FedUpUSA

Archive for the ‘Deflation’ Category

In response to Will Quantitative Easing Spur Inflation? Job Creation? Credit Expansion? Do Anything? (a point-by-point discussion of thoughts from Chris Ciovacco at Ciovacco Capital Management regarding quantitative easing), I received a nice reply from Chris.

Chris writes …

Hello Mish:

I agree with your comments today. We could have done a better job properly framing our comments on quantitative easing. We added the following to the top of our review to clarify our remarks:

Our interpretation below relates to the asset markets and asset prices. We believe quantitative easing can impact asset prices in the short-to-intermediate term. We do not believe quantitative easing is the solution to the global economy’s problems, nor do we believe it will create long-term prosperity or job growth.

As money managers, our job is to understand the possible impact of Fed policy on the value of our clients’ investments. The short-to-intermediate-term driver of asset prices would be the perception of market participants, right or wrong, that the Fed can create positive inflation.

We firmly believe quantitative easing can impact the prices of stocks, commodities, and currencies in the short-to-intermediate term. In that light, we believe quantitative easing, or even the potential for the Fed to buy Treasury bonds, is an important factor in determining investment outcomes in the next six to twelve months. Financial market performance and the long-term economic impacts of quantitative easing are two separate issues.

Have a great weekend,

Ciovacco Capital Management
Chris Ciovacco

My Reply …

Thanks Chris.

That is much better expressed. It is possible we are seeing some up-front effects now. If so, we could see a spike and a sell the news event, if and when the Fed does start QE2.

Moreover, this could be another “bazooka” ploy. So far all such ploys have failed. However, it is conceivable one of these bazooka plays “works” (rather appears to work), temporarily. One must balance that with the possibility QE2 blows up in the Fed’s face if they try it.

This is a very difficult market to judge. I see absolutely no reason to be long here. However, that is not an endorsement to short.

Mish

Chris Responds – Deflationary Outcomes Possible:

Hi Mish:

Appreciate the feedback. These are difficult times for investors and professional asset managers. We agree QE2 could result in another speculative leg higher in the markets or it could backfire.

Your comment “this is a very difficult market to judge” is right on the money. In our view, investors must understand and respect that short-term, primarily speculatively-based, gains are possible in asset prices. However, deflationary outcomes are also possible.

Asset price deflation (stocks & commodities) could take hold near current levels or could occur after another leg higher. We see the threat of a deflationary spiral accelerating if the S&P 500 again revisits the 1,010 to 945 level.

Any sustained break of 945 could open the door to very unpleasant outcomes. I think posting the email (and your thoughts) is a good idea. As I am sure you agree, our objective is to help people understand possible outcomes, over different time horizons.

Ciovacco Capital Management
Chris Ciovacco

Inflation Threat is Congress Not the Fed

The real inflation threat in the US is not the Fed. I think the Fed is pretty much powerless here. If quantitative easing seems to work, it will be temporary, just as happened in Japan.

Many people have emailed me stating that the Fed will give away money. No the Fed won’t.
The Fed cannot throw money out of helicopters or give money away. Such talk is nonsense. However, Congress can give money away.

Here are the pertinent questions:

1. How likely is that?
2. Enough to cause a serious bout of inflation?

The answer to #1 is straightforward enough: It is certain. Indeed, Congress has reluctantly agreed to toss another $26 billion at states to “save jobs”. The idea is foolhardy of course. One of the big problems cities and states face is public unions and public union salaries.

Those problems wrecked Greece and in my opinion have virtually bankrupted many major cities and states. Yet, here we are making another policy error, attempting to keep union wages intact and a defined benefit pension scheme alive, both of which desperately needs to be tossed in the gutter permanently.

The more important question is #2. Most think yes. I think no.

For starters the next Congress is going to be a lot more conservative than this one. Already we have seen unemployment benefits delayed for week. Money for the states came out of another pocket so the deficit did not go up.

However, a major reason a massive helicopter drop is not coming in spite of what everyone seems to think, is neither the Fed nor banks wants one! The Fed does not want hyperinflation as it will end the game. Banks do not want hyperinflation for the same reason.

What Do Banks Want?

Leaving aside the issue of hyperinflation, a complete loss of faith in the value of currency (an idea I believe is extremely remote), does anyone benefit from strong inflation?

