The Automatic Earth (11/08)
[...] we are facing deflation and… I wanted to review and explain the suggestions we have made previously for dealing with a deflationary scenario….
1. Hold no debt (for most people this means renting)
2. Hold cash and cash equivalents (short term treasuries) under your own control
3. Don’t trust the banking system, deposit insurance or no deposit insurance
4. Sell equities, real estate, most bonds, commodities, collectibles (or short if you can afford to gamble)
5. Gain some control over the necessities of your own existence if you can afford it
6. Be prepared to work with others as that will give you far greater scope for resilience and security
7. If you have done all that and still have spare resources, consider precious metals as an insurance policy
8. Be worth more to your employer than he is paying you
9. Look after your health!
1) The reason that getting rid of debt is priority #1 is that during deflation, real interest rates will be punishingly high even if nominal rates are low. That is because the real rate (adjusted for changes in the money supply) is the nominal rate minus inflation, which can be positive or negative. During inflationary times, this means that the real rate of interest is lower than the nominal rate, and can even be negative as it was during parts of then 1970s and again in the middle of our own decade. People have taken on huge amounts of debt because they were effectively being paid to borrow, but periods of negative real interest rates are a trap. They lure people into too much debt that they may not be able to service if real rates rise even a little. Most people are thoroughly enmeshed in that trap now as real rates are set to rise substantially.
When inflation is negative (i.e. deflation), the real rate of interest is the nominal rate minus negative inflation. In other words, the real rate is higher than the nominal rate, possibly significantly higher. Even if the nominal rate is zero, the real rate can be high enough to stifle economic activity, as Japan discover during their long sojourn in the liquidity trap. Standard money supply measures don’t necessarily capture the scope of the problem as they don’t adequately account for on-going credit destruction, when credit has come to represent such a large percentage of the effective money supply.
The difficulty from the point of view of debtors can be compounded by the risk that nominal interest rates will not stay low for years, as they did in Japan, but may shoot up as the international debt financing model comes under stress. For instance, on-going bailouts may cause international lenders to balk at purchasing long term treasuries for fear of their effect on the value of the dollar, even though those bailouts are not increasing liquidity thanks to hoarding behaviour by banks. We are not there yet, but the probability of this scenario rises as we move forward with current policies. The effect would be to send nominal interest rates into the double digits, and real interest rates would be even higher. The chances of being able to service existing debts under those circumstances are not good, especially as unemployment will be rising very quickly.
There is no safe level of debt to hold, including mortgages. For those who are not able to own a home outright, most would be much better off selling and renting, as real estate becomes illiquid faster than almost anything else in a depression. By the time you realize that you need to sell because you can no longer pay the mortgage, it may be too late. Renting is essentially paying someone else a fee to take the property price risk for you, which is a very good bet during a real estate crash. It would also allow you address point #2 – having access to liquidity.
2) Holding cash and cash equivalents (i.e. short term treasuries) is vital as purchasing power will be in short supply. Cash is king in a deflation. Access to credit is already decreasing and will eventually disappear for ordinary people. Mass access to credit has been a product of an historic credit expansion that expanded the supply of pockets to pick to an unprecedented extent, feeding off widespread debt slavery in the process. As you can’t count on the availability of credit for much longer, you will need savings in liquid form that you can always access.
When interest rates spike, not only will debt become a millstone round your neck, but a debt-junkie government forced to pay very high rates will be in the same position. As a result government spending will have to be cut drastically, withdrawing the social safety net just as it is most needed. In practical terms, this means being on your own in a pay-as-you-go world. You do NOT want to face this eventuality with no money.
3) Keeping the savings you need in the banking system is problematic. The banking system is deeply mired in the crisis in the derivatives market. Huge percentages of their assets are not marked-to-market, but marked-to-make-believe using their own unverifiable models. The market price would be pennies on the dollar for many of these ‘assets’ at this point, and poised to get worse rapidly as the forced assets sales that are coming will lower prices further. The losses will eventually dwarf anything we have seen so far, pushing more institutions into mergers or bankruptcy, and mergers are becoming more difficult as the pool of potential partners shrinks.
If we do see a rash of bank failures, each of which weakens the position of others as the sale of their assets and unwinding of their derivative positions can re-price similar ‘assets’ held by other parties, then deposit insurance will not be worth the paper it’s written on. When everything is guaranteed, nothing is, as the government cannot guarantee value. Savings held in these institutions are at much higher risk than commonly thought due to the systemic threats posed by a derivatives meltdown and spreading crisis of confidence. Fractional reserve banking depends on depositors not wanting their money back all at once, in fact with reserve requirements so whittled away in recent years, it depends on no more than a fraction of 1% of depositors wanting their money back at once. This is a huge vulnerability and the government deposit guarantee is a bluff waiting to be called.
4) The general rule of thumb in a deflation is to sell everything that isn’t nailed down and then sell whatever everything else is nailed to, for the reasons that assets prices will fall further than most people imagine to be possible, and the liquidity gained by selling (hopefully) solves the debt and accessible savings problems (provided you don’t lose the proceeds in a bank run). Assets prices will fall because everywhere people will be trying to cash out, by selling not what they’d like to, but what they can. This means that all manner of assets will be offered for sale at once, and at a time when there are few buyers, this will push prices down to pennies on the dollar for many assets.
