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February 19, 2009

The Last Bastion Against Deflation: The Federal Government
by Robert Prechter

This article is part of a syndicated series about deflation from market analyst Robert Prechter, the world's foremost expert on and proponent of the deflationary scenario. For more on deflation and how you can survive it, download Prechter's FREE 60-page Deflation Survival eBook, part of Prechter's NEW Deflation Survival Guide.

The following article was adapted from Robert Prechter's NEW Deflation Survival eBook, a free 60-page compilation of Prechter's most important teachings and warnings about deflation.

Now that the downward portion of the credit cycle is firmly in force, further inflation is impossible. But there is one entity left that can try to stave off deflation: the federal government.

The ultimate source of all the bad credit in the U.S. financial system is Congress. Congress created the Federal Reserve System and many privileged lending corporations: Fannie Mae, Freddie Mac, Ginnie Mae, Sallie Mae, the Federal Housing Administration and the Federal Home Loan Banks, to name a few. The August issue [of The Elliott Wave Theorist] cited our estimate that the mortgage-encouraging entities that Congress created account for 75 percent of all U.S. debt creation with respect to housing. For investors in mortgage (in)securities, the ratio is even greater. Recent reports show that these agencies, which have been stealing people blind by taking interest for nothing, account for a stunning 82 percent of all securitized mortgage debt. Roughly speaking, the government directly encouraged the indebtedness of four out of five home-related borrowers. As noted in the August issue, it indirectly encouraged the rest through the Fed's lending to banks and the FDIC's guarantee of bank deposits. These policies allowed borrowers to drive up house prices to absurd levels, making them unaffordable to people who wanted to buy them with actual money. Proof that these mortgages are artificial and the product of something other than a free market is the fact that while Germany, for example, has issued mortgage-backed securities with a value equal to 0.2 percent of its annual GDP, the U.S. has issued them so ferociously that their value has reached 49.6 percent of annual GDP, a multiple of 250 times Germany's rate, and that is not in total value but only in value relative to the U.S.'s much larger GDP. (Statistics courtesy of the British Treasury.)

Well, the ultimate source of this seemingly risk-free credit still exists, at least for now. When Bernanke & Co. met in the back rooms of the White House in recent weekends, he must have said this: "Boys, we're nearly out of ammo. We have $400b. of credit left to lend, and we have two percentage points lower to go in interest rates. The only way to stave off deflation is for you to guarantee all the bad debts in the system." So far, government has leapt to oblige. One of its representatives strode to the podium to declare that it would pledge the future production of the American taxpayer in order to trade, in essence, all the bad IOUs held by speculators in Fannie and Freddie's mortgages for gilt-edged, freshly stamped U.S. Treasury bonds.

Now, what exactly does that mean for deflation? This latest extension of the decades-long debt-creation scheme has essentially exchanged bad IOUs for T-bonds. This move does not create inflation, but it is an attempt to stop deflation. Instead of becoming worthless wallpaper and 20-cents-on-the-dollar pieces of paper, these IOUs have, through the flap of a jaw, maintained their full, 100 percent liability. This means that the credit supply attending all these mortgages, which was in the process of collapsing, has ballooned right back up to its former level.

You might think this shift of liability is a magic potion to stave off deflation. But it's not.

Believers in perpetual inflation will ask, "What's to stop the U.S. government from simply adopting all bad debts, keeping the credit bubble inflated?" Answer: The U.S. government's IOUs have a price, an interest rate and a safety rating. Just as mortgage prices, rates and safety ratings were under investors' control, so they are for Treasuries. Remember when Bill Clinton became outraged when he found out that "a bunch of bond traders," not politicians, determined the price of T-bonds and the interest rates that the government must charge? If investors begin to fear the government's ability to pay interest and principal, they will move out of Treasuries the way they moved out of mortgages. The American financial system is too soaked with bad debt for a government bailout to work, and the market won't let politicians get away with assuming all the bad debts. It may take some time for the market to figure out what to do about it, but as always, there is no such thing as a free lunch. The only question is who pays for it.

The Fed is nearly out of the picture, so the consortium of last resort, the federal government, is assuming the job of propping up the debt bubble. It is multiples bigger than any such entity that went before, because it can draw on the liquidity of American taxpayers and clandestinely steal value from American savers. So the question comes down to this: Will the public put up with more financial exploitation? To date, that's exactly what it has done, but social mood has entered wave c of a Supercycle-degree decline, and voters are likely to become far less complacent, and more belligerent, than they have been for the past 76 years.

An early hint of the public's reaction comes in the form of news reports. In my lifetime, I can hardly remember times when the media questioned benevolent-sounding actions of the government. Articles were always about who the action would "help." But many commentators have more accurately reported on the latest bailout. USA Today's headline reads, "Taxpayers take on trillions of risk." (9/8) This headline is stunning because of its accuracy. When the government bailed out Chrysler, no newspaper ran an equally accurate headline saying, "Congress assures long-run bankruptcy for GM and Ford." They all talked about why it was a good thing. This time, realism and skepticism (at a later stage of the cycle it will be cynicism and outrage) attend the bailout. The Wall Street Journal's "Market Watch" reports an overwhelmingly negative response among emailers. Local newspapers' "Letters" sections publish comments of dismay and even outrage. CNBC's Mark Haines, in an interview on 9/8 with MSNBC, began by saying ironically, "Isn't socialism great?" This breadth of disgust is new, and it's a reflection of emerging negative social mood.

Social mood trends arise from mental states and lead to social actions and events. Deflation is a social event. Ultimately, social mood will determine whether deflation occurs or not. When voters become angry enough, Congressmen will stop flinging pork at all comers. Now the automakers want a bailout. Voters have remained complacent about it so far, but this benign attitude won't last. The day the government capitulates and announces that it can't bail out everyone is the day deflationary psychology will have won out.

For more on deflation, download Prechter's FREE 60-page Deflation Survival eBook or browse various deflation topics like those below at www.elliottwave.com/deflation.

• What happens during deflation?
• Can the Fed stop deflation?
• Why is deflation bad?
• Inflation vs. deflation
• And much more in Prechter's FREE Deflation Survival Guide.

Bob Prechter, CMT
Elliott Wave International

Robert Prechter, Chartered Market Technician, is the world's foremost expert on and proponent of the deflationary scenario. Prechter is the founder and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

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