I do not believe banks want serious inflation for the simple reason they do not want to be paid back with inflation cheapened dollars. Banks who were bailed out by taxpayers, already got what they want. They have nothing but scorn for the average Joe on the street his problems.

Besides, rising prices is no guarantee there will be job growth.

If banks don’t want it, and the Fed doesn’t want it, and Congress is likely to be far more conservative, then how is it going to happen? It is possible of course, but how likely?

That was a hidden theme in Fooled by Stimulus – Structural Problems Still Intact.

Problems Many, Solutions Nonexistent

• Tide of Debt: Consumers are swimming against a tide of debt with no way to pay it back.
• Demographics: Boomers are heading into retirement scared half to death because they did not save enough.
• Jobs: There is no source of jobs
• Wages: Global wage arbitrage
• Attitude Changes: a secular shift in the attitudes of consumers towards housing and risk taking is underway.
• The Fed is powerless to change attitudes.

It is going to be extremely difficult to counteract all of the structural problems in place.

As long as those structural problems are in place, the most likely outcome by far is a long drawn out Japanese style malaise. Whether or not prices as measured by the CPI stay above the zero line or dip below is actually a fairly insignificant point.

Bank lending and job creation are what matters most. The Fed is powerless on both of those scores, and barring massive efforts by Congress (and probably even with massive efforts by Congress), job creation is not around the corner.

Here is the essential question: If $1 trillion in fiscal stimulus did next to nothing, pray tell why would another trillion do anything?

Is another $trillion in fiscal stimulus coming? I highly doubt that.

Might a $trillion in QE2 come? Sure, perhaps even double that. But would it accomplish anything?

Long-term Chris Ciovacco agrees that it will not spur growth or fix any structural problems.

Short-term is more debatable, but perhaps the only response is a move in treasuries or gold.

Shorting Treasuries

Many have gotten their heads blown off again shorting treasuries. With all the above-mentioned structural issues, and with the Fed threatening QE2 on top of it, why would one want to be short treasuries here?

Fed Cannot Change the Trend

Let’s return to the revised thesis, that QE2 may cause a bounce in the markets. Chris believes “quantitative easing can impact the prices of stocks, commodities, and currencies in the short-to-intermediate term.”

While possible, please remember …

The Fed can speed up or delay, but not change the primary trend.

Quantitative easing might give a boost to that downward trend in 10-year treasuries, but Fed purchases of treasuries is certainly is not the cause of plunge in 10-year treasury yields. The slumping economy and deflation are the cause.

Fundamentally, yields ought to be falling, and they are. If and when yields are poised to rise, the Fed will not be able to do much to stop it.

Perhaps QE2 causes a bounce in the equity markets, but it will quickly fade unless the market was ready to head in that direction permanently.

Uncharted Territory

To be sure, we are in uncharted territory, not only in treasuries, but in the Fed’s response to the crisis. I called for the Fed’s power grab and willingness to break rules in advance on April 3, 2008 in the Fed Uncertainty Principle.

Nonetheless, I do not know for sure what is coming up next. No one else does either. Yet I see statements every day on the internet such as “I know gold is headed to $2000″, “The bottom is in”, etc.

Well gold may (or may not) hit $2000 but certainly no one knows. It may also fall to $500. The Bottom in the stock market may be in, but there is a very good chance it isn’t.

The Known

1. Structural problems (tide of debt, demographics, etc – as noted above) are numerous.

2. Stocks are not cheap if you factor in quality of earnings, dividends, historical PEs, etc. Stocks only “appear” cheap if you believe forward earnings estimates in the face of those structural problems.

3. Buying stocks in the face of such structural issues, at a time when they are not cheap is highly likely to yield poor results.

4. It is difficult if not impossible to time the effect (if any) of quantitative easing. In fact, we may have already seen it in advance.

5. Gold is in a long-term bull market with its monthly trendlines intact. Other than treasuries, not much if anything else is.

Some may debate point number two, but I am willing to state that is what I know. However, knowing stocks are not cheap, and knowing where they are headed are two entirely different things.

The Unknown

We do not know what Congress will do, what the Fed will do, or what foreign central banks will do if the economy heads south again in a major way. We have ideas, but we cannot say we know.

