{"id":2577,"date":"2009-06-26T11:13:11","date_gmt":"2009-06-26T16:13:11","guid":{"rendered":"http:\/\/countingpips.com\/fx\/?p=2577"},"modified":"2009-06-26T11:13:11","modified_gmt":"2009-06-26T16:13:11","slug":"the-last-bastion-against-deflation-the-federal-government","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/fx\/2009\/06\/26\/the-last-bastion-against-deflation-the-federal-government\/","title":{"rendered":"The Last Bastion Against Deflation: The Federal Government"},"content":{"rendered":"

This article is part of a syndicated series about deflation from \t\t\t\t\tmarket analyst Robert Prechter, the world\u2019s foremost expert \t\t\t\t\ton and proponent of the deflationary scenario. For more on deflation \t\t\t\t\tand how you can survive it, download \t\t\t\t\tPrechter\u2019s FREE 60-page Deflation Survival eBook<\/strong><\/a>, \t\t\t\t\tpart of Prechter\u2019s NEW Deflation Survival Guide.<\/p>\n

The following article was adapted from Robert Prechter\u2019s \t\t\t\t\tNEW Deflation \t\t\t\t\tSurvival eBook<\/a><\/span><\/strong>, a free 60-page compilation of Prechter\u2019s \t\t\t\t\tmost important teachings and warnings about deflation.<\/p>\n

By Robert Prechter, CMT<\/p>\n

Now that the downward portion of the credit cycle is firmly in \t\t\t\t\tforce, further inflation is impossible. But there is one entity \t\t\t\t\tleft that can try to stave off deflation: the federal government.<\/p>\n

The ultimate source of all the bad credit in the U.S. financial \t\t\t\t\tsystem is Congress. Congress created the Federal Reserve System \t\t\t\t\tand many privileged lending corporations: Fannie Mae, Freddie Mac, \t\t\t\t\tGinnie Mae, Sallie Mae, the Federal Housing Administration and the \t\t\t\t\tFederal Home Loan Banks, to name a few. The August issue [of The \t\t\t\t\tElliott Wave Theorist] cited our estimate that the mortgage-encouraging \t\t\t\t\tentities that Congress created account for 75 percent of all U.S. \t\t\t\t\tdebt creation with respect to housing. For investors in mortgage \t\t\t\t\t(in)securities, the ratio is even greater. Recent reports show that \t\t\t\t\tthese agencies, which have been stealing people blind by taking \t\t\t\t\tinterest for nothing, account for a stunning 82 percent of all securitized \t\t\t\t\tmortgage debt. Roughly speaking, the government directly encouraged \t\t\t\t\tthe indebtedness of four out of five home-related borrowers. As \t\t\t\t\tnoted in the August issue, it indirectly encouraged the rest through \t\t\t\t\tthe Fed\u2019s lending to banks and the FDIC\u2019s guarantee \t\t\t\t\tof bank deposits. These policies allowed borrowers to drive up house \t\t\t\t\tprices to absurd levels, making them unaffordable to people who \t\t\t\t\twanted to buy them with actual money. Proof that these mortgages \t\t\t\t\tare artificial and the product of something other than a free market \t\t\t\t\tis the fact that while Germany, for example, has issued mortgage-backed \t\t\t\t\tsecurities with a value equal to 0.2 percent of its annual GDP, \t\t\t\t\tthe U.S. has issued them so ferociously that their value has reached \t\t\t\t\t49.6 percent of annual GDP, a multiple of 250 times Germany\u2019s \t\t\t\t\trate, and that is not in total value but only in value relative \t\t\t\t\tto the U.S.\u2019s much larger GDP. (Statistics courtesy of the \t\t\t\t\tBritish Treasury.)<\/p>\n

Well, the ultimate source of this seemingly risk-free credit still \t\t\t\t\texists, at least for now. When Bernanke & Co. met in the back \t\t\t\t\trooms of the White House in recent weekends, he must have said this: \t\t\t\t\t\u201cBoys, we\u2019re nearly out of ammo. We have $400b. of credit \t\t\t\t\tleft to lend, and we have two percentage points lower to go in interest \t\t\t\t\trates. The only way to stave off deflation is for you to guarantee \t\t\t\t\tall the bad debts in the system.\u201d So far, government has leapt \t\t\t\t\tto oblige. One of its representatives strode to the podium to declare \t\t\t\t\tthat it would pledge the future production of the American taxpayer \t\t\t\t\tin order to trade, in essence, all the bad IOUs held by speculators \t\t\t\t\tin Fannie and Freddie\u2019s mortgages for gilt-edged, freshly \t\t\t\t\tstamped U.S. Treasury bonds.<\/p>\n

Now, what exactly does that mean for deflation? This latest extension \t\t\t\t\tof the decades-long debt-creation scheme has essentially exchanged \t\t\t\t\tbad IOUs for T-bonds. This move does not create inflation, but it \t\t\t\t\tis an attempt to stop deflation. Instead of becoming worthless wallpaper \t\t\t\t\tand 20-cents-on-the-dollar pieces of paper, these IOUs have, through \t\t\t\t\tthe flap of a jaw, maintained their full, 100 percent liability. \t\t\t\t\tThis means that the credit supply attending all these mortgages, \t\t\t\t\twhich was in the process of collapsing, has ballooned right back \t\t\t\t\tup to its former level.<\/p>\n

