

Gustave Doré The Ninth Circle of Hell (Treachery) 1857



Eventful days in the middle of summer. Just as the Greek Pandora’s box appears to be closing for the holidays (but we know what happens once it’s open), and Europe’s ultra-slim remnants of democracy erode into the sunset, China moves in with a one-off but then super-cubed renminbi devaluation. And 100,000 divergent opinions get published, by experts, pundits and just about everyone else under the illusion they still know what is going on.

We’ve been watching from the sidelines for a few days, letting the first storm subside. But here’s what we think is happening. It helps to understand, and repeat, a few things:

• There have been no functioning financial markets in the richer parts of the world for 7 years (at the very least). Various stimulus measures, in particular QE, have made sure of that.

A market cannot be said to function if and when central banks buy up stocks and bonds with impunity. One main reason is that this makes price discovery impossible, and without price discovery there is, per definition, no market. There may be something that looks like it, but that’s not the same. If you want to go full-frontal philosophical, you may even ponder whether a country like the US still has a functioning economy, for that matter.

• There are therefore no investors anymore either (they would need functioning markets). There are people who insist on calling themselves investors, but that’s not the same either. Definitions matter, lest we confuse them.

Today’s so-called ‘investors’ put to shame both the definition and the profession; I’ve called them grifters before, and we could go with gamblers, but that’s not really it: they’re sucking central bank’s udders. WHatever we would settle on, investors they’re not.

• The stimulus measures, QE, were never designed to induce economic recovery. They were meant to transfer private losses to public purses. In that, they have been wildly successful.

• China is the end of the line. It was the only economy left that until recently could boast actual growth on a scale that mattered to the global economy. Growth stopped when China, too, introduced stimulus measures. To the tune of some $25 trillion or more, no less.

The perhaps most pivotal importance of China is that it was the world’s latest financial hope. The yuan devaluation shatters that hope once and for all. The global economy looks a lot more bleak for it, even if many people already didn’t believe official growth numbers anymore.

Because we’ve reached the end of the line, the game changes. Of course there will be additional attempts at stimulus, but China’s central bank has de facto conceded that its measures have failed. The yuan devaluations, three days in a row now, mean the central People’s Bank of China has, openly though reluctantly, acknowledged its QE has failed, and quite dramatically at that. They just hope you won’t notice, and try to bring it on with a positive spin.

Central banks are not “beginning” to lose control, they lost control a long time ago. The age of central bank omnipotence has “left and gone away” like Joltin’ Joe. Omnipotence has been replaced by impotence.

This admission will reverberate across the globe. China is simply that big. It may take a while longer for other central bankers to admit to their own failures (though ‘failures’, in view of the wealth transfer, is a relative term here), but it won’t really matter much. One is enough.

What will happen from here on in will be decided by how, where and in what amounts deleveraging will take place. This will of necessity be a chaotic process.

Debt deleveraging leads to, or can even be seen as equal to, debt deflation. This is a process that has already started in various places and parts of economies (real estate), but was kept at bay by QE programs. It will now accelerate to wash over our societies like a biblical plague.

The Automatic Earth started warning about this upcoming deflation wave many years ago. I am wondering if I should rerun some of the articles we posted over the past 8 years or so. I might just do that soon.

It is fine for people to say that since it hasn’t happened yet, we were wrong about this, but for us it was never, and is not now, about timing. If you think like an investor -or at least you think you do- timing may seem to be the most important thing in the world. But that’s just another narrow point of view.

When deflation takes its inevitable place center stage, it will wipe away so much wealth, be it real or virtual or plain zombie, that the timing issue will be irrelevant even retroactively. Whether the total sum of global QE measures is $22 trillion or $42 trillion, its deflation-driven demise will wipe out individuals, companies and nations alike at such a pace, people will wonder why they ever bothered with trying to get the timing right.

This may be hard to understand in today’s world where so many eyes are still focused on central banks and asset- and equity markets, on commodities and precious metals, on housing markets. In that regard, again, it is important to note that there have been no functioning markets for many years. Those eyes are focused on something that merely poses as a market.

For us this was clear years ago. It was never about the timing, it was always about the inevitability. Back in the day there were still lots of voices clamoring for – near-term or imminent – hyperinflation. Not so much now. We always left open the hyperinflation option, but far into the future, only after deflation was done wreaking its havoc. A havoc that will be so devastating you’ll feel silly for ever even thinking about hyperinflation.

