Friday, August 14, 2009
The Waterfall Effect
Well, the inflation-deflation debate has surfaced once again. Not in a big way, but in a way that drives me to clarify my position a little. Perhaps you will be surprised.
Today's economy consists of an expanding divide driven by opposing forces. Like the jaws of life, they are ripping open a gap between reality (real economic goods) and fantasy (the US dollar). On one side we have the collapsing real economy, and on the other we have unprecedented electronic reproduction of the base unit of measure. On one side we have the exponential expansion of social promises denominated in trillions of dollars, and on the other we have a real economy incapable of delivering such value.
This divergence has been ongoing for some time. But in 2009, the angle of opposition has finally reached 179 degrees. The graph of opposing parabolic trends is almost complete. The only possible outcome at this point can be the Waterfall Effect as described by Martin Armstrong.
The Waterfall Effect describes the "overnight" collapse of a complex system, without even the forewarning of a run up (like gold in 1980 or the dot com run up). The following two graphs demonstrate this effect as seen in the collapse of Roman money in the 3rd century AD. The similarities to today are chilling.
The economy is such a complex organism with so many variables that it simply cannot be controlled. It is the height of arrogance that our politicians and so-called economists think they can control it. And it is the absolute height of arrogance that they attempt to do so in such a way as to ALSO benefit their selfish goals. With this level of stupidity, unintended consequences become many orders of magnitude more probable than the intended consequences. In fact, betting on the exact opposite of stated political goals is a sure bet for the long run right now. And the payoff will be tremendous!
In "How ALL Systems Can Collapse Overnight", Martin Armstrong uses the concept of entropy. Entropy is the amount of chaos, disorder or unknowable elements in any system. A system has low entropy when it is highly organized, ordered, controlled, contained, and all the elements are known. A system has high entropy when it is disordered, chaotic, out of control, and many elements cannot be known. Science teaches us that everything in the universe ultimately ends in absolute entropy (chaos) through the passage of time. In other words, ashes to ashes and dust to dust.
One thing that can affect the natural progression of entropy along the way is adding energy into a system. In certain closed systems with a high degree of order and control, adding energy can actually reduce entropy, increasing organization and order. This can be seen in the wonders of life and reproduction. In the closed system of a baby, we add energy (food) and watch it grow. Ultimately, though, entropy wins out and we return to dust.
But adding energy to a system usually has the opposite affect. It speeds up the journey to absolute entropy. This can be seen in an explosion. A bomb can take an entire building from low entropy to high entropy in a fraction of a second. Another example is a forest fire. The fire is energy added to the system (the forest) and it speeds up the journey from order to chaos. A fireman can slow this process because he has the knowledge that adding water, another form of energy, will affect the progression to entropy in a positive way. But what if the fireman was acting without perfect information? What if the fireman sprayed gasoline on the fire?
I will say it once again because it is worth repeating; the economy is such a complex organism with so many variables that it simply cannot be controlled... ESPECIALLY by politicians. The same fuel that ignited this fire is being used to put it out!
The fact of the matter is that this entropic journey our economy is on must be played out to its natural end. There is no amount of information or energy the politicians or so-called economists could come up with that would be able to turn back time. Nature must play out. And by adding imperfect, frantic energy, by adding fuel to the fire, they are doing the equivalent of setting off a time bomb. They are ensuring that we will all have to ride the waterfall!
Deflation is the shrinking of the money supply relative to the economy. It causes the purchasing power of money to rise and prices to fall. But according to our modern deflationists, today's deflation comes at a time of shrinking economy and rising money supply. According to them it is driven by the lack of demand from the collapsing economy, and it is defined by the falling price of assets like homes.
Robert Prechter is out and about today talking about the deflationary depression, with stocks, commodities and real estate all falling together. He says that we are just coming off a top the likes of which have not been seen in 200 years. He says that the best way to ride this out is in the "safest possible cash equivalents".
Basically, he sees this next major down-leg in the depression taking stocks, commodities and real estate down another 85%. He says that oil will ultimately fall to between $4 and $10 per barrel! The danger in making a prediction like this is while it may be fundamentally sound, it is still denominated in the dollar, a piece of paper with shaky credibility.
While I view Robert Prechter as extremely bearish, I must say that I agree with him to a certain extent. The extent at which I do not agree with him is the steady state of the dollar. Prechter views the world through his Elliot Wave cycle theory, which is not unlike Martin Armstrong. But the problem is that the waves he measures are against the backdrop of a steady state dollar.
Like Prechter, I expect all aspects of the economy will continue downward to depths below that of the great depression. But during the great depression, we did not have Ben Bernanke and we did not have a purely symbolic currency as a measuring stick. We had a gold-backed dollar.
Think about this for a minute. The average retiree on Social Security receives about $1,100 per month, or $13,000 per year. This is a dollar denominated promise. If the crash from top to bottom is 90% or more as Prechter predicts, this would give each and every Social Security recipient the equivalent purchasing power of $130,000 per year when purchasing real estate, the stock market or even commodities. Basically everything.
And this will be true not only for Social Security, but for anyone on the receiving end of a dollar denominated promise, including all pensioners, anyone with a tenured job, like teachers and government workers, and including everyone in Congress. Virtually everyone with an income or cash savings will see their purchasing power rise ten-fold!
The problem with this view is that the real economy right now cannot even afford to deliver real economic goods at TODAY'S dollar purchasing power, let alone another 800% rise in purchasing power, with Ben printing new ones the whole way there.
So Bob and I both see a waterfall approaching, but how can we reconcile our seemingly opposite views on deflation?
Currency is the key!
Take another look at the first chart at the top. Something has to give, and soon! Think of those two diverging lines as fingers stretching a rubber band. Then ask yourself, what IS that rubber band? I'll tell you. It is the dollar, the unit of measure for everything economic.
There is a quote I like that comes from Le Metropole Cafe. It goes, "we will have deflation in everything we own, and inflation in everything we use". This is partly true. It is true during the run up to the rubber band snapping. It is true until we hit the waterfall. At that point I have my own version of the quote. "We will have hyperDEflation in everything measured against real money, GOLD, and we will have hyperINflation in everything measured against paper dollars."
So, just to clarify one more time, we will see hyperinflation in gold as the dollar collapses on the world stage and loses its global reserve privilege. This will be followed by nominal hyperinflation in all things priced in dollars as the US frantically prints more and more to support its dying dream of a socialist paradise. The distribution systems for these new dollars will be wide and varied. But distribution will not be through wages tied to economic increases in production (traditional inflation). It will be through a variety of programs that will be called "stimulus". (See my "New Stimulus Plan" and "Free Money" for clues).
The deflation that Prechter sees (as well as Mish, Denninger, Ackerman, Weiss and many others) is very real. It is the collapsing economy and paper financial structure. It is real deflation in real terms. But unfortunately for them, the dollar is not the true base of the pyramid, and it will only benefit temporarily as a "pass through level". (See "All Paper is STILL a short position on gold").
Hyperinflation (a currency event as Jim Sinclair so eloquently tells us) is always concurrent with deflation (economic malaise) when measured in real terms (gold). The dollar is only paper, and it is being printed like crazy. So to measure things in dollars becomes very confusing when looking to the future. The above-mentioned deflationists cannot imagine the hyperinflation event that I describe because they are stuck on their cycles and technical analysis that has always been measured in dollars. But in this crisis, the currency itself is the key. All else is noise.
Images 1, 3 & 5
New Stimulus Plan
All Paper is STILL a short position on gold
Jim Sinclair "Currency event"