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Inflation? Deflation? - What Matters About the News From Europe

Thursday, January 22, 2015

Here we go again...

Mario Draghi - the European counterpart to Janet Yellen (and Ben Bernanke before her) is announcing that the European Central Bank is going to do what the agreement that created the Euro expressly said would not be done - directly fund European governments' deficit spending.

OK, now at this point I realize a few things: 1) It is very likely you thought "Mario who?  Isn't that the guy from Donkey Kong?" (I just dated me and my Asteroids-champion self.); 2) If it's morning and you're working on your coffee you probably just thought "good grief, it's too early for this!" and 3) "Hold on, didn't the President just say the crisis has passed?  Why are you people still writing about this stuff?"

Well, mainly, because of economic gravity... what goes up must come down.  And if it went up fast, be assured, it'll come down fast.

Let me start by pointing out an economic measure: The "Shiller Price-to-Earning Ratio" is a multiple that expresses how the stock market values a share of stock.  If the "P/E" ratio is 10, it means each share of that company's stock is priced at 10 times earnings per year, per share.  Robert Shiller has created a model for this number that takes into account relative profit margins during periods of economic growth (when profits will be strong) and contraction (when they will be weak).  The reason I think this is worth your attention is it makes what is happening today easy to understand.

First, if you click on the link above you will see a chart that shows you the history.  This shows a "mean" P/E of 16.58 all the way back the late 1800's.  Anything below that means the market is "deflated."  Anything above that means the market is "inflated."  In order to understand what is happening in our economy, we absolutely MUST start with this historical context.

So when we hear central bankers like Draghi talk about "deflation," the very first thing we need to do is look at where the P/E ratio is against its historic mean.  When we see that it is at 27.10 (as of this writing) against a mean of 16.58 - and all we hear on the news is hand-wringing about "deflation" - we should be putting on our critical thinkers' hats and start asking some tough questions.

Again, at 27.10, the market is incontrovertibly inflated from its historic mean.  So what do they mean when they say they are going to create more money to avoid "deflation?"

They mean they do not want to let the air out of the balloon.

They are assuming we start with valuations as they are today, and that if the balloon loses air, that will be "deflationary."  And they (politicians and their bankers both) know full well what happens when their bubbles burst.  The politicians lose their jobs... and the money printers lose their sponsors.

The jig is up, the news is out, we finally found them...

Let me try to show here why they're fighting a losing battle:

If you have ever repaid a loan, you know part of each payment goes to interest.  And you may recall a time when you could put money in a savings account and get paid a few percent in interest on your savings.  Well, money works by the laws of supply and demand like anything else.  The more money is out there, the cheaper it becomes.  But that price is expressed as an "interest rate."  And you cannot go lower than zero.  Well, you can, but if the interest rate on your savings account is in the negative, you are actually paying to have the bank hold on to your money for you.  At that point you're better off pulling it from the bank and sticking it under your mattress.

The lesson in simple terms?  There is a limit to how much money central bankers like Draghi can create before the entire idea of money - and the banking system with it as people yank their deposits instead of paying the banks to hold onto them - begins to fall apart.  If anyone should know better it is the Europeans, who have seen this movie before in the "Wiemar Republic."  This was the German government predecessor to Hitler's Third Reich, and their money printing to pay debt (exactly what Draghi has announced they are going to start doing) is what created the economic circumstances which then gave rise to the Third Reich.

Again, Europe has seen this movie before.  It did not end well the last time.

This is, actually, quite easy to understand.  Try blowing up a balloon.  Just ignore that sneaky suspicion that the rubber is being stretched to its limit and keep on blowing.  In terms of money, the closer interest rates get to zero, the more persistent that sneaky suspicion should become.  But if you want to ignore that sneaky suspicion, just keep on creating new money (blowing).  Even you jocks out there should figure out how this ends without too much difficulty.

The reason the P/E ratio is the number to watch here is because the stock market has become the dominant "inflation sink."  Here I'll reach into my computer geek hat for an analogy. The laptop I am writing this post on is a few years old and the system fan is starting to stress out and make noise.  The chip in this laptop has a "heat sink" which dissipates the heat generated by the chip as the fan blows air over it.

What happens when extra money is created is prices act as a "sink" to dissipate the excess money. Before the computer, new money had to actually be printed, and so it would be dissipated among ordinary consumer products - prices would rise across the board.  But because of the computer, when banks want to invest their reserves (all the excess money) they deploy that money mainly into the stock market (and real estate to a related extent).  And so we see a spike in the valuation of stock prices as well as real estate.  The best way to track those spikes is the Shiller P/E Ratio (and the Case/Shiller Home Price Index).

The other way to track this is income inequality.

Wealth is measured more and more in terms of stock and real estate, and more and more of this wealth is going to fewer and fewer people.  The problem with the Occupy crowd is all they do is rail about this without really understanding the underlying cause.  The problem with conservatives is they think any effort to correct this distortion is an attack on the free market.  The Occupy crowd needs to realize the same politicians who strike their populists poses are the ones calling for more money printing.  Conservatives need to disabuse themselves of the assumption that we even have a free market to attack.  We haven't had a free market since 1971.

No matter how good you are (were?) at Donkey Kong or Asteroids (or Call of Duty if you're of the younger set), there will eventually come a time when the screen will say "GAME OVER."  The higher the Shiller P/E number gets against its historic mean, and the lower interest rates fall, the closer we are to that point.

You heard it here first... Donkey Kong will eventually prevail.

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P.S. TO MY READERS IN THE UKRAINE: Stay AWAY from the Euro.  Stay as far away as you possibly can. Chart your own course. In the Euro lies a mathematically inevitable collapse. In your hearts lies the future of Europe.  Please, show us a future of industry, innovation and wealth creation; of an exceptional people among whom is the greatest possible room for all ethnicities, their languages and their religions.

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