Deflation: Good, bad and ugly …

Martin Weiss with his father, Irving Weiss, studying the causes of deflation in 1980.

Deflation challenges the most brilliant minds at the Fed, defies the smartest traders on Wall Street, and threatens to rip through the strategies of millions of investors.

And yet, among all those now making the decisions that could forever change our future, no one has personal experience with a prolonged period of deep deflation.

I don’t either. I was born in 1946, just as we were leaving the final vestiges of America’s deflation decade behind. I’ve studied that historic period with books, charts, and numbers, but that’s not the same thing. I’ve lived in Japan during deflationary times, but that, too, is different.

What truly brings me close to a visceral understanding of deflation is the half century I shared with my father, J. Irving Weiss, one of the few economists who not only advised investors during America’s 1930s deflationary period, but actually predicted it.

Dad was so proud of that unusual feat that he began telling me stories about it when I was old enough to blow up a balloon and make it go “pop.”

I even remember talking about balloons, inflation and deflation while walking down the beach in Brazil at the age of six.

Vicariously, I lived through America’s great deflation of that era, and from that education alone (plus a few years of research since), I can point out seven common fallacies about deflation:

Fallacy #1. Deflation (declining prices) is not the same thing as a depression (a falling economy). Sometimes the two go hand in hand, sometimes they don’t.

Fallacy #2. Most people think deflation is bad for gold. But Dad witnessed personally how the 1930s was good for the yellow metal and even better for mining shares.

Homestake, for instance, went from a bottom of $65 per share after the crash to $130 and change in 1931. From there, it doubled again to more than $350 a share by 1933. By the time it peaked in 1936, it had climbed to $540 a share — an astronomical gain of more than $470 per share. That was a sevenfold increase.

The dividends also doubled, redoubled, and doubled again, reaching $56 per share in 1935. Think about it. The dividends earned in one year alone almost paid back the entire purchase price of the stock.

Dome, another great gold producer, did even better. You could have bought its shares for as little as $6 after the crash. But in the next seven years, it paid $16.60 per share in dividends. The dividends alone were equal to more than 2.5 times the cost of the stock.

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Meanwhile, the price of Dome rose to $61 a share. A person who put $10,000 into Dome could have walked away with more than $100,000, while nearly everything else remained mired in deflation.

Fallacy #3. The deflation of that era didn’t begin in 1929 with the stock market crash. It actually began in the early 1920s and continued for most of that decade. Likewise, the first fortune-busting crash of the 1920s didn’t happen in New York. Nor was it in the Dow. It was the Florida real estate crash of 1925-26.

Fallacy #4. The so-called Roaring Twenties did not roar for everyone. Even while Wall Street and industrial elites were making fortunes, rural families were plunging into poverty. 

Fallacy #5. The Roaring Twenties didn’t even lift up national consumer prices. Quite to the contrary, the U.S. consumer price index, which had already suffered one big plunge in the late 1910s and early 1920s, began to slide again in July of 1926. Then, it continued going down virtually nonstop until May of 1929.

That wasn’t just low inflation like we’re seeing today in consumer prices. It was outright deflation.

Fallacy #6. Inflation is not necessarily “the norm” of history. Yes, it may be more common than deflation. But in addition to the 1920s and 1930s, there were major, deep, prolonged deflations in the 14th century, throughout the 1860s, during the 1870s; and, as I said, in the late 1910s to early 1920s.

Fallacy #7. These deflations were not caused mostly by fatal policy mistakes or unique geo-political events. They were all natural economic phenomena that occurred in different eras, under different political conditions, and with different triggers. Some prime examples …

Deflation of the 14th Century

In the decades following the Great Famine of 1315-17, the UK experienced a severe deflation accompanied by a dramatic plunge in English mint outputs.

Researchers cite a few possible reasons:

• Major European silver mines had been seriously depleted, making it physically difficult to coin money. In other words, a forced contraction in the money supply.
• The English Crown had overspent on troops overseas, which led to excessive outflows of bullion. And in Florence, early 14th century banks had gone overboard in expanding credit, especially to England.

England went broke, the Florentine government defaulted on its bonds, Italian banks went bust, and credit dried up almost entirely. That “mancamento della credenza” (shortage of credit) triggered a 50% crash in real estate prices along with massive wage-and-price deflation.

Deflation of 1658-1669

This episode was closely tied to political crisis: The year 1658 brought the death of Oliver Cromwell, Lord Protector of the Commonwealth of England, Scotland and Ireland … then abdication of his son, Richard, just eight months later … and, soon, financial chaos.

In 1665, England was devastated again by the plague. A year later, much of the capital was destroyed in the Great Fire of London. And in 1667, the Dutch raid on Chatham was, according to historians “one the most humiliating military reverses England had ever suffered.”

End result: Massive deflation as the purchasing power of gold jumped by 42%.

But not all deflations are caused by disasters …

Deflation of the Late 19th Century

In this case, deflation was driven primarily by two factors — (1) a boom in productivity thanks to sweeping technological advances in industry, plus (2) fiscal and monetary discipline as several major countries joined the gold standard.

Between 1870 and 1890, iron production in the five largest producing countries more than doubled from 11 million tons to 23 million tons, while the price of iron fell in half. And steel production increased twentyfold — from half a million tons to 11 million tons, while steel prices sank.

The declines spread to grain prices, which, by 1894, had plunged to just one-third of their 1867 peaks … and to cotton, which fell by nearly 50% in five years.

