Roger Baker :
OK, deflation has arrived. Now what?

The global situation is in its deflationary, cascading-default phase, where entire countries can go broke from bad petrodollar-denominated debt.

Deflated train

By Roger Baker | The Rag Blog | January 27, 2016

“Every time history repeats itself, the price goes up” — Anonymous, as quoted in Tainter, The Collapse of Complex Societies

The deflation monster has arrived onstage, and is playing out its role as an influential actor in our history right now. Hang out on Zero Hedge for daily news of the important details.

This global situation is in its deflationary, cascading-default phase, where everything, including entire countries like China, can go broke because of the mountain of bad petrodollar-denominated debt haunting their balance sheets. We can see a global tendency to cash out going right now. Not at all what the Fed had in mind, but the logical outcome of delaying structural reform in an era of falling profits and slower growth, which are actually rooted in global resource depletion.

Keynesianism got a ‘free lunch’ image that became associated with Democrats.

After WWII, Keynesian economists were considered to be able to fix depressed capitalist economies, basically by giving out public money, even to poorer citizens during hard times. This was a policy intended to stabilize market demand through the periodic boom and bust phases of capitalist economic expansion. FDR may have used Keynesianism, but it has gotten a “free lunch” image that became associated with Democrats. Such grassroots and civic project spending under Obama, except for the military, became too politically unpopular to pass and was discontinued, whereas bailouts for banks on a much greater scale was not.

Even when Keynesian stimulus to the grassroots can survive political challenge, however, this method of stabilizing capitalism is also a policy subject to diminishing returns due to natural resource limits.

A vital part of our system of global finance capitalism and its related international trade is the use of organized human labor to generate more than enough energy to sustain the existing population. The energy return on energy investment (EROEI) must be something like five-to-one payback or civilizations that rely on this energy surplus tend to break down, an important insight developed by Dr. Charles Hall.

In the days of the ancient Roman economy, the wealth of the empire waxed and waned according to the prevailing economic cost of its grain. Over time, the market exchange value of grain must always average less than the cost of feeding the slaves who grow and harvest the grain, and also the armies of enforcers who keep it coming in. If net grain production is ever interrupted longer than the Emperor’s grain reserves can hedge against, the population gets hungry, and the Empire is liable to undergo management change.

During the start of the industrial revolution, England prospered too using cheap energy, by using cheap coal to power its steam engines that wove the cotton cloth made from cotton. This helped the USA prosper too because the cotton was grown with slave labor in the USA. Steam power set the stage for an expansive capitalist investment process. This was made highly profitable by means of a combination of cheap coal-based mechanical energy, in combination with a system of finance capital like London banks seeking to continually reinvest the profit on continued expansion, both domestic and abroad.

The economy prospered based on the U.S. being a large nation with abundant mineral reserves.

And so did the economy prosper for the past century, largely based on the U.S. being a physically large nation with abundant mineral reserves, including fossil fuels like oil to supply cheap abundant energy, and a secure base of imperial and military control throughout Latin America. It was not until the energy crisis of the 1970’s, after the U.S. peak in oil production, that a sudden global oil price shock forced serious consideration of resource limits to growth.

Roger peak oil graph

Graph from “”Revisiting the Limits to Growth After Peak Oil,”
American Scientist.

It was about this time that the 1972 book, The Limits to Growth, came out, with a famous chart, a picture of interacting resource limits on things like total human population and longevity, factors which have enormous human implications. This same chart with a recently added timeline still looks reasonably accurate today in its warning of the natural limits to exponential growth, which together imply hard times to come. Global warming has rather unexpectedly added to these limits since the work was published.

As Jared Diamond wrote in Collapse: How Societies Choose to Fail or Succeed,

One of the disturbing facts of history is that so many civilizations collapse. Few people, however, least of all our politicians, realize that a primary cause of the collapse of those societies has been the destruction of the natural resources on which they depend. Fewer still appreciate that many of those civilizations share a sharp curve of decline. Indeed, a society’s demise may begin only a decade or two after it reaches its peak population, wealth and power.

Insufficient cheap energy to maintain profits on investments on anticipated growth implies “stagflation.” This describes a combination of inflation and stagnation which unexpectedly appeared during the energy crisis of the 1970s, to the great frustration of the Keynesian economists.

Stagflation can play out in two contrary ways. During our energy crisis of the 1970s, roughly 1973-1982, insufficient oil supply to maintain the anticipated real growth on investments revealed itself as oil price-related “cost-push” inflation, where everything moved by burning oil; in other words, practically everything material, went up in price.

