while EPS are on their long-term trend, earnings remain 20% or so above the long-term average, relative to GDP (Exhibit 2).

There's a follow-on point here: Earnings have been unusually high over the past 15 years. This is important, because one valuation tool I focus on is the so-called Graham-Dodd P/E, which is based on a trailing 10-year earnings series. Using 10-year earnings is designed to remove cycle variation, and hence value the market based on sustainable through-the-cycle earnings. But the persistence of this earnings bubble suggests that the earnings number in the Graham-Dodd P/E may be too high.

The Graham-Dodd P/E is now around its long-term average of 16.4. If, however, I use an earnings number consistent with the long-run profit share of GDP (rather than 10-year average), the Graham-Dodd P/E is 25.

An alternative valuation measure that smoothes everything is to use profits derived from a trend GDP series assuming a constant profit share. That profit series is compared with the total value of equities (as reported by the Fed each quarter).

This super-smooth valuation measure has historically tracked the Graham-Dodd P/E (Exhibit 3). The gap that opened up in the past few years hints at the E-bubble in G-D earnings.

While trailing earnings are back at trend (from 70% above trend), consensus earning forecasts have just realized that the outlook is worsening. Seriously. Exhibit 4 shows consensus forecasts for the S&P 500 excluding financials. Up until last month, there had been no downgrades. According to colleague Jason Todd, the third quarter reporting season has offered uniformly bleak outlook statements. This convinced analysts to downgrade their numbers. Expect more of this.

The big issue for investors, of course, is how much of the prospective downgrades are in the price. No investor I know believes the sell-side consensus numbers. However, the past month has clearly seen a renewed mark-down in both sell-side numbers and the already lowered expectations of investors. Sell-side numbers may be too high, but they move coincidently with buy-side forecasts. Moreover, at the stock level, companies that downgrade are sold. In short, despite broad skepticism about earnings forecasts, there are few signs that the market is willing to take downgrades in its stride.

The significant deterioration in the macro outlook was clearly not in stock prices a month ago. Is it now? Exhibit 5 shows the global ex-US MSCI index and the consensus 12 month-ahead EPS forecast. The chart is constructed so that the index is on a P/E of 14 when the lines overlap. On current estimates, the market is trading on a P/E of around 10. But here's the rub: If earnings fall to 2003 levels - which, given the severity of the coming recession, seems a suitable base case - then the market is trading on 22 times those earnings. The bubble has popped, but there's more air to escape.

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END OF RESEARCH ABSTRACT

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Disclosure Section
The information and opinions in Morgan Stanley Research were prepared or are disseminated by Morgan Stanley Asia Limited (which accepts the responsibility for its contents) and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z, regulated by the Monetary Authority of Singapore, which accepts the responsibility for its contents), and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H, regulated by the Monetary Authority of Singapore, which accepts the responsibility for its contents), and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services license No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley").
For important disclosures, stock price charts and rating histories regarding companies that are the subject of this report, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures, or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Equity Research Management), New York, NY, 10036 USA.

Analyst Certification
The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Gerard Minack.
Unless otherwise stated, the individuals listed on the cover page of this report are research analysts.

Global Research Conflict Management Policy
Morgan Stanley Research has been published in accordance with our conflict management policy, which is available at www.morganstanley.com/institutional/research/conflictpolicies.

Important US Regulatory Disclosures on Subject Companies
The research analysts, strategists, or research associates principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues.
Certain disclosures listed above are also for compliance with applicable regulations in non-US jurisdictions.

STOCK RATINGS
Morgan Stanley uses a relative rating system using terms such as Overweight, Equal-weight, Not-Rated or Underweight (see definitions below). Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold and sell. Investors should carefully read the definitions of all ratings used in Morgan Stanley Research. In addition, since Morgan Stanley Research contains more complete information concerning the analyst's views, investors should carefully read Morgan Stanley Research, in its entirety, and not infer the contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations.

Global Stock Ratings Distribution
(as of October 31, 2008)
For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equal-weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively.

	Coverage Universe		Investment Banking Clients (IBC)
Stock Rating Category	Count	% of Total	Count	% of Total IBC	% of Rating Category
Overweight/Buy	869	39%	275	42%	32%
Equal-weight/Hold	983	44%	286	44%	29%
Not-Rated/Hold	22	1.0%	6	0.9%	27.3%
Underweight/Sell	403	18%	89	14%	22%
Total	2,277		656

Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley or an affiliate received investment banking compensation in the last 12 months.

