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Deflation Delayed is not Deflation Denied!

David Chuhran
Sep 7, 2004

Sometimes you just have to sit back and watch. Since the correction that started in April for the precious metal sector, we've had an onslaught of credible arguments for both hyperinflation and deflation. There are so many global moving parts that it's really difficult to account for every factor that may come into play once one or more of the myriad of economic imbalances attempts to balance itself. Many analysts have used what appears to be a US-centric view in a somewhat static, two dimensional environment to put forth the "synthetic short" dollar thesis. This argument has merit in that environment, but fails to fully account for the forces that will come into play in a dynamic, global, multi-dimensional World. I can't begin to predict how humans all over the World will vote with their wallets once the dominos start to fall, but I do know that there's an age-old saying that "money goes where it's treated best."

My gut feeling is that will not be a force that moves the USDollar into strength over the long term.

Back at the end of 2003 when I wrote "Where Did All The Money Go" I asserted that much of the money supply expansion had found its way into the stock market fueling a cyclical bull within the secular bear. I still believe this was true; that's where the money was treated best. I also asserted that unless the Fed was able to reverse the topping pattern in the money supply that showed up in the latter half of 2003, we'd likely see a corresponding outflow from the equity markets. In fact, the Fed was able to resume the monetary inflation in early 2004 with the help of Japan's unprecedented intervention in the currency markets along with China's need to find a place to put their huge trade surpluses. Much of that foreign help has slowed as those countries seek diversification away from dollar denominated debt instruments.

Once again we find ourselves in much the same situation as we did last year; the broadest measure of the money supply (M3) appears to have stopped or at least slowed its expansion.

Here are the raw numbers since mid-May:

2004-05-17 9287.5
2004-05-24 9261.4
2004-05-31 9263.5
2004-06-07 9272.5
2004-06-14 9309.9
2004-06-21 9297.7
2004-06-28 9326.4
2004-07-05 9263.5
2004-07-12 9258.9
2004-07-19 9280.1
2004-07-26 9292.6
2004-08-02 9286.5
2004-08-09 9268.5
2004-08-16 9280.1
2004-08-23 9316.6

For an economy that has experienced annual monetary inflation in the neighborhood of $6-700 billion per year over the last several years, a 4 month M3 growth of only $30 billion certainly qualifies as flat. I believe we're once again backed into the corner as the Fed is desperately attempting to keep a monetary deflation from taking place. Unfortunately, this time it's different from last fall because we have an upward bias on interest rates with most consumers already tapped out of their extra "free" money from home equity loans or cash-out refis.

So, who's left to borrow?

Since a fractional reserve banking system uses debt as its foundation in the creation of money, we need additional borrowers to avoid monetary deflation. Also, if the money supply begins to contract or deflate, then I still think we'll experience capital flight from the equity markets as many will find their money treated better by retiring debt, holding cash, or moving into safe havens like the precious metals. I believe this process has resumed. In addition, based on the number of foreign investors holding US equities, I consider it a strong possibility that they'll simultaneously liquidate their equities and flee from the USDollar heading back into the currency that treats them best. Also, foreign central banks may find it necessary at some point to divest a portion of their US Treasury Bond holdings once the dominos begin to fall. This foreign movement away from Dollars will counteract any "synthetic short" strengthening of the USDollar within the US-centric marketplace. Nevertheless, the short term ebbs and flows will be extremely hard to predict as volatility will increase substantially in the FOREX currency markets.

In the end, the USDollar will plummet to all-time lows sending the anti-Dollar, Gold, to all-time highs.

While I was sitting back watching, waiting, listening, and learning from others, I continued to search for the missing link that correlated the recent action in the equity markets to the money supply. Among the many monetary aggregates available, I started watching the M1 Money Multiplier with interest. The M1 Multiplier is a crude gauge of the effects of money growth on the most liquid end of the money supply. It's basically M1 expansion relative to the monetary base. M1consists of currency held by the public, travelers checks, demand deposits, and other checkable deposits while the monetary base consists of deposits (reserves) held by depository institutions at Federal Reserve Banks plus Treasury currency and coins outstanding.

Since all money is loaned into existence, it stands to reason that a portion of that newly created money will find its way into demand or checkable deposits. Much of our post-bubble recovery has relied on consumers tapping into their home equity through loans or refinances. Those loans were deposited and then used for everything from big screen televisions to jet skis, but I also believe a significant portion was used in a "personal carry trade" where people invested their borrowed home equity money in the stock market. The potential for this "personal carry trade" may have a direct relationship with the activity on the most speculative end of the equity markets, the Nasdaq. My rationale is that should people have excess cash earning little or no return, or untapped low interest lines of credit where they feel their market rate of return will exceed their tax exempt rate of interest, then they're likely to find a place where they feel that money is treated better. Conversely, people will draw down their riskiest investments first to satisfy their short term needs for cash once they are unable or no longer wish to borrow, or when their portfolio's value approaches their outstanding loan balance. Here's a comparison of the M1 Money Multiplier to the Nasdaq (courtesy of StockCharts.com).

Is this a coincidence?

First, just simply look at these two combined charts from a distance and notice their similarities. The topping of the Nasdaq occurred simultaneously with the topping of the M1 Multiplier (1). The Multiplier reached an intermediate low and reversed upward prior to descending to a final bottom ahead of the Nasdaq (2 and 3). The Mulitplier came off the bottom first (3) and began a steady climb into mid-2003 where it then flattened while the Nasdaq continued up into its cyclical bull top (4). I believe this flattening signaled deflationary trouble as well as the impending equity market tops down the road. Recall that there was also a mid-year bond market plunge as well as a flattening of the broader M3 money supply in the second half of the year as evidenced by the first chart. Finally, the Fed realized there was trouble and began an all out effort to inflate the money supply in the first several months of 2004. This is apparent as you can see an initial divergence (5) as the Multiplier climbed to an intermediate top after the Nasdaq had begun its descent from the early 2004 top. That stimulus has exhausted itself. Finally, notice the close synchronization of the recent moves between the two with both apparently hooking downward.

Once again, I believe the trend toward a monetary flat-line will continue to bode ill for the equity markets unless the Fed can force another reversal to the upside. Should the monetary trend move in a negative direction, then I believe we could possibly see a precipitous market drop as we move directly into the jaws of deflation. There's a dire need for borrowing; this is the fatal flaw of fractional reserve banking. The Fed can affect the monetary base, but they cannot create borrowers that cycle money through the economy creating economic activity. Unfortunately, while the Fed is the lender of last resort, the government is the borrower of first and last resort. In this election year environment one wouldn't expect too much to happen, but post-election could bring on a new, full blown round of economic stimulus regardless of the election's outcome.

So, if the government is the only one left to borrow, then for what purpose could they possibly find that would have the full backing and support of our entire nation?


Should there be a perceived or real defensive need to save our country, we'll willingly sacrifice anything and everything, including the Constitution and the USDollar, to preserve our republic. My guess is the war will spread, the borrowing will resume, the money supply will expand, the dollar will fall, the bankers will profit, monetary hyperinflation will spillover into consumer prices, and many more of our nation's youth will be asked to go into harm's way. The inevitable deflationary outcome will not be thwarted; it will only be delayed by this hyperinflation at an ever increasing cost in both economic and human terms.

You see... deflation delayed is not deflation denied!

Sep 5, 2004
David Chuhran
email: goldbull@bellsouth.net

Copyright © 2004 David S. Chuhran. All Rights Reserved

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