This fuel cost-centered energy crisis was finally resolved primarily by a surge in Alaskan oil production. That plus a the guarantee of cheap OPEC oil in exchange for military protection forever, a deal made with the Saudi King.

Global oil production from OPEC soon
overshot market demand.

In other words, the end of our 1982 inflationary crisis could not have been resolved by financial means, despite the credit sometimes given to Paul Volker. It took real oil to reduce inflation. Global oil production from OPEC soon overshot market demand, global oil prices collapsed in 1986, and our long-term global fossil fuel addiction problem seemed to disappear, with the price hitting a low about 1998. In truth, our universal economic dependence on cheap oil was hidden by its low price, and the problem of an economic limit to oil production was postponed, rather than the problems being resolved.

This time, the underlying energy deficiency is revealing itself primarily through stagnation, papered over with credit expansion to maintain the illusion of business as usual. And now in the end, deflation.

As James Kunstler recently noted in a podcast interview he did with Gail Tverberg, it appears that oil at less than $75 a barrel breaks oil companies. At the same time, oil at more than $75 breaks economies, leading to stagnation and deflation. Take your choice, keeping in mind that oil companies can probably be resuscitated more easily than deflation-ravaged economies.

Deflation by its nature implies a massive uncontrolled and disorderly wave of demand destruction. A world of reduced expectations, of stranded investments, rusting machines, cheap energy-dependent capital invested in the boom era, the high-water mark of a world aiming for maximum commodity production, ghost town suburbs without residents.

An ominous sign of things to come is seen in massively idle ocean freight capacity. Through a depression in the heavy construction equipment industry. Capital investment that played an essential role in making our current lifestyle possible and secure.

Wall Street, unlike Main Street, still holds a great accumulation of hibernating cash reserves.

However, there is still an important act to follow. Wall Street, unlike Main Street, still holds a great accumulation of hibernating cash reserves, a mountainous cyber-tangle of derivatives and legally-binding credit obligations. The cash doesn’t exist in any material form. If it were all in the form of real cash, there probably wouldn’t be enough room on Manhattan to store it all.

Something like $100 trillion of new interconnected global debt obligations have been added by the world’s central banks since the great recession of 2008-2009. This Wall Street stockpile of dollar reserves and legally binding obligations is mostly comprised of the accumulated wealth of the top .01% of income earners, but it represents theoretical debt obligations. These obligations are far too great to be repaid in real dollars with anything like their current buying power.

Our national wealth is comprised of computer bits, of all the super-secure digits in the computers of those with power. A priestly power that the banks and the Fed can deploy to influence the outside world. As things are now structured, a power that can field armies, a power that politicians instinctively fear, a vast global money power system maintained through a complex network of established legal and political procedures, through salaries, friendships, and official credentials.

As Chris Martenson writes, “The Deflation Monster has arrived and it sure looks angry”:

… At Peak Prosperity we favor the model that predicts ‘”first the deflation, then the inflation’” or the “Ka-Poom! Theory” as Erik Janszen at iTulip described it. While it may seem that we are many years away from runaway inflation (and some are doubting it will or ever could arrive again), here’s how that will probably unfold.

Faced with the prospect of watching the entire financial world burn to the figurative ground (if not literal in some locations), or doing something, the central banks will opt for doing something.

Given that their efforts have not yielded the desired or necessary results, what can they realistically do that they haven’t already?

The next thing is to give money to Main Street.

That is, give money to the people instead of the banks. Obviously puffing up bank balance sheets and income statements has only made the banks richer. Nobody else besides a very tiny and already wealthy minority has really benefited. Believe it or not, the central banks are already considering shifting the money spigot towards the public.

You might receive a credit to your bank account courtesy of the Fed. Or you might receive a tax rebate for last year. Maybe even a tax holiday for this year, with the central bank monetizing the resulting federal deficits.

Either way, money will be printed out of thin air and given to you. That’s what’s coming next. Possibly after a failed attempt at demanding negative interest rates from the banks. But coming it is.

This “helicopter money” spree will juice the system one last time, stoking the flames of inflation. And while the central banks assume they can control what happens next, I think they cannot.

Once people lose faith in their currency all bets are off. The smart people will be those who take their fresh central bank money and spend it before the next guy.

This probably describes the one last Krugman-esque move that the Fed has an ability to make, the last lever that it can pull to make important things happen in the real outside world. Finally, they see a surefire way to rekindle inflation and make debt disappear.

