By Robert Prechter, CMT
Elliott Wave International

The following was adapted from Bob Prechter’s 2002 New York Times and Amazon best seller, Conquer the Crash – You Can Survive and Prosper in a Deflationary Depression.

Deflation requires a precondition: a major societal buildup in the extension of credit (and its flip side, the assumption of debt). Austrian economists Ludwig von Mises and Friedrich Hayek warned of the consequences of credit expansion, as have a handful of other economists, who today are mostly ignored. Bank credit and Elliott wave expert Hamilton Bolton, in a 1957 letter, summarized his observations this way:

In reading a history of major depressions in the U.S. from 1830 on, I was impressed with the following:

(a) All were set off by a deflation of excess credit. This was the one factor in common.
(b) Sometimes the excess-of-credit situation seemed to last years before the bubble broke.
(c) Some outside event, such as a major failure, brought the thing to a head, but the signs were visible many months, and in some cases years, in advance.
(d) None was ever quite like the last, so that the public was always fooled thereby.
(e) Some panics occurred under great government surpluses of revenue (1837, for instance) and some under great government deficits.
(f) Credit is credit, whether non-self-liquidating or self-liquidating.
(g) Deflation of non-self-liquidating credit usually produces the greater slumps.

Self-liquidating credit is a loan that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan – for business start-up or expansion, for example – generates the financial return that makes repayment possible. The full transaction adds value to the economy.

Non-self-liquidating credit is a loan that is not tied to production and tends to stay in the system. When financial institutions lend for consumer purchases such as cars, boats or homes, or for speculations such as the purchase of stock certificates, no production effort is tied to the loan. Interest payments on such loans stress some other source of income. Contrary to nearly ubiquitous belief, such lending is almost always counter-productive; it adds costs to the economy, not value. If someone needs a cheap car to get to work, then a loan to buy it adds value to the economy; if someone wants a new SUV to consume, then a loan to buy it does not add value to the economy. Advocates claim that such loans “stimulate production,” but they ignore the cost of the required debt service, which burdens production. They also ignore the subtle deterioration in the quality of spending choices due to the shift of buying power from people who have demonstrated a superior ability to invest or produce (creditors) to those who have demonstrated primarily a superior ability to consume (debtors).

Near the end of a major expansion, few creditors expect default, which is why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount of involuntary debt liquidation because almost no one expects deflation before it starts.

For more on deflation, including the following topics, see Elliott Wave International’s free guide to deflation, inflation, money, credit and debt. There, you can also download two free chapters from Conquer the Crash.

Learn more about these six important topics:

1. What is Deflation and When Does it Occur?
2. Price Effects of Inflation and Deflation
3. The Primary Precondition of Deflation
4. What Triggers the Change to Deflation?
5. Why Deflationary Crashes and Depressions Go Together
6. Financial Values Can Disappear in Deflation

Robert Prechter, Certified Market Technician, 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.

Popularity: 2% [?]

September 22, 2008

Bob Prechter, President of Elliott Wave International (EWI), is no stranger to challenging the status quo. His New York Times bestseller, Conquer the Crash, was published in 2002 before anyone was even talking about the current financial crisis.

In his recent 10-page market letter, Prechter shifts his focus to the government’s role in the latest financial turmoil.

Elliott Wave International is offering the full 10-page report free if you’d like to read all 28 answers. Visit EWI to download the full report, free.

Here are 3 questions excerpted from the free report:

1. Didn’t Congress create the Federal Housing Authority, Fannie Mae, Freddie Mac, Ginnie Mae and the Federal Home Loan Banks for the purpose of helping the public buy homes?

You’re kidding, right? What happened is that clever businessmen schemed with members of Congress to create privileged lending institutions so they could get rich off the public’s labor. In return, members of Congress got big campaign contributions from the privileged corporations and, as a bonus, even more votes. The public’s welfare had nothing to do with it.