Analyst Stock Ratings
Overweight (O or Over) - The stock's total return is expected to exceed the total return of the relevant country MSCI Index, on a risk-adjusted basis over the next 12-18 months.
Equal-weight (E or Equal) - The stock's total return is expected to be in line with the total return of the relevant country MSCI Index, on a risk-adjusted basis over the next 12-18 months.
Not-Rated/Hold (NA or NAV) - Currently the analyst does not have adequate conviction about the stock's total return relative to the relevant country MSCI Index, on a risk-adjusted basis, over the next 12-18 months. Please note that NA or NAV may also be used to designate stocks where a rating is not currently available for policy reasons. For the current list of Not-Rated/Hold stocks as counted above in the Global Stock Ratings Distribution Table, please email morganstanley.research@morganstanley.com.
Underweight (U or Under) - The stock's total return is expected to be below the total return of the relevant country MSCI Index, on a risk-adjusted basis, over the next 12-18 months.
Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.
For Australian Property stocks, each stock's total return is benchmarked against the average total return of the analyst's industry (or industry team's) coverage universe, instead of the relevant country MSCI Index, on a risk-adjusted basis, over the next 12-18 months.

Analyst Industry Views
Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below.
In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below.
Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark, as indicated below.
Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index.
.

Other Important Disclosures
Morgan Stanley produces a research product called a "Tactical Idea." Views contained in a "Tactical Idea" on a particular stock may be contrary to the recommendations or views expressed in this or other research on the same stock. This may be the result of differing time horizons, methodologies, market events, or other factors. For all research available on a particular stock, please contact your sales representative or go to Client Link at www.morganstanley.com.
For a discussion, if applicable, of the valuation methods used to determine the price targets included in this summary and the risks related to achieving these targets, please refer to the latest relevant published research on these stocks.
Morgan Stanley Research does not provide individually tailored investment advice. Morgan Stanley Research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities/instruments discussed in Morgan Stanley Research may not be suitable for all investors. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. The securities, instruments, or strategies discussed in Morgan Stanley Research may not be suitable for all investors, and certain investors may not be eligible to purchase or participate in some or all of them.
Morgan Stanley Research is not an offer to buy or sell or the solicitation of an offer to buy or sell any security/instrument or to participate in any particular trading strategy. The "Important US Regulatory Disclosures on Subject Companies" section in Morgan Stanley Research lists all companies mentioned where Morgan Stanley owns 1% or more of a class of common securities of the companies. For all other companies mentioned in Morgan Stanley Research, Morgan Stanley may have an investment of less than 1% in securities or derivatives of securities of companies and may trade them in ways different from those discussed in Morgan Stanley Research. Employees of Morgan Stanley not involved in the preparation of Morgan Stanley Research may have investments in securities or derivatives of securities of companies mentioned and may trade them in ways different from those discussed in Morgan Stanley Research. Derivatives may be issued by Morgan Stanley or associated persons
Morgan Stanley and its affiliate companies do business that relates to companies/instruments covered in Morgan Stanley Research, including market making and specialized trading, risk arbitrage and other proprietary trading, fund management, commercial banking, extension of credit, investment services and investment banking. Morgan Stanley sells to and buys from customers the securities/instruments of companies covered in Morgan Stanley Research on a principal basis.
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It's difficult to assess how much farther the deleveraging process has to go:

First, this is not one adjustment. There were many facets to the debt super-cycle, and they may unwind at a different rate and to a different extent. In short, there is no one deleveraging metric to watch.

Second, the process of deleveraging almost always produces a feedback loop from declining asset values to strain on balance sheets to forced sales. Because of that feedback, how far leverage may fall before the process ends is a function of how quickly the process occurs. The faster the unwind, the more likely that there is an overshoot (in terms of both asset prices and leverage rates).

Third, it's hard to get good data. In fact, it was only as the deleveraging process started that some areas of leverage were exposed.

Today's note has charts from two colleagues (Neil McLeish, head of European credit, and Huw van Steenis, head of European banks) that aim to show how the deleveraging process is going in several areas. (See Neil McLeish, Deleveraging: Unwinding the Tape, 5 November; Huw van Steenis, European Banks: The Long Unwinding Road, 5 November.)

Neil argues that there will be four phases to the deleveraging process:

1. 'product' deleveraging. This is the writing down or liquidation of structured products that were themselves leveraged. This includes the now-famous alphabet soup of high finance: SIVs, CDOs, CPDOs, etc.

2. bank deleveraging. This process is still under way, but has been accelerated by government injections.

3. investor deleveraging, which affects both hedge funds and other traditional investors.

4. consumer deleveraging. This will take longer to play out. While it will have implications for investment markets, perhaps the main impact will be on the macro environment.

The evidence suggests that there have been some areas of significant deleveraging and risk reduction. However, there are areas where the pressure to reduce leverage will remain intense.