So it looks like the stage is set for a deflationary bust and then later, as part of the same process, hyperinflation, with approximately the results to be expected from Martenson’s description.

Read more articles by Roger Baker on The Rag Blog.

[Roger Baker is a long time transportation-oriented environmental activist, an amateur energy-oriented economist, an amateur scientist and science writer, and a founding member of and an advisor to the Association for the Study of Peak Oil-USA. He is active in the Green Party and the ACLU, and is a director of the Save Our Springs Alliance and the Save Barton Creek Association in Austin. Mostly he enjoys being an irreverent policy wonk and writing irreverent wonkish articles for The Rag Blog. ]

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11 Responses to Roger Baker :
OK, deflation has arrived. Now what?

  1. anonymous says:

    “Wall Street, unlike Main Street, still holds a great accumulation of hibernating cash reserves, a mountainous unseen and virtual cyber-economy.”

    If the US government taxed this idle wealth but gave breaks for new capital investment in machinery and infrastructure, the stranded money would move again and people would be re-employed.

    Problem solved!

    “hyper inflation” only happens if all resources are occupied, with overall demand stronger than overall supply.

    With a strong supply of surplus labor and other resources (including, yes, oil) worldwide, this won’t happen. There’s already been lots of “helicopter money” distributed w/ no resulting super-inflation. In fact, there’s been the so-called deflation of which the author writes.

    The real reason Keynesianism doesn’t work as it used to is any new stimulus leaks out of a national economy quickly b/c it’s spent on imports. The US, and most national economies, are far more interconnected and global than they used to be.

    So the monetary/credit expansion effect still works, but it’s diffuse, more slower and less predictable. The upside is that domestic price inflation gets restrained even as the money supply grows, b/c much of the new cash disappears into a vast global marketplace.

    Money’s effect on the economy isn’t just about “printing” (which is a dumb analogy, b/c same author acknowledges it isn’t paper money) but about CIRCULATION of money. Circulation doesn’t happen unless someone spends the money.

    The inflation won’t return until all surplus goods and labor supply are burned off. That doesn’t happen very rapidly in a globalized world economy awash in cheap labor and surplus capital.

    The short run problem is what is, in effect, hoarded cash reserves inside the USA not being spent (parked in cash held by corporations and/or marooned in low return funds).

    • Roger Baker says:

      Thanks, a lot of what you say is both true and important to understand.

      It is true that Keynesian stimulus methods can’t work without governmental support. Banks won’t do it on their own because it isn’t profitable, and FDR wasn’t popular with Wall Street when he did it.

      Of course with a lot of cheap money going to the biggest investment banks due to the Fed’s QE injections, it headed toward China and other emerging economies where investment profits still appeared to high, up until the current deflationary slump.

      Another looming problem is that the banks can’t control the velocity of money circulation since it is a key economic factor based only on consumer spending psychology. You can go from deflation to hyperinflation without the Fed creating more money. Since our fiat currency dollar has no intrinsic value, it is only worth what it will buy on any given day. If dollars start losing purchasing power, everyone, including the banks, will start spending their dollars to preserve their value. That is when you get dollars chasing limited goods and a world of trouble.

      — Roger

  2. Namjodh Singh says:

    There are a couple of problems with this article.

    One is the author says at one point:
    “As James Kunstler recently noted in a podcast interview he did with Gail Tverberg, it appears that oil at less than $75 a barrel breaks oil companies. At the same time, oil at more than $75 breaks economies, leading to stagnation and deflation.”

    OK, so oil right now is selling for about $30 a barrel yet the author seems to be claiming that oil has to be over $75 for deflation to occur? Wtf? If that’s the case we shouldn’t be fearing deflation at all. Has anyone out there seen prices falling on say rent or houses in Austin?

    In the same paragraph it is claimed oil under $75 a barrel breaks oil companies, has anyone heard that Shell or Exxon/Mobil have gone out of business?

    Furthermore, though not stated explicitly, it seems the author is one of those “Peak Oil” folks. Remember how ten years ago they were saying we were reaching the end of oil reserves on the planet? Well, obviously we’re not.

    Part of that is due to shale oil production which, if low oil prices continue, may stop due to the loss of money involved in the production. But also large new oil reserves have been discovered under the sea, Iraq is finally getting back to full oil production, and now that sanctions are being removed on Iran – Iranian oil is also going to flood the world market. Plus I might add, with the Chinese economy slowing down considerably their oil consumption is going to drastically fall also increasing the supply of oil on the market.

