Comparing the current US Deflation with Japan's lost Decade (Things are not similar)

To start off, I would like to point out that 70% of the US economy is based on consumer spending.  What this means in life-cycle terms is that as the baby boomers pass the age of 46 they leave the highest period of discretionary spending and enter a period of relatively low spending.

This transition occurred in Japan in 1990, it is occurring now in the USA.  This effectively becomes a baseline for comparison as it ties the two country's consumption patterns together across time.

In Japan the period from 1986-1990 was the period of the real-estate bubble, which was effectively fueled by bank lending being based on real-estate values. This lead to excessive liquidity entering real-estate markets and a booming Nikkei index, which effectively peaked in 1989. The bubble burst in 1990 and Japan entered a recession.

At this point in Japan's economic history, the country had:

• A high savings rate- averaging over 8% during the 1980's
• Relatively low unemployment in 1989 of 2% rising to 4% as the recession got underway
• Debt to GDP of 20%
• No foreign debt (Most Japanese Treasuries were held within Japan)

Data from BOJ, graphed by me

In 1992 the Bank of Japan in conjunction with the LDP party executed the first known combined fiscal and monetary stimulus, by bringing the prime rate down to 1% and then eventually to 0.00% in the middle of 1993.  The Governing LDP party lost its majority in 1993 and a coalition of parties approved aggressive Fiscal stimulation from 1993 onwards.

As the Graph on the right shows Japan's Consumer Price Index remained deflationary till 1994, and only after the zero rate policy went into effect did the CPI return to the 100 level, rising to 102.62 in 1996.

What happened to Japan's Debt to GDP? It went from a healthy 20% in 1990 to the current level of 235%, which effectively amounts to the complete destruction of Japan's savings. So in Summary, Japan begins the "lost decade" in a relatively strong position.

For the US the situation is completely the opposite!  Lets start with the Unemployment rate which is currently running at 9.7% this is known as the U-3 measure. The broader U-6 measure is 16.8%, and if one adjusts for the Clinton era changes in measuring unemployment the U-6 rate would be 22% (the discouraged workers were banished from the measure during the Clinton era in order to make the numbers more palatable).

Source Bureau of Labor Statistics

Inflation measurement in the US has also seen significant politically introduced changes.  So a comparable chart to Japan's inflation chart would involve making adjustments to the series from 1990 onwards.  The Bureau of Labour Statistics does publish the Historic CPI-U series that uses 1982 as the index point of 100, from this series in 2007 CPI was 4.7%, and is 1.2% today in 2010. This measure of inflation is very problematic and I will delve into this later.

In 2010 the US Debt to GDP is 94.6% , not counting unfunded liabilities, if these are added the debt obligation becomes approximately 80 Trillion and that gives us a true Debt to GDP of 540%, so this is one of the key differences between US and Japan. The other difference is that the US holds the world's reserve currency and can borrow from the world to finance its deficits. The holders of US treasuries are largely foreign while the holders of Japanese Treasuries are entirely domestic!

In effect Japan can continue on its high debt path, since it is borrowing largely from its own people, clearly the US cannot. This is the key fact that points to problems ahead for the US, since Japan holds 1 Trillion of US Treasuries and will eventually stop rolling these over (as they have to meet their own internal debt obligations).

There are two core arguments moving forward: a) The US like Japan will experience a prolonged deflation or b) The US is unlike Japan in the structure and size of its debt and will over time face Hyper-inflation.

So which argument is the correct one? Are their factual evidence based approaches to determine the long term inflationary trends for the US?

The answer to this question is quite simple.  Essentially we are in a period of deflation due to the massive increase in the size of the Federal Reserves Balance sheets. Since the Federal Reserve has never been audited we do not know the extent of bad debts on its books. An expansionary monetary policy will not have much effect in the face of large and hidden bad debts, since the banks will simply absorb the stimulus. Moving forward one should start to see inflationary signs in commodities as money leaves the equity markets and flows to commodities, especially gold.

Is their a way to adjust inflation measures to reflect a truer value? John Williams of Shadow Government Statistics has done just this. As shown on the chart there is a significant difference between CPI-U and John's SGS Alternate CPI, current rates of inflation are running at 7%+.

Source: Shadowstats.com click on image to visit shadowstats

This clearly validates the later argument that the US will be seeing higher levels of inflation in the future.

Is Hyperinflation a possibility? I think looking forward, 2013 and beyond it is a clear possibility.
Certainly we are not in a double-dip recession, what we are in is a stagflationary recession, with real inflation having reached 12% in 2008, and then declining only to 5% in 2009, in stark contrast to the official below zero levels we often see reported in the media.  The current fiscal budgetary framework of the US government assumes no major increases in interest rates for the next 4-5 years, hence the published National Accounts do not reflect this clear risk.

Simply put the US governement assumes that the interest it pays on its debt (Treasuries) will not change significantly moving forward. The problem of course is that the appetite for purchasing more US debt is now waning globally as the major holders of US Treasuries have begun openly signaling that they wish to diversify into precious metals (The Saudi's and Chinese have made open statements to this effect). The Japanese will not be able to keep purchasing more Treasuries as they have to service their own burgeoning deficits. So it is highly unlikely that the US government will be able to attract buyers of treasuries without offering higher interest rates.

Since none of the countries want to see a run on the dollar, induced by large sales of US Treasuries, they have simply reduced further purchases effectively forcing the US government to find other ways to pay for its debt.

To get around this problem the most recent meeting of the Federal Reserve announced plans to monetize the sale of Treasuries. Essentially the Federal Reserve will create money (out of thin air) and use this to buy up Treasuries. This avoids the need to offer Treasuries to foreign buyers at higher interest rates.  Unfortunately this means more inflation in the US, as this effectively injects more money into the economy. Hence the term monetizing debt--effectively you try to get rid of your debt by creating inflation and paying back the amount owed with devalued dollars. 

According to the minutes of the Federal Reserve meetings, they are fully aware that monetizing debt will be inflationary, but they feel that "monetary easing" will be a good thing to address a slowing economy.  Clearly we have an interesting play on semantics, in that a misleading measure of inflation is being used to justify a policy of inflation. 

The data I have present clearly show that we are not in a deflation, but rather in a stagflation, and so massive fiscal stimulus will eventually lead to hyper-inflation. 

According to GATA - the Gold Anti- Trust Action committee, the only way to hide the reality of inflation is to naked short gold. They claim (with considerable evidence) that their has been price manipulation of gold markets, and that use of derivatives without any physical backing has enabled this manipulation.

Controversial as GATA's hypothesis is, the price of Gold has been increasing steadily since 2001.  So regardless of the veracity of GATA's hypothesis , the price of Gold is showing the reality of inflation (and the general flight to safety that Gold has always represented).

As there are many commentators on the web who talk about gold and silver, I will not delve into these markets, only observing that at the present time silver is clearly undervalued with respect to gold and will likely see significant price appreciation.

Another strategy not explored in such times is FOREX, and for many who are inexperienced in these markets I would recommend that you look at automated trading advisory systems such as OmniForex, or Bulletproof Forex. The recent declines in the Euro, also point to the need to hedge currency positions especially those exposed to the US dollar on a long term basis.