You might think this shift of liability is a magic potion to stave \t\t\t\t\toff deflation. But it\u2019s not.<\/p>\n

Believers in perpetual inflation will ask, \u201cWhat\u2019s \t\t\t\t\tto stop the U.S. government from simply adopting all bad debts, \t\t\t\t\tkeeping the credit bubble inflated?\u201d Answer: The U.S. government\u2019s \t\t\t\t\tIOUs have a price, an interest rate and a safety rating. Just as \t\t\t\t\tmortgage prices, rates and safety ratings were under investors\u2019 \t\t\t\t\tcontrol, so they are for Treasuries. Remember when Bill Clinton \t\t\t\t\tbecame outraged when he found out that \u201ca bunch of bond traders,\u201d \t\t\t\t\tnot politicians, determined the price of T-bonds and the interest \t\t\t\t\trates that the government must charge? If investors begin to fear \t\t\t\t\tthe government\u2019s ability to pay interest and principal, they \t\t\t\t\twill move out of Treasuries the way they moved out of mortgages. \t\t\t\t\tThe American financial system is too soaked with bad debt for a \t\t\t\t\tgovernment bailout to work, and the market won\u2019t let politicians \t\t\t\t\tget away with assuming all the bad debts. It may take some time \t\t\t\t\tfor the market to figure out what to do about it, but as always, \t\t\t\t\tthere is no such thing as a free lunch. The only question is who \t\t\t\t\tpays for it.<\/p>\n

The Fed is nearly out of the picture, so the consortium of last \t\t\t\t\tresort, the federal government, is assuming the job of propping \t\t\t\t\tup the debt bubble. It is multiples bigger than any such entity \t\t\t\t\tthat went before, because it can draw on the liquidity of American \t\t\t\t\ttaxpayers and clandestinely steal value from American savers. So \t\t\t\t\tthe question comes down to this: Will the public put up with more \t\t\t\t\tfinancial exploitation? To date, that\u2019s exactly what it has \t\t\t\t\tdone, but social mood has entered wave c of a Supercycle-degree \t\t\t\t\tdecline, and voters are likely to become far less complacent, and \t\t\t\t\tmore belligerent, than they have been for the past 76 years.<\/p>\n

An early hint of the public\u2019s reaction comes in the form \t\t\t\t\tof news reports. In my lifetime, I can hardly remember times when \t\t\t\t\tthe media questioned benevolent-sounding actions of the government. \t\t\t\t\tArticles were always about who the action would \u201chelp.\u201d \t\t\t\t\tBut many commentators have more accurately reported on the latest \t\t\t\t\tbailout. USA Today\u2019s headline reads, \u201cTaxpayers take \t\t\t\t\ton trillions of risk.\u201d (9\/8) This headline is stunning because \t\t\t\t\tof its accuracy. When the government bailed out Chrysler, no newspaper \t\t\t\t\tran an equally accurate headline saying, \u201cCongress assures \t\t\t\t\tlong-run bankruptcy for GM and Ford.\u201d They all talked about \t\t\t\t\twhy it was a good thing. This time, realism and skepticism (at a \t\t\t\t\tlater stage of the cycle it will be cynicism and outrage) attend \t\t\t\t\tthe bailout. The Wall Street Journal\u2019s \u201cMarket Watch\u201d \t\t\t\t\treports an overwhelmingly negative response among emailers. Local \t\t\t\t\tnewspapers\u2019 \u201cLetters\u201d sections publish comments \t\t\t\t\tof dismay and even outrage. CNBC\u2019s Mark Haines, in an interview \t\t\t\t\ton 9\/8 with MSNBC, began by saying ironically, \u201cIsn\u2019t \t\t\t\t\tsocialism great?\u201d This breadth of disgust is new, and it\u2019s \t\t\t\t\ta reflection of emerging negative social mood.<\/p>\n

Social mood trends arise from mental states and lead to social \t\t\t\t\tactions and events. Deflation is a social event. Ultimately, social \t\t\t\t\tmood will determine whether deflation occurs or not. When voters \t\t\t\t\tbecome angry enough, Congressmen will stop flinging pork at all \t\t\t\t\tcomers. Now the automakers want a bailout. Voters have remained \t\t\t\t\tcomplacent about it so far, but this benign attitude won\u2019t \t\t\t\t\tlast. The day the government capitulates and announces that it can\u2019t \t\t\t\t\tbail out everyone is the day deflationary psychology will have won \t\t\t\t\tout.<\/p>\n

\u2026\u2026\u2026.<\/p>\n

For more on deflation, download \t\t\t\t\tPrechter\u2019s FREE 60-page Deflation Survival eBook<\/strong><\/a> or browse various deflation topics like those below at www.elliottwave.com\/deflation<\/a><\/strong><\/span>.<\/p>\n