In response, France, Germany, and the United States threw up major import tarrifs, which in turn, triggered major economic declines and mass emigration from Italy, Spain, Austria-Hungary, and Russia.

Deflation of 1919-1921

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World War I ended.

Suddenly, the primary impetus behind an inflationary commodity boom simply ceased to exit. And commodity prices collapsed.

This wasn’t just a drawn-out period of falling prices; it was a massive rout in nearly all commodity prices, accompanied by a sudden plunge in the world’s leading economies.

From peak to trough, GNP shrunk by 18% in the United States, 20% in Germany, 24% in Canada and, worst of all, 29% in the United Kingdom. In fact, the impact on the UK was so severe, its “Roaring Twenties” were barely more than a whimper; and it stayed mostly depressed until World War II.

Lessons Learned

First, they’re all quite different. So never assume the next deflation is going to be like the last one. Aside from the self-evident fact that all deflations come with falling prices, each deflation follows a trajectory that’s unique in many ways.

According to five authors writing for the National Bureau of Economic Research (Bordo, Landon-Lane, Redish, Borio and Filardo), deflations can be roughly divided into three groups — the good, the bad and the ugly.  

• “Good deflations” are those that arise from sharp increases in supplies — “supply shocks” not only bring on lower product prices, but also higher profits, rising real wages, rising stock prices and good news for Wall Street.
• “Bad deflations” are those associated with recessions as the demand for goods falls sharply. And …
• “Ugly deflations” come with the collision of (a) big price declines and (b) big debts. That’s when you typically see corporate failures, bond market crashes, and even debt defaults by entire nations.

Later, historians may try to blame the bad and ugly deflationary busts on policy blunders, such as the Fed tightening credit or raising interest rates at precisely the wrong time. But the true cause is usually too much easy money and too much debt during the prior period of inflationary boom.

Second, sometimes deflation is the prelude to a big bear market in stocks (as it was in the 1920s and 1930s); sometimes it’s not (as we’ve seen so far in the 2010s.)

My father explains his 1929 experience this way …

“The main reason I didn’t invest in stocks in the late 1920s was because I couldn’t afford to. But there was also another reason: I saw how Florida real estate had crashed in 1925. I saw how commodity prices were still falling and how the nation’s farms were so devastated. I couldn’t imagine risking our family’s money in stock market speculation.

“I didn’t break that rule until 1930 when I borrowed $500 from my mother to invest in the market — but to play the decline by selling stocks short. I didn’t catch the exact top of the market in 1929. Instead, I waited until April of the following year, when the market had enjoyed a big post-crash rally. That’s when I started selling short, targeting shares in U.S. subsidiaries of British companies. I figured they were the most vulnerable because the British pound was so vulnerable.”

Sure enough, the Crash of ‘29 was just the opening act of the greatest market decline in modern history. From its peak, the Dow Jones Industrials Average fell 89 percent. But never forget: The commodity deflation started way back in 1919. The stock market crash didn’t begin until a full ten years later.

And needless to say, what the NBER researchers call “good deflation” often comes with continuing bull markets in stocks as a whole, or at least in major sectors of the stock market.

Finally, the most important lesson (and question): What kind of deflation are we experiencing — or most likely to see — this time around?

Strangely, it looks like a rare combination of the good and the ugly …

• The good: As Tech Trend Trader’s Jon Markman explains, we are witnessing sweeping technological innovations that promise to make almost everything we do or buy more efficient and cheaper.
• The ugly: As I told you here two weeks ago, and as Supercycle Trader’s Larry Edelson has warned, we could see a major collision between debt and deflation in Europe, then in Japan, and ultimately in the United States as well.

That implies major dangers in bonds and stock market sectors that are being hurt by debts and deflation (such as energy majors), plus major buying opportunities in those that stand to benefit (such as technology innovators).

Some experts have argued that deflation is impossible nowadays because massive QE (quantitative easing, or money printing), is designed to be inflationary.

In theory, that made sense. But in practice, it’s been dead wrong: Despite the biggest-ever QE by the world’s five most powerful central banks — the U.S. Fed, the European Central Bank, the Bank of England, the Bank of Japan and Bank of China — oil prices have crashed and most other commodities have followed suit.

Larry Edelson is one of the few in the world who predicted this unique convergence of events. And Credit Lyonnais Southeast Asia’s Christopher Wood explains why:

“The best way to illustrate that quantitative easing is not working is the continuing decline in velocity and the resulting lack of a credit multiplier since the unorthodox monetary regime was introduced. In America, Japan and the eurozone, velocity has continued to decline since the financial crisis in 2008 …

“Indeed, US money velocity is now at a six-decade low. This is why those who have predicted a surge in inflation in recent years caused by the Fed “printing money” have so far been proven wrong. Inflation, as defined by conventional economists like Bernanke in the narrow sense of consumer prices and the like, will not pick up unless the turnover of money increases.”

As you can see in the chart below, money velocity not only plunged in 2009, but it has also continued on a long-term decline that began in the late 1990s.

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All deflationary! All helping to explain why QE didn’t work. And all leading to the conclusion that more deflation is still in the works as the Fed tries to back out from its money-printing madness.

My advice: Learn from history. But don’t be its prisoner. Avoid the big dangers by maintaining a big stash of cash. Then, be ready to invest in extreme high quality companies with the brightest business models and most innovative technology.  

Good luck and God bless!

Martin

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