Moreover, it is not what the Fed or Congress does in isolation that will matter most, rather what they do in relation to what other countries is what matters, and we certainly do not know that.

China is a wildcard and its response to the next global slowdown will greatly impact commodities. Does anyone know for sure what China will do? I think not.

The Mideast is another wildcard. Certainly we might see a startling reaction if Israel were to attack Iran or vice versa.

The Odds

While stocks may rise in this environment, the odds are they don’t. While treasury yields may shoot to the moon, the odds are they won’t. While gold may collapse, the odds are it won’t.
While quantitative easing (assuming it happens) may temporarily effect stock prices favorably, the odds are against someone timing it correctly.

This is is not a call for anyone to short this market as most of those structural problems are reasonably well understood. However, this is quite a good time to be thinking about risk-reward setups, because the odds of a sustained rally sure do not look favorable.

Bear in mind unfavorable and impossible are not the same thing. While one might throw sevens, four times in a row at craps, I would not advise betting on it.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

Krugman has “explained” why deflation is “bad”.  Well, he’s tried.  But in fact he’s made the case for deflation, especially following insane bouts of INflation.

His idiocy requires a response….

Ok, point-by-point:

So first of all: when people expect falling prices, they become less willing to spend, and in particular less willing to borrow.

Why is this bad?  Real capital formation comes from savings.  Indeed, it is the essence of capital formation of all sorts.  You can’t lend except from excess capital (production ex required spending, that is, surplus) so being less willing to borrow or spend is a net public good over time.

Yes, it makes the Madison Avenue people go nuts, and it particularly makes those people nuts who want to blow bubbles with borrowed money (which always ends in a bust with a huge number of people going bankrupt) but in terms of public policy saving of surplus and thus capital formation should be encouraged, not punished.

A second effect: even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts.

GOOD!

It’s supposed to be expensive to borrow.

Again, there are three sorts of borrowing:

• Productive borrowing.  That is, borrowing for the purpose of purchasing the means of production, where the reasonably-expected outcome is that the productive means purchased will return more than the amortized principal and interest on the loan.  An example of this sort of borrowing is taking out a line of credit to buy a CNC machine which, along with raw materials, electricity, tools and labor turns out precision aircraft parts.  This sort of borrowing is of net benefit to society as a whole, as it generates employment and net increases in GDP after the fully-amortized cost of the loan.

• Consumptive borrowing. This serves only to pull forward demand.  That is, it is borrowing to buy today what one cannot afford until tomorrow.  This produces a temporary distortion in the supply:demand curve.  Since the signal it sends to the economy is false, in that the demand proffered cannot be maintained indefinitely without an ever-increasing amount of debt being taken on (by definition a Ponzi Scheme) it is thus of negative value to society and as a matter of policy should be discouraged.

• Speculative borrowing.  This is borrowing to place a bet that whatever is purchased will sell for a higher price tomorrow than it does today – not for utility value or consumption itself.  This is the most-destructive form of borrowing of all, since it is both inherently a Ponzi scheme and provides for no positive consumption boost whatsoever, as the item(s) purchased are not bought for the purpose of consumption in the first place.  That is, this is not “pulled forward” demand (that would otherwise exist tomorrow) it is entirely false demand that but for speculative borrowing would not exist at all, at any price.  Policy should thus always discourage such borrowing.

Now the right of free action says that there will always be some mix of these three forms of borrowing in the economy.  That is, absent draconian (and unconstitutional) acts one cannot prevent someone from borrowing to speculate, or to pull forward demand.

But the public interest makes clear that society should not provide incentives to borrow for purposes that are against the public interest.  It is for this reason above all others that “zero interest rates” and other similar policy pronouncements, along with inflation, are CORROSIVE and DESTRUCTIVE to long-term economic stability and growth – they DESTROY the incentive to form capital, and it is from capital formation that all legitimate and productive new business interests spring.

Finally, in a deflationary economy, wages as well as prices often have to fall – and it’s a fact of life that it’s very hard to cut nominal wages — there’s downward nominal wage rigidity. What this means is that in general economies don’t manage to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept those wage declines.

Oh, so the cure for wages that are above the economic value of the work performed is to keep paying people for work they don’t do, like, for example, government workers who make $250,000 pensions as SCHOOL ADMINISTRATORS?  Exactly where’s the money supposed to come from Paul?