    I am totally in favor of decreasing oil consumption for more environmentally sound energy sources. And I am also in favor of increasing taxes on the Ultra-wealthy, defunding the Pentagon, and using that money to both fund public infrastructure projects, create decent paying “government” jobs for the average American, and also to send most Americans an extra annual “bonus” check which would undoubtedly spur consumption. However, this whole article seems like it is filled with wishful thinking and some incorrect conclusions which contradict some of the author’s main points.

    • Roger Baker says:

      I hate to say this, but I believe you are wrong on a number of points.

      It was sustained $100 oil that broke the global economy, especially China, and sent it into deflation. Cheap central bank credit has not helped the global economy to recover. A shale oil glut finally caused an oil price collapse in the always inelastic and volatile global oil market in early 2014, but other commodities like copper and steel were already deflating in price. See Gail Tverberg’s blog Our Finite World.

      The Texas shale oil drilling industry was not really making a profit even at over $110 a barrel. Now that industry is very broken and and losing a huge amount of money, but is forced to sell its oil into a very unprofitable market to postpone bankruptcy. Shell and Exxon did little shale drilling, but now the global oil price collapse is hitting them hard too. A lot of the cheap Fed credit went into shale drilling, which is now being revealed as an “asset bubble” because of its junk bond rate loans.

      Houston may be our next Detroit since its industrial capacity is so closely tied to oil production. That is what the latest unhappy Dallas Fed numbers are suggesting.

      OF COURSE I believe in peak oil, because it is a geological fact and the best geologists agree it is probably happening now. Oil is probably peaking this year because it is no longer profitable to produce outside the Middle East, and that sets the stage for the next oil price spike:

      http://www.theragblog.com/roger-baker-metro-is-cheaper-driving-here-to-stay/

      See this following link and the rest of Ron Patterson’s Peak Oil Barrel posts for lots of good data and analysis:

      http://peakoilbarrel.com/all-roads-lead-to-peak-oil/

      Austin’s still-booming tech job-based economy is probably really another unsustainable asset bubble as I expect will be revealed this next year. You can see this from the falling NASDAQ and biotech stock indexes. Read this:

      http://www.peakprosperity.com/blog/94818/death-hopium

      — Roger

  3. Tjoe says:

    A US Treasury Dollar could be made a co-currency and the FED capped at present levels. A new, controlled amount would be made and spent into existence over 10 years.

    Germany made the mistake of nationalizing the Jewish Wiemar banks, where this solution stops the run-away, exponential growth of debt in a borrow from Peter to pay Paul economy on steroids.

  4. Tjoe says:

    M3 followed the following simple math curve of compounding interest until they did away with it.

    $1 borrowed in 1913 at an average interest of 6% for 100 years. It’s basic compounding math and nearly perfectly matched M3. If M3 continued per the graph, it has reached an exponential growth that is not sustainable…hyperinflation. We just don’t know it yet

    At he end, the graph shows usury of near $330 on the one dollar, next it is about $600 and then $1300. From there on, the scale has to be changed to accommodate the quantity growth…hyperinflation. Germany’s Wiemar bankers had made so much money, “it took a wheel borrow full to buy a loaf of bread”.

    Here we go again, unless that growth is gotten under control by the US Treasury Dollar. I say fractional reserve should be capped, but operating without losing any assets and thus may prevent WW3.

    • Roger Baker says:

      There are lots of deceptive banking tricks such as you suggest, but ultimately exponential growth is a type of Ponzi scheme. You cannot maintain exponential growth in a finite world and nothing can paper over that underlying reality. An end to cheap oil remains the most limiting factor in our modern industrial economy. We do have cheap oil at the moment because of deflation, but oil needs to be both profitable AND cheap for that to remain good news for very long.

      — Roger

  5. “Over time, the market exchange value of grain must always average less than the cost of feeding the slaves who grow and harvest the grain, and also the armies of enforcers who keep it coming in.” Roger, is this correct ??
    I’ve just started reading the article, but this seems counterintuitive and contrary to what you write in the succeeding para about cheap coal/steam power. The exchange value of the cotton cloth thus produced, following your example, was MORE than the cost of the energy used, or it wdn’t have been profitable, or what am I missing? Shouldn’t the “less” in the quote above be “more”?

    • Roger Baker says:

      Every commodity in the marketplace has to pay its keep in terms of the cost of energy that went into its production, including the slaves employed to grow cotton.

      With Roman slaves the masters were relying on them to always produce more than enough grain grain to feed themselves plus a surplus for the master, or slavery wouldn’t work.