Deflation will obliterate our economies as we know them. Imagine an economy for instance where next to no-one sells cars, or houses, or college educations, simply because next to no-one can afford any of it.

Where everything that today is bought on credit will no longer be bought, because the credit will be gone. Where homes are not worth more than the cardboard they’re made of, and still don’t sell.

Where ships won’t sail because letters of credit won’t be issued, where stores won’t open in the morning because they can’t afford their inventory even if it arrives in a nearby port.

As for today’s reality, the Chinese leadership has been eclipsed by its own ignorance about economic systems, the limits of their control over them, and the overall hubris they live in on a daily basis. These people were educated in the 1960s and 70s China of Mao and Deng Xiaoping. In the same air of omnipotence that today betrays all central bankers. Why try to understand the world if you’re the one who shapes it?!

It was obvious this moment would arrive in Beijing as soon as the one millionth empty apartment was counted. There are some 60 million ’empties’ now, a number equal to half the total US housing contingent.

Beijing then heavily promoted the stock market for its citizens, as a way to hide the real estate slump. All the while, it kept the dollar peg going. And now all this is gone. And all that’s left is devaluation. As Bill Pesek put it: “China Adds a Chainsaw to Its Juggling Act”.

Ostensibly to improve the country’s trade position, for lack of a better word. Whether that will work is a huge question. For one thing, the potential increase in capital flight may turn out to be a bigger problem than the devaluation is a solution.

Moreover, one of the main reasons to devalue one’s currency is the idea that then people will start buying your stuff again. But in today’s deflationary predicament, one of the main failures of mainstream economics pops up its ugly head: the refusal to see that many people have little or nothing left to spend.

This as opposed to economists’ theories that people must be sitting on huge savings whenever they don’t spend “what they should”. Ignoring the importance of personal debt levels plays a major part in this. Any which way you define it, the result is a drag on the velocity of money in either a particular economy, or, as we are increasingly witnessing, a major spending slowdown in the entire global economy.

Seen in that light, what good could a 1.9% devaluation (or even a, what is it, super-cubed 5% one, now?!) possibly do when China producer prices fell for the 40th straight month, exports were down 8.3% in July, and cars sell at 30% discounts? Those numbers indicate a fast and furious reduction in spending.

Which in turn lowers the velocity of money in an economy. If money doesn’t move, an economy can’t keep going. If money velocity slows down considerably, so does the entire economy, its GDP, job creation, everything.

This of course is the moment to, once again, point out that we at the Automatic Earth define deflation differently from most. Inflation/deflation is not rising/falling prices, but money and credit supply relative to available good and services, and that, multiplied by the velocity of money.

When this whole debate took off, even before Lehman, there were only a few people I can remember who emphasized the role of deflation the way we did: Steve Keen, Mike Mish Shedlock and Bob Prechter.

And Mish doesn’t even seem think the velocity of money is a big factor, if only because it is hard to quantify. We do though. Steve is a good friend, he’s the very future of economics, and a much smarter man than I am, but still, last time I looked, stumbling over the inflation equals rising prices issue (note to self: bring that up next time we meet). Prechter gets it, but believes in abiotic oil, as Nicole just pointed out from across the other room.

So yeah, we’re sticking out our necks on this one, but after 8+ years of thinking about it, we’re more sure than ever that we must insist. Rising prices are not the same as inflation, and falling prices are but a lagging effect of deflation.

Spending stops when people are maxed out and dead broke. And then prices drop, because no-one can afford anything anymore.

We’ve had a great deal of inflation in the past decade or two, like in US housing. We still have some, for instance in global stock markets and Canada and Australia housing. But these things are nothing but small pockets, where spending persists for a while longer.

Problem is, those pockets pale in comparison to diving -consumer- spending in the US, China, Europe, Japan. Spending that wouldn’t even exist anymore if not for QE, ZIRP and cheap credit.

The yuan devaluation tells us the era of cheap credit is now over. The first major central bank in the world has conceded defeat and acknowledged the limits to its alleged omnipotence.

It always only took one. And then nothing would stand in the way of the biblical plague. It was never a question. Only the timing was. And the timing was always irrelevant.