Remember folks:

All borrowing must inherently come from surplus capital – that is, production less the cost of production and sustenance.  IT CANNOT BE OTHERWISE since one cannot manufacture CAPITAL out of thin air – one must PRODUCE it.

There is an underlying problem with people like Krugman: They hate private capital formation and private self-determination with a passion. 

They can’t deal with the idea that government doesn’t have all the answers, even when government is demonstrated to be the problem and blows serial bubbles on purpose, driving policies that offshore tens of millions of jobs.

Then when the bubble bursts they refuse to see the basic math of exponents, and proclaim that we must continue to spend more than we make – even though such policies are mathematically impossible to continue forever, just as all such exponents are into any physical environment bounded by actual fixed size.

Since the Earth is a rock of fixed size, it is thus inherently impossible for such “prescriptions” to work in the intermediate and long term.

Krugman claims to have an advanced degree.  I presume that having such means he passed basic algebra, in which class he would learn how exponents work.

I therefore must presume that the garbage that comes from his mouth is knowingly falsely spewed, and not argued from ignorance.

The only solution to be found in a free market to such idiocy is to lead a boycott of those “media institutions” that give people like him a voice, along with their advertisers.

It’s time folks.

The Market-Ticker

Paris, France – There are two major schools of thought on what is coming next…and two renegade, home-schools too. There are those who believe we have a recovery…though weak…that will continue and eventually bring the economy back to health. This is the line of the Obama Administration and most mainstream economists.

Then, there are those who think the recovery will not come as planned…and that the feds’ efforts to spur a recovery – along with strong demand from Asia and the emerging markets – will lead to higher levels of inflation, destroying the dollar and bonds. This is what Marc Faber expects. He urges listeners to avoid going too heavily into cash, since it might be the number one victim of inflation. Instead, you’ll do better in stocks and real estate, he says.

A third line of thinking is what Faber calls “hard core deflationism” – typified by Robert Prechter and Gary Shilling. They think the de-leveraging trend will be catastrophic – leading to outright deflation, taking the Dow down below 1,000, for example.

Then, there’s The Daily Reckoning line. You can call it “soft-core deflationism”:

1) There is no recovery; there won’t ever be a recovery
2) The de-leveraging period will be longer and harder than people expect…leading to spells of deflation and double…triple…dipping
3) The feds will fight it with every weapon available
4) However, they will not push the ‘nuclear button’ – wanton, reckless money printing – until the bond market cracks
5) It will not crack soon, because the feds are incompetent; they will not succeed in getting higher rates of inflation; at least, not soon.
6) The dollar will remain strong. Bonds will go up…for now…
7) The Dow will fall…but not below 1,000…probably not below 5,000

What does that mean for gold? Well, it means gold won’t do spectacularly well. It might decline…say, down to $850 or so.

Eventually, the bull market in gold will resume, however. You can’t keep a good metal down. Just don’t expect it to go up dramatically while the private sector is reducing its debts in an orderly fashion.

Does that mean you should sell your gold? We wouldn’t if we were you. Because something could go very wrong. Another big bank failure. A blow-up in China. It wouldn’t take much to cause a panic. Investors could turn to gold for security.

Or, maybe the feds will panic…and dump dollars from helicopters as Ben Bernanke threatened.

Besides, we could be wrong. Predictions are always difficult to get right. Especially when they’re about the future.

Regards,

Bill Bonner
for The Daily Reckoning

Economist Dave Rosenberg warns investors to Get a Grip on Reality.

Double-dip risks in the U.S. have risen substantially in the past two months. While the “back end” of the economy is still performing well, as we saw in the May industrial production report, this lags the cycle. The “front end” leads the cycle and by that we mean the key guts of final sales — the consumer and housing.

We have already endured two soft retail sales reports in a row and now the weekly chain-store data for June are pointing to sub-par activity. The housing sector is going back into the tank – there is no question about it. Bank credit is back in freefall. The recovery in consumer sentiment leaves it at levels that in the past were consistent with outright recessions. Last year’s improvement in initial jobless claims not only stalled out completely, but at over 470k is consistent with stagnant to negative jobs growth. And exports, which had been a lynchpin in the past year, will feel the double-whammy from the strength in the U.S. dollar and the spreading problems overseas.

