[Skybird]

Beware that inflation could quickly turn into deflation.


The banks' credit expansion has not increased economic resources, since the capital goods needed for investment have not been co-created. In the race for scarce capital goods and labor, entrepreneurs bid up prices and wages. This creates the illusion of greater wealth. The recipients of higher wages spend more money; the monetary illusion makes them feel richer even when in reality they have received only a wage increase that compensates for the loss of monetary value.

As long as the prices of goods have not adjusted to the increased money supply, more is consumed, because the entrepreneurs who sell at the old prices sell too cheaply, i.e. without taking their future higher costs into account in the calculation.

While the boom is still underway, the errors are becoming apparent. The capital goods that would be necessary for all entrepreneurs to successfully complete the investments they have embarked upon are not available. The abundance of credit and the artificially low interest rate had feigned a greater amount of capital than actually exists. The guardian function that the interest rate was supposed to perform - by ensuring that only those investments are started whose completion is possible with the available resources and desired by consumers - must now be taken over by market prices: Escalating costs lead to the abandonment of many projects. No one can get around the natural law that one must save in order to invest. If there is no voluntary saving, then the artificial boom brought about by expansionary monetary policy leads to forced saving: general price increases that reduce consumption. There is now more money in circulation, but it has less purchasing power per unit.


Suddenly comes the abrupt reversal. Credit expansion falters. This can happen through a reversal of monetary policy by central banks (interest rates rising instead of falling). But it also happened in the era before central banks existed, such as when lenders become nervous at a certain point by the sheer volume of credit (and the concomitant stretching of bank balance sheets) and/or by the arrival of news that contrasts with the exuberant optimism (and is evidence of the entrepreneurial errors committed during the credit expansion phase).

Since there are no liquidity buffers in the whole system, this triggers a chain reaction, prices fall. This is a perfectly good thing, but it is perceived as a crisis, which in our time the central banks are countering with the only tool at their disposal: Reinflate by cutting interest rates or, if that doesn't do the trick, by taking unorthodox measures like buying government bonds.

We are seeing the first signs of deflation. Many of the indicators that showed inflation in 2020/2021 have turned against a backdrop of rising interest rates. The Nasdaq index is down more than 20 percent year-to-date. Oil and commodity prices are well off their March highs. Gold's March surge to an all-time high of $2070 per troy ounce quickly turned out to be a false signal: It is now more than $200 lower. Due to rising market interest rates, demand for real estate loans in the U.S. has plunged by half compared to the same period last year. A worse-than-expected quarterly report from Alcoa, one of the world's largest aluminum producers, led to a slump in numerous commodity stocks at the end of April as investors wondered whether the zenith of the commodity boom might have passed.

The price of copper (in U.S. dollars), which is often used as an indicator of future economic activity ("Dr. Copper"), is already 20 percent below its all-time high in March. Not to mention all the listed companies whose quarterly results disappointed.

However, the picture is not uniform: Another important economic indicator, the Baltic Dry Index (which shows how much it costs to transport bulk goods across the oceans) has reached an annual high these days.

The financial crisis year of 2008 showed how quickly the turnaround from credit expansion to deflation occurs. It was characterized by galloping inflation, especially in the commodities, energy and construction sectors. The oil price reached its all-time high in July 2008, when the price of North Sea Brent crude climbed to $147. By December 2008, it had fallen to just 33 U.S. dollars. The galloping inflation was the end point of a credit expansion, or bubble, orchestrated by the central banks.

Six months before the bankruptcy of the investment bank Lehman Brothers, you could already see a sign of deflation if you knew what to look for: The U.S. dollar, which had been steadily losing ground against the euro since the summer of 2002, hit its all-time low in March 2008, on that weekend when the major U.S. investment bank Bear Sterns admitted its liquidity problems. From then on, the dollar went up sharply - not because the prospects for the American economy had improved (they hadn't), but because investors who had borrowed cheaply in U.S. dollars to put the money into all kinds of speculations around the world got cold feet. They smoothed out their trades and repaid the dollar loans, leading to strong demand for the American currency. The rising dollar was the sign that financial markets were in risk-off mode: Capital preservation was more important than capital gain. We are in such a phase today as well.

What will happen next? One factor of uncertainty is the People's Republic of China. The lockdowns there are currently one of the biggest drags on the global economy. If they are lifted and there is a major infrastructure program in China in the run-up to the 20th National Congress of the Chinese CP, which will take place in October, this could lead to a new phase of credit expansion in the summer - especially if the key interest rate increases by the U.S. Federal Reserve are smaller than market participants expect. And that's the second uncertainty: For decades, U.S. central bank heads Greenspan, Bernanke & Co. were the patrons of the stock markets. Every time there was a crash, they responded with interest rate cuts. This time, however, Federal Reserve Chairman Powell wants to raise interest rates without regard to plummeting stock prices. Is he bluffing or not? If you knew, you could get rich quick. If Powell is not bluffing and continues on his course, then the signs point to deflation.

Just as not all prices will rise at the same time, they will not fall at the same time. Some will fall immediately, others later or not at all. Pizza maker Enzo certainly won't roll back his price increases. But an oil price of more than $100 a barrel may be just a memory by the end of the year. Maybe it will only be at forty by then. Yes: deflation is a good thing. At least for those who don't have stocks.


by Stefan Frank for AdG

Translated with www.DeepL.com/Translator (free version)