      The invention of steam power fueled by coal plus finance capitalism made centuries of fast exponential growth possible, by breaking the economic link to human and animal labor fueled by grain.

      As a further advance in energy use, our modern world is possible only because of cheap oil. Our Faustian bargain is that our world as we know it cannot continue to function properly without cheap oil. We try to deny that because finance capitalism by its nature demands perpetual growth.

      — Roger

  6. “As James Kunstler recently noted in a podcast interview he did with Gail Tverberg, it appears that oil at less than $75 a barrel breaks oil companies. At the same time, oil at more than $75 breaks economies, leading to stagnation and deflation. Take your choice, keeping in mind that oil companies can probably be resuscitated more easily than deflation-ravaged economies.”
    Love this!! but actually, oil companies as we know them under capitalism can best be replaced by state-operated enterprise.
    I was thinking earlier today about how the technological revolution has altered/is altering social relationships to the means of production as well as to many formerly difficult skill sets. 3-D printing has the potential to make everyone with a bright idea a manufacturer, so how would that affect economic relationships? (What led to this train of thought was a letter in the Austin American-Statesman about 3-D printers’ use of petrochemicals, thus undesirability. I want to write a letter pointing out that ANYTHING THAT CAN BE MADE FROM PETROCHEMICALS CAN BE MADE FROM NON-TOXIC, BIODEGRADABLE, INFINITELY RENEWABLE HEMPSEED OIL but have had a letter printed by them w/in the last 30 days so why bother?)
    Despite the availability of plant-based products that could replace almost all oil now used, the international oligarchy continues to insist on oil’s primacy. They can do this because oil is NOT something everyone can produce in their own back yard (despite the claims of ardent fracking supporters!); it is dangerous, smelly, nasty, toxic, etc.
    Despite the oligarchy’s insistence otherwise, oil can be replaced by more widely distributed resources; the sooner, the better for society and the planet.

  7. Steve Russell says:

    All of this, the article and the responses underneath, represent what folks who practice my retirement hobby call “investible information.” That is to say, those who think their analysis is correct in context can place bets on that thought. Just about the only thing Roger says I agree with is that growth cannot continue without energy, which is a finite resource.

    All the energy we have to work with comes from the sun. In the case of fossil fuels, a long time ago. In the cases of wind and solar, right now.

    Fossil fuels externalize the costs of CO2 emissions. The way to fight that is to force those who profit to internalize the costs rather than putting them off on the commons.

    Wind and solar, as harnessed so far, are allowed to finesse the hidden cost of redundancy with government subsidies. That’s fine for now, but the problems of storage and distribution have to be solved and government needs to be a little less protective to force the solutions.

    The costs of redundancy are real but they are solvable. When they are solved, the finite nature of energy will still be a fact but the amount of energy we could capture in real time is so immense that it probably makes more sense to worry about another existential threat that is also on a timeline in the thousands of years: the sun will burn out and cease to support life and if we are not prepared to leave the solar system then H. saps had a pretty good run but it’s over.

    In terms of our lifetimes, there’s no collapse on the horizon.

    I am reminded of the argument that Canadian bitumen deposits were not viable because they would cost more to exploit than the market would pay for the resulting refined products.

    While I won’t invest in the tar sands because I won’t stand for the environmental degradation, but there are ways to place bets on what oil prices make what methods economically sound.

    You read the 10-K statements filed with the SEC. Those forms contain information that, if false, is not only criminal but subject to almost limited civil liability.

    Right now, you would not have to read though very many 10-Ks to show that those with both the most relevant education and the most skin in the game disagree with you about where their breakeven point is located. (The point differs among the oil companies depending on where their assets are located.)

    I have placed bets consistent with what I said in this comment. If I’m wrong, it’s going to cost me. So far, my bets on political and economic trends have paid off pretty well.

    This is the age of the Internet and discount brokers that make the whole process a DIY. If you’ve got a line on a truth that the players have overlooked, the market will pay you for being right.

    To the objection that to invest in your analysis a timeline is required, I would say correctamundo.

    A timeline is also required if you are advocating public policies based on Peak Oil or any other prophesy you hold dear.

    If the downsides you predict can only be changed at the margins and nothing you say predicts collapse any time soon, why have this conversation?

    If you really do believe collapse is imminent, then you can move your assets to gold or bitcoin, but you will weather the storm better if you have assets.

    It’s kind of like Trump claims Mexico will pay for the wall. The businesses you think are about to destroy the world as we know it will pay for your survival.

    If you place your bets and win.

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