Spanish banks cannot get funding and another Chinese bank regulator has warned in the past 24 hours of the growing risks from the country’s credit excesses. A disorderly unwinding of China’s credit and property bubble may well be the principal global macro risk for the remainder of the year. Indeed, perhaps the equity market finally realized yesterday that allowing China more control to defuse an internal property and credit bubble may well be a classic case of “be careful of what you wish for.”

The Bond Cycle and Deflation

I was at an event recently where I was able to see two legends among others – Louise Yamada and Gary Shilling. Louise made the point that while secular phases in the stock market generally last between 12 and 16 years, interest rate cycles tend to be much longer – anywhere from 22 to 37 years; and she has a chart back to 1790 to prove the point! So while all we ever hear is that this secular bull market in bonds is getting long in the tooth, having started in late 1981, it may not yet be over. After all, the deleveraging part of this cycle has really only just begun and if history is any guide, it has a good 5-6 years to go – at a time when practically every measure of underlying inflation is running south of 1%.

Double Dip, Anyone?

The data suggests that we are now seeing the consumer sputter with what looks like a very weak handoff into the third quarter. The housing sector is collapsing again. The export-import data are pointing to a sudden deceleration in two-way trade flows. Commercial real estate is dead in the water. Bank credit is in freefall right now.
There is still something left in the tank as far as capex and inventory investment is concerned, but by the fourth quarter, we could well be looking at a flat or even negative GDP print.

Even if we don’t get a double-dip recession, economic growth will probably be insufficient to absorb the still-large amount of excess capacity in the system. What that means is that the U.S. unemployment rate will remain high for as far as the eye can see. It also means that inflation and interest rates will remain low for a sustained period of time, and that a stock market priced for peak earnings in 2011 could be in for some disappointment.

Yield Curve as of 2010-06-22

click on chart for sharper image

The above chart shows Weekly Closing Yields.

The chart does not reflect inflation, inflation expectations, reflation, or an improving economy. It does reflect what one would see after a reflation effort that has failed.

Yet, equities are priced not only for reflation, but for a strong reflation at that. Either stocks or the yield curve is wrong. I suggest you pay attention to the yield curve.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Heh, Someone Gets It (Buiter)

Posted by Karl Denninger

Hattip Zerohedge:  (The original article is here)

Note the structural deficit number.  This is what happens when you allow this to go on for a decade:

Which in turn leads to this:

That red line is actual private demand expressed as the delta (or change) in GDP.

I don’t have accurate debt and GDP numbers on a contemporary basis for the rest of the nations that Buiter cites, and besides, I focus on the United States anyway.

Buiter posits that The Fed could eventually be “forced” to monetize – that is, try to inflate it away.

This is where Buiter and I part company, because it is impossible to inflate out of a mess like this when you have social spending indexed to inflation – and our entitlement programs all are in one form or another, with the most-ridiculous, Medicare, rising at much higher rates than general inflation.

As such attempting to “inflate out” won’t work – it will instead result in Weimar-style hyperinflation which, as it did in Weimer, will inevitably result in political and economic collapse.

Note that Bernanke has said “we cannot grow out of this“; he has (belatedly, but surprisingly) finally “gotten it.”

It would have been nice if he “got it” three years ago, of course.  It might have altered his view on bailing out people and providing artificial support instead of demanding ab-initio not only the legal ability but the legislative mandate to close all of the so-called “too big to fails” and use the funds we have blown to pay off depositors instead.

Yes, that would have resulted in a Depression being “recognized.” 

But we’re in one now, as the above chart shows conclusively, and we have in fact been in one for two years.  There is no evidence we’re going to get out of it either – the only way that can happen is if private final demand replaces the government borrow-and-spend, and for that to happen deficit spending must decline while GDP continues to advance.

When you’re borrowing from $115 to $333 billion a month and pumping it into the economy – that is, from roughly 9% to 30% of GDP – there’s zero evidence that this can or will occur, and in fact despite all the market and media crooners claiming “it’s getting better” the mathematical facts say exactly the opposite – it is in fact getting worse, as government replacement of private final demand with borrowed money is going up, not down.

That recognition of the math is starting to seep into the consciousness of economic analysts at major international banks is an important signpost. 