Who celebrated when Congress passed the latest housing bill? Answer: “The California Mortgage Bankers Association applauded Congress for permanently increasing the size of loans Fannie Mae and Freddie Mac can buy….” (USA, 7/28) The legislation exists to “protect the nation’s two largest mortgage companies….” (NYT, 7/24) Who took out full-page ads to encourage Congress to “enact housing stimulus legislation now”? Answer: the National Association of Home Builders. Who celebrated when the administration “unveiled a new set of best [sic] practices designed to encourage banks to issue a debt instrument known as a covered bond”? Answer: “[Treasury Secretary] Paulson was joined at the news conference by officials from the Federal Reserve [and] the Federal Deposit Insurance Corporation…. Officials from banking giants Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co. and Wells Fargo & Co. issued a joint statement saying, ‘We look forward to being leading issuers’” (AP, 7/29) of covered bonds. And voters still believe that Congress is there to help the needy.

2. Who cares if a bank goes under? Won’t the FDIC protect depositors?

The FDIC is not funded well enough to bail out even a handful of the biggest banks in America. It has enough money to pay depositors of about three big banks. After that, it’s broke. But here is the real irony: The FDIC, as history will ultimately demonstrate, causes banks to fail. The FDIC creates destruction three ways. First, its very existence encourages banks to take lending risks that they would never otherwise contemplate, while it simultaneously removes depositors’ incentives to keep their bankers prudent. This double influence produces an unsound banking system. We have reached that point today. Second, the FDIC imposes costly rules on banks. In July, it “implemented a new rule…requiring the 159 [largest] banks to keep records that will give quick access to customer information.” As the American Bankers Association puts it, the new rule “will impose a lot of burden on a lot of banks for no reason.” (AJC, 7/19) Third, the FDIC gets its money in the form of “premiums” from—guess whom?—healthy banks! So as weak banks go under, the FDIC can wring more money from still-solvent banks. If it begins calling in money during a systemic credit implosion, marginal banks will go under, requiring more money for the FDIC, which will have to take more money from banks, breaking more marginal banks, etc. The FDIC could continue this behavior until all banks are bust, but it will more likely give up and renege. Remember, every government program ultimately brings about the opposite of the stated goal, and the FDIC is no exception.

3. Who are the “homeowners”?

Everywhere you turn, news articles are discussing how Congress, the President and the Fed are taking action to “help homeowners.” People’s understanding of this statement is 100 percent wrong. The homeowners in question are not the residents of the houses. The homeowners are banks. Unlike some states, Georgia made its law very specific on this point. Our local paper recently explained that, by recognizing the reality of ownership, “Georgia employs primarily a nonjudicial foreclosure” and therefore “has one of the fastest procedures in the country.” Specifically, “The property owner gives the mortgage holder a ‘security deed’ or a ‘deed to secure debt’. Technically, until the debt is paid, in full, the mortgage holder owns the property and allows the borrower to possess it.” (GT, 8/6) In states where the mortgage holder is deemed the property owner, the title is merely a legal technicality. The day he stops making mortgage payments, he no longer owns the property; the bank does. After foreclosure, many of those whom politicians and the media call homeowners will simply go from paying interest to a bank to paying rent to a landlord. For those with little or no equity, it’s not that big a deal. The real devastation is happening in banks’ portfolios, and banks, not home-dwellers, are the ones whom the government is trying to rescue, at others’ expense.

One might be tempted to charge therefore that Congress makes its laws for the purpose of helping banks. This idea, too, is incorrect. Helping banks is merely a side effect. The reason that Congress creates privileges for bankers is to benefit politicians. They make laws in response to campaign contributions from lending institutions, real-estate organizations and builders’ associations. They also garner votes from mortgage holders and, miraculously, from voters who think that their “representatives” are being “compassionate.”

---

The previous 3 questions and answers from Bob Prechter were excerpted from his recent 10-page market letter, The Elliott Wave Theorist.

Elliott Wave International is offering the full 10-page report free if you’d like to read all 28 answers. Visit EWI to download the full report, free.

Popularity: 2% [?]