For those few who still have liquidity, it will be a time when there are many choices available very cheaply. In other words, if you manage to look after the proceeds from the sale of your former assets, you should be able to buy them back later from much less money. Of course flashing your wealth around at that point could be highly inadvisable from a personal safety perspective, and you may find that you’d rather hang on to your money anyway, since it will be getting harder and harder to earn any more of it. During the Great Depression, some of the best farms in the country were foreclosed up on and received no bids at auction, not because they had no value, but because those few with money were hanging on to it for dear life.
Being entirely liquid has its own risks, which is why I wouldn’t sell assets that insulate you from economic disruption if you didn’t buy them on margin (ie with borrowed money that you may not be able to pay back) and if you have enough liquidity already that you can afford to keep them. For instance, a well equipped homestead owned free and clear is a valuable thing indeed, whatever its nominal price. It is totally different from investment real estate owned on margin, where the point of the exercise is property price speculation at a time when doing so is disastrous.
One important point to note with regard to commodities is that commodities have already fallen along way since I first published the above list of suggestions. At that time, selling commodities was a very good idea, but now, since commodities are already down a very long way, it may depend on the commodity in question. If you only own commodities in paper form then selling is still a good idea in my opinion, as there are generally more paper claims than there are commodities, and excess claims will be extinguished. At some point soon I will write an intro on my view of energy specifically, since energy is the master resource. In short, we are seeing a demand collapse now, but eventually we will see a supply collapse, and it is difficult to predict which will be falling fastest at which times.
5) If you already have no debt and have liquidity on hand, I would strongly suggest that you try to gain some control over the essentials of your own existence. We live in a just-in-time economy with little inventory on hand. Economic disruption, as we are already seeing thanks to the problems with letters of credit for shipments, could therefore result in empty shelves more quickly than you might imagine. Unfortunately, rumours of shortages can cause shortages whether or not the rumour is entirely true, as people tend to panic buy all at once. If you want to stock up, then I suggest you beat the rush and do it while it’s still relatively easy. You need to try to ensure supplies of food and water and the means to keep yourselves warm (or cool as the case may be). Storage of all kinds of basic supplies is a good idea if you can manage it – medicines, first aid supplies, batteries, hand tools, wind-up radios, solar cookers, a Coleman stove and liquid fuel for it, soap etc.
At the moment, there are many things you can obtain with the internet and a credit card, but that will not be the case in the future. Water filters are a good example, as the quality of water available to you is likely to deteriorate. You can buy the kind of filters that aid agencies use oversees for all of about $250, with extra filter elements for a few tens of dollars at sites such as Lehmans Non-Electric Catalogue or the Country Living Grain Mill site.
6) Most people will not be able to get very far down this list on their own, which is why we suggest working with others as much as possible and pooling resources if you can bring yourself to do so. Together you can achieve far greater preparedness than you could hope to do alone, plus you will be building social capital that will stand you in good stead later on.
7) If you have already taken care of the basics, then you may want to put at least some of whatever excess you still have into precious metals (in physical form). Although the price of metals should still have further to fall, since distressed sales have not yet had an effect on price, obtaining them could get more difficult. Buying them now would amount to paying a premium price for an insurance policy, which may make sense for some and not for others. Metals will hold their value over the long term as they have for thousands of years, but you may have to sit on them for a very long time, so don’t by them with money you might need access to over the next few years.
Metal ownership may well be made illegal, as it was during the Great Depression, when gold was confiscated from safety deposit boxes without compensation. That doesn’t stop you owning it, but it does make ownership far more complicated, and makes trading it for anything you might need even more so. You could easily attract the wrong kind of attention and that could have unpleasant consequences. In short, gold is no panacea. Other options may be far more practical and useful, although there is an argument for having a certain amount of portable wealth in concentrated form if you should have to move suddenly.
8) Being worth more to your employer than he is paying you is a good idea at a time when unemployment is set to rise dramatically. This is not the time to push for a raise that would make you an expensive option for a cash-strapped boss, and in fact you may have to accept pay cuts in order to keep your job. During inflationary times, people can suffer cuts to their purchasing power year after year, but they don’t complain because they don’t notice that their wage increases are not keeping up with inflation. However, deflation brings the whole issue into the harsh light of day.
People would have to take pay and benefit cuts for their purchasing power to stay the same, thanks to the increasing value of cash, but keeping people’s purchasing power the same will not be an option for most employers, who will be struggling themselves. In other words, expect large cuts to pay and benefits. As unions will never accept this, for obvious reasons, since their membership has its own fixed costs, there will be war in the labour markets, at great cost to all. You need to reduce your structural dependence on earning anything like the amount of money you earn now, and don’t expect benefits such as pensions to be paid as promised.
9) Your health is the most important thing you can have, and most citizens of developed societies are nowhere near fit and healthy enough. Already medical bills are the most common reason for bankruptcy in the US, and while you can’t protect yourself against every form of medical eventuality, you can at least improve your fitness. You will be be living in a world where hard physical work will be much more prevalent than it is now, and most people are ill-equipped to cope. The solution Ilargi and I have chosen, as we have mentioned before, is the P90X home fitness programme. While it wouldn’t be the right choice for everyone, if I can do it, as I have for 11 months already, then most people can. For others, there are gentler options available, but everyone should consider doing something to make themselves as healthy and robust as possible.
We here at TAE wish you the best of luck at this difficult time. We will all need it.