The next one will be when recognition of the same math starts to poke through the mainstream media – despite strident claims otherwise from Geithner and others. 

Once that second signpost is reached there will no longer be time or opportunity for government to proactively respond.  The market will, at that point, take final and irrevocable control.

If Obama has any intelligence at all he will fire Summers and Geithner immediately and in doing so stick them with responsibility for refusal to deal with the truth, close or break up the too-big-to-fails (via executive order if he can’t get a bill passed immediately – yes, I know that will raise howls of protest but this truly is a national emergency!) and demand reimposition of Glass-Steagall and mark-to-market – right here, right now, forevermore.

The tough choices are never popular, but mathematics doesn’t care about popularity, and as recognition is now seeping into the “mainstream economists” employed by major multinational financial institutions it is simply a matter of time before they ENFORCE austerity and withdraw their support for the markets if it is not forthcoming.

All I can say is “see, I told you so!”

The Contrarian Trade of the Decade: the U.S. Dollar 

By Charles Hugh Smith

Just as a speculative thought experiment: perhaps the great contrarian trade of this decade is cash/the U.S. dollar.

The majority of economic observers seem convinced that the dollar is doomed, and not in some distant future. The basic reason for this unanimity is the reasonableness of the basic thinking, which goes like this:

The Federal Reserve and the U.S. Treasury are “printing money” and flooding the economy with easy money and credit, and the result of this debasement of the nation’s currency will be rampant inflation.

In other words, if a nation greatly expands its money supply without expanding its production of goods and services, then all that surplus money ends up chasing scarce goods and services, and you get inflation: the same sum of currency buys less and less goods and services.

This is the goal of State policy, according to the standard line of thinking: The only way the Federal Reserve and the Treasury can “save” the debt-burdened U.S. economy is by creating high inflation, which enables debtors to repay debt with “cheaper” dollars. Everyone who owns debt or low-yield bonds will lose huge chunks of their assets, but for no-asset debtors, inflation will be the cat’s meow.

But perhaps this thinking is wrong on virtually every important count.

I am indebted to my tireless and insightful blogging colleague Mish for an understanding of money supply: True Money Supply. Here is Mish’s chart of three ways to calculate money supply, and he argues persuasively for TMS1 as being the most accurate:

While the Federal Reserve successfully goosed money supply in their massive “quantitative easing” campaign, money supply is no longer expanding at a fast clip.

The critical distinction between printing press and credit is rarely discussed: is money literally being printed or is it credit-based? The distinction has profound consequences. If a government prints stacks of currency and then distributes the freshly conjured money via helicopter drops (in the visually compelling imagery of Fed Chairman Ben Bernanke’s famous “helicopter drop” quip), then the money supply has been expanded and distributed into the economy where it then leads to inflation if the production of goods and services lags money growth.

But if a government–for instance, the U.S. Treasury–prints bonds and sells those bonds to raise cash to distribute in the economy, that is not “printing money.” The Treasury bonds are traded for cash presented by purchasers; the money already exists and is simply being transferred to the State for distribution into the economy.

If money is being created via the magic of fractional reserves (that is, via bank credit), then it does not flow into the economy if those banks do not lend it and if consumers do not borrow it. As Mish has repeatedly observed, banks cannot be forced into lending nor consumers into borrowing.

It seems the money “created” by the Federal Reserve and lent to private banks at near-zero interest rates is simply sitting in the banks as reserves to offset their continuing horrendous losses. As a result, it is not flowing into the economy, and thus it cannot trigger inflation.

In contrast, a State such as Zimbabwe does run its printing presses to create money, and this explains why it suffers from hyper-inflation.

It can be argued that the billions of dollars the Fed orders into existence and then trades for Treasury bonds (i.e. to buy T-Bills) is in fact “freshly created money” that flows into the economy via Federal deficit spending. True, but then the question becomes, do these purchases of Treasuries add enough to the $13 trillion U.S. economy to offset the reduction in credit as people and businesses either pay down debt or write off uncollectable/bad debt?

According to the Wall Street Journal (Drought of Credit Hampers Recovery), consumer credit outstanding has shrunk some $119 billion, or 4.6%, from its peak in July 2008, to $2.46 trillion.