Exhibits 1 and 2 show two aspects of the product deleveraging phase. Exhibit 1 shows the cumulative liquidation of collaterized debt obligations (CDOs) since December 2007. Exhibit 2 shows the sharp decline in the exposure of a select group of lenders to leveraged finance.

I will leave bank deleveraging for another note, because it needs more discussion. There is also feedback between bank behaviour the economic cycle to consider. The more cautious banks become, the tighter credit, the worse the downturn, and the worse likely bank losses will be.

Investor deleveraging continues. Huw expects that hedge fund assets will shrink by more than one-third in the current half-year (Exhibit 3). The outlook for 2009 is for more adjustment, with a bear-case scenario of assets falling to just over US$1tr (from $1.93tr at mid-2008). AUM at equity hedge funds is down over US$100bn from the peak (Exhibit 4).

Traditional investors are likewise seeing redemptions. Exhibit 5 shows annualised net flows on a year-to-date basis for European mutual funds. The outflow from mutual funds is on one level predictable - flows tend to follow market performance. It may also reflect pressure on the household sector to reduce its own leverage.

The point that the deleveraging process will go through different phases is important for investors. It will likely mean that the pressure on different markets will vary. Neil argues that the initial wave of deleveraging pressure on structured products had the perverse effect of high-quality assets underperforming lower-quality assets (super-senior debt underperformed equity, credit underperformed stocks). But as that process has abated, relative quality has become more relevant. Consequently, higher-quality credit assets look attractive on both an absolute and relative basis. 
 

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by Eric Janszen

With all of this panicking into dollars we get asked a lot about deflation. "Why don't you just admit that a 1930s style depression and deflation spiral has begun and soon there will be soup lines and we'll be buying cars for $2,000 and gold will trade at $100." The reason is that we are 100% certain that dollar appreciation that we call "Ka" as part of Ka-Poom Theory will not turn into a deflation spiral. Cars are not going to cost $2,000, although there will be plenty of cheap used cars for sale, and gold will not go to $200. Here's why.

The essence of Ka-Poom Theory is that after the phony credit-based boom ends, first the dollar rises and inflation falls before dollar repatriation and government reflation policies kick in. We don't think the transition from disinflation to inflation is trade-able because we expect it to be chaotic. But we don't blame readers for trying, or wanting to.

This ain't deflation

We're not nit picking terminology here. We'll show you what a real deflation spiral looks like: nothing whatsoever like the deflation we are seeing today that we have long forecast and call disinflation to distinguish it from the run-away deflations that occurred under the gold standard in the pre Bretton Woods era.

Deflation was common back in the days when there was something for a currency to deflate against for more than a brief period of time before the government got involved: gold. Even then, governments often abandoned the gold to inflate the money supply to stop deflation, especially in times of war. If you are a government and need to inflate and there's no war to fight, then make something up–like a oil shortage in the 1970s.

Note the early 1920s deflation reached -30% in some months and on and off for years at a time. Note also the massive inflations produced as the US government temporarily suspended gold convertibility and printed money to fund wars. Many forget that these huge swings occurred: 80% inflation during WWI and 100% inflation after WWII.

Governments can always produce inflation. Always.


The period of deflation that occurred in the early 1930s is the one that most people think about when they hear the word "deflation." What they really mean is a deflation spiral, with the money supply imploding, credit contacting, large scale bankruptcies, rising unemployment, and falling economic output. Note that there was not a single month of inflation from 1930 to 1933. Prices went down and down and down. For years.

The 1930s deflation spiral ended abruptly in 1934. Why? FDR took the US off the gold standard and devalued the dollar against gold which remained the international currency for trade transactions. And–this is key–there has never been another similar period of deflation since then, in any country. Ever.

There is a reason for that: since the 1930s no country has been on a national gold standard.

Only one other government made the choice to stay on the gold standard at the time, Germany. Every other government got off the gold standard in the 1930s and inflated. Many, such as the US, finally resorted to currency depreciation when the pain got bad enough, exporting deflation. That was the impetus for Bretton Woods after the war: don't allow a repeat of competitive currency devaluations because nations in a global depression that fight each other with currencies are soon fighting each other with guns.


There were a very brief few months of deflation after WWII as the government attempted, Paul Volcker style, to wring inflation out of the post WWII economy. But note the deflation scale in this post-Bretton Woods period has now changed from the post-gold standard era where deflations exceeded 30% in some periods. Since then, no more 30% deflations. Rarely, for short periods when deflation has happened since Bretton Woods deflation has only once exceeded 10% in one month and has generally been limited to less than 5%.

Take-away: No gold standard, no deflation spirals. Ever again.