Add in the mortgages paid down, paid off or written down in excess of new mortgages issued, corporate debt retired or written off, etc. etc., and it seems the deleveraging that is underway in both consumer and corporate balance sheets is reducing credit and money supply by hundreds of billions of dollars.

The Fed purchasing $300 billion or even $500 billion in Treasury bonds simply doesn’t pump enough money into a deleveraging $13 trillion GDP-economy to create inflation. It merely offsets some of the destruction of credit going on at every level of the economy.

Thus you can have a central bank shoveling credit-created money into private banks where it sits, never entering the economy at all. How can that create inflation? Indeed, as has often been noted by Mish and others, this is what has happened in Japan for the past two decades: the central bank shovels money into private banks, who either engage in “carry trade” activities (borrowing at near-zero interest and then moving the money overseas to earn a decent yield elsewhere for easy profits) or they stash the funds to offset their ongoing losses in defaulted/impaired portfolios.

Those portfolios of impaired assets in Japanese, U.S. and European banks–just how much are they worth in a transparent “marked to market” setting? How many trillions of dollars in mortgage-backed securities, household debt, corporate debt and defaulted/impaired sovereign debt do these banks hold? If they had to sell those assets in an open market, how much would they fetch? How big would the losses be?

Nobody knows, but we can guess the losses are easily in the tens of trillions of dollars. The accounts of banks keeping defaulted mortgages on the books are legion; Japan has played the “waiting for better asset prices” game for decades, and now U.S. banks are playing the same game: accepting interest-only payments of a few hundred dollars from homeowners as an accounting gimmick to keep the loan on their books as “performing.”

This artifice does nothing to clear the actual bad debt.

And how about all those impaired off-balance sheet liabilities? Regulators are not only allowing financial institutions to continue marking assets to fantasy, they are also allowing them to continue holding assets off their legitimate balance sheets.

The ever-astute Karl Denninger of the Market Ticker blog has relentlessly exposed these frauds and accounting tricks.

Since we live in a credit-based monetary system and economy, then income and collateral are the foundations of credit/borrowing. Unfortunately for those wishing for vast expansions of borrowing to fuel inflation, real estate collateral is not just impaired, it has fallen to historic lows. We can only wonder what this chart would look like if all real estate was truly marked to market:

The point is that the collateral represented by the average U.S. household’s primary store of wealth–their home–is near-negligible. Why? As noted above, houses are still being valued far above their true market value, so any reduction in value comes straight off the equity.

For example, a house valued at $300,000 on the bank’s books justifies the $270,000 mortgage being held at full value. The homeowner supposedly has $30,000 in equity/ collateral. But if the house is actually marked to market at $250,000, the owner’s collateral vanishes and the bank’s “asset” (the mortgage) also declines in value.

Second, suddenly-prudent lenders won’t lend more than up to about 75% of loan-to-value (except for the Fantasyland 3%-down payment loans backed by FHA, which are fast-defaulting). So much of the homeowner’s equity is untouchable. The only collateral which is available to borrow against is that above 25%–perhaps 10% of the total vaulation of all homes in the U.S.

And since some 33% of all homes in the U.S. are owned free and clear (50 million mortgages, 25 million homes owned outright), then the “owners equity” is largely in the hands of those without mortgages. We might infer that anyone who resisted the temptations to use their house as an ATM machine via a home equity line of credit (HELOC) either does not want/need to borrow against their home or they are unable to for other reasons (such as low income, poor credit, etc.).

Put all this together and we can deduce that those homeowners who might desire to extract some equity from their homes via borrowing have no collateral left to borrow against.

What about other collateral, such as income? As we all know, functional unemployment/underemployment is around 17%. According to the BEA, personal income has declined by over $200 billion from 2008 to 2009. (Subtract government transfers and the number is more like $600 billion.)

The BEA table reveals that “Net increase in household liabilities” hit $1.8 trillion in 2006 and $1.4 trillion in 2007, and then fell to $146 billion in 2008. Households are no longer borrowing (adding liabilities). Meanwhile, savings jumped from $178 billion in 2007 to $470 billion in 2009.

Mortgage debt rose by $1.1 trillion in 2005, $1 trillion in 2006, $686 billion in 2007–and then fell by $106 billion in 2008. No data is available yet for 2009, but you can bet both mortgage debt and new liabilities continued plummeting.

So household incomes have fallen, meaning there is less collateral for new borrowing, and new liabilities and mortgages have both collapsed from nearly $3 trillion in 2006 to $46 billion in 2008. Yes, from $3 trillion in new borrowing in 2006 to a total of $46 billion in 2008.

That is deleveraging, and adding $300 billion in money supply via Federal Reserve buying of T-Bills is offsetting a meager 10% of that decline in household credit.

Now that we’ve seen that housing and income collateral have fallen off a cliff and are not recovering, and that households are deleveraging ($3 trillion they were borrowing in 2006 has fallen to a mere $46 billion–more or less statistical error or pocket change in a $13 trillion economy)–then we might ask if those who still have assets would wish to leverage them into more borrowing/debt.

The vast majority (83%) of other financial assets are held by the top 10% households. here is a chart I reprinted recently in The Stock Market As Propaganda (March 10, 2010).

Equities (stocks) currently represent about $11.4 trillion of the total $33.3 trillion in financial assets. Business assets and real estate make up the remaining $20 trillion in total assets. According to the BEA, total household assets fell from $63.9 trillion in 2007 to $52.9 trillion in 2008–a decline of $11 trillion.

The recent stock market rally and “recovery” in housing has caused a blip up in total assets, which now appears to be rolling over.

Since the bottom 80% of U.S. households only hold 7% of financial assets ($2.3 trillion spread amongst 105 million households), then their ability to leverage their declining income and modest assets into huge dollops of new debt is somewhere between low and zero.

Recall that households added $3 trillion in new borrowing in 2006 alone. So those heady bubble days of credit/money supply growth are gone for good.

Since the top 10% households own $27 trillion in financial assets, we might ask what need they would have for new debt.

We might also ask what might happen if nobody comes forward to buy $1.5 trillion in new Treasury debt every year (money needed to fund the Federal deficit of $1.5 trillion a year) at very low yields. I outlined the high probability of this happening in The Trouble With Bonds (March 18, 2010).

Interest rates will rise. Recall that the Fed does not set yields for Treasury bonds; that is set by the bond market (supply and demand). The only way for the Fed to influence the yield of T-Bills is to buy them outright, as it has been doing heavily of late. Since every other major nation is also selling bonds to fund deficits, then we can anticipate some lively competition for investor’s cash.

In the standard view that “governments just print money,” then why governments sell bonds is never explained. Why don’t all governments just print up money and spend that? Why go to all the trouble of selling bonds to raise cash to fund deficits? It comes down to the distinction between credit-based systems and currency-based systems.

Inflation is impossible in credit-based systems when credit is being paid down/destroyed/ written off and banks are wary of lending/risk and consumers refuse to (or cannot) borrow.

We might also ask what might happen to stocks, bonds and real estate valuations if interest rates rise: they tank as I explained in What If (Almost) All Assets Fall Together? (March 11, 2010).

As a side-effect, the meager assets of the bottom 90% of U.S. households would fall, and the “smart money” might well decide selling out before further declines occur is the wisest capital-preservation strategy.

Since so much debt is dollar-denominated, then there will be demand for dollars to pay down debt. That is the essence of deleveraging.

And since other assets will be falling as interest rates rise and risk aversion returns with a terrible vengeance, then “cash will be King.” Dollars will rise in value, and the best and safest return on capital will be money-market funds or short-term notes.

Rather than doom the dollar, these trends suggest the dollar could rise in purchasing power and demand for years to come. I know this is contrarian, but ponder the distinction between “printing money” and selling bonds/attempting to expand credit in a credit-averse, collateral-impaired system.

This might be one of the most important bits I write this decade. Or then again, maybe not. Only time will tell. Before chastizing me for rampant hyperbole–”most important story of the decade, bah”–please consider The Most Important Chart of the Century. Now the chart is extremely important, and I recommend reading this story, but the century is a bit young to declare “the chart of the century.” One wonders what the “chart of the century” would have been in 1910, and how prescient we would find it in hindsight.

Let’s say this is one of the most important charts of the past 50 years, which is entirely supportable.

The charts simply shows that adding debt no longer adds to GDP. So even if the Fed were able to force banks to lend to poor credit risks and deleveraging borrowers lost their sanity and added to their liabilities, then the economy still wouldn’t grow/”recover.” The “reflating the credit bubble” game is over.