The first years of the 1960s were the golden era of monetary stability. In fact, life was so good the US government decided to ruin it by starting a war, building the military industrial complex, and launching numerous entitlement programs that we are to this day still kidding ourselves into thinking we can pay for. After running up a trade deficit that our trade partners feared we intended to pay with devalued dollars, the Europeans figured we were cheating and called our bluff by demanding payment of debts in gold. So we defaulted. US to the world: Thanks for playing!


This was the ugly era of birth of the FIRE Economy. I won't go into the details here but, clearly, deflation was not the problem. I will mention that this is when we came up with the dollar cartel to knock back OPEC and Nixon got to tell OPEC: "Thanks for playing!"


As the Volcker Fed raised interest rates, the US economy experienced a short spike of deflation around -5%. Since the technology stock bubble popped in 2000, the US has had several months of deflation like that in 2002, 2004, 2006, and 2007.

If you want to call today's period of low inflation a "deflationary period" then you must also call 2002, 2004, 2006, and 2007 deflationary–actually more deflationary than today if you look at the graphs. Meanwhile oil increased from $20 to $147 over that period, which is not exactly a typical symptom of deflation.

Japan also has never experienced a deflation spiral. They could end their modest deflation, never exceeding -2% in a quarter off and on for more than a decade in short order, but the trade-off for them is a crashed yen– so they don't. I think we'll crash the dollar fighting off deflation.

The critical take-away is that we are indeed experiencing short term deflation. We call it disinflation here in the context of Ka-Poom Theory to keep readers from confusing the process with the start of a deflation spiral–which cannot happen under a floating exchange rate, fiat money system. The only way it could is if governments around the world all got together and decided to crash the global economy. That strikes us as unlikely. More likely one or more will move to reflate using currency devaluation.

If the Fed so desired the US could have 100% inflation by the middle of 2009 as the US did in 1946. All that is needed is for Congress to borrow a few more trillion into existence to fund old and new liabilities and have the Fed print it because our government cannot borrow the money from overseas or raise taxes, or devalue the dollar, or both.

It's just that simple. Wish it wasn't so. Trust your government not to do it?

Neither do we.

If not deflation, then what? Stagflation?

Keep an eye on producer price index, commercial lending rates, and wage rates. These tell you how much your local grocery stores, restaurants, gasoline stations, and other businesses have to pay–their input costs–as the recession drags on. As recession deepens, businesses have to cut prices to their customers to meet lower demand. If input costs don't fall quickly, many of these companies will either go out of business or be acquired by stronger rivals that have more cash or access to credit. If this goes on for years, as we expect it to, instead of a short drive to the local Home Depot it's a long drive, instead of 10 restaurants to choose from in the area there are five, instead of four grocery stores to visit there are two, instead of four daily flights to your favorite destination from the nearest airport there is one. The plane is crowded. You are packed in like a sardine. The fare is expensive.

Inflation comes not only from surfeit of money relative to goods and services but also a shortage of goods and services relative to the supply of money.

In a couple of years when you get to the one remaining Home Depot in your area that has not closed you will find that it's crowed. As most of the goods that Home Depot sells are imported, and the dollar continued to decline after the current short term panic into dollars ends–and the impact of net negative capital flows exerts its natural downward pricing on the dollar–the wholesale prices Home Depot pays will not decline much if at all. The government will welcome the devalued dollar, as it has since 2002, because the inflationary impact helps counter the deflationary impact of debt deflation and helps the US export position. Wage rates will not rise because recession will have caused higher unemployment and reduced wage earner's pricing power. However, at that point there will be few stores (boom market in plywood to cover plate glass windows?) and two or three times as many consumers vying for the same goods, and the cost of imports is up because the dollar had depreciated further; prices may actually rise.

In response, consumers will buy fewer things and will substitute lower quality products for higher quality products, hamburger for steak. The golden age of the American consumer ends.

Let's say you are an American visiting an indebted country years ago that has lost its ability to extend its purchasing power via foreign borrowing because that is the situation that the US faces today. For example, Mexico in the early 1980s. What do you see? You spend your strong dollars so experience prices there as cheap. You see crowded stores and low prices–crowded because the equilibrium price between the cost of goods that stores pay and prices that customers can afford creates only enough demand to support a small number of stores for the local population. But the people who live there experience the same stores as crowded but with high prices. Why? Because while the new equilibrium price for goods is now the same as before or maybe higher, but the purchasing power of consumers has fallen due to lack of access to credit and falling incomes.

That is our future in the US once the spike in the value of the dollar ends and the dollar continues its decline through this recession. This picture may, however, be distorted by government intervention to support the housing and credit markets to slow debt deflation. Government spending may further weaken the US dollar. Then there is the possibility that immigration and trade policy will change to address wage deflation by lowering competition for jobs via restrictions on outsourcing and immigration.