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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.

By Robert Prechter, CMT

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.

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.

By Robert Prechter, CMT

1) Should you invest in real estate?

Short Answer: NO

Long Answer: The worst thing about real estate is its lack of liquidity during a bear market. At least in the stock market, when your stock is down 60 percent and you realize you’ve made a horrendous mistake, you can call your broker and get out (unless you’re a mutual fund, insurance company or other institution with millions of shares, in which case, you’re stuck). With real estate, you can’t pick up the phone and sell. You need to find a buyer for your house in order to sell it. In a depression, buyers just go away. Mom and Pop move in with the kids, or the kids move in with Mom and Pop. People start living in their offices or moving their offices into their living quarters. Businesses close down. In time, there is a massive glut of real estate.

– Conquer the Crash, Chapter 16

2) Should you prepare for a change in politics?

Short Answer: YES

Long Answer: At some point during a financial crisis, money flows typically become a political issue. You should keep a sharp eye on political trends in your home country. In severe economic times, governments have been known to ban foreign investment, demand capital repatriation, outlaw money transfers abroad, close banks, freeze bank accounts, restrict or seize private pensions, raise taxes, fix prices and impose currency exchange values. They have been known to use force to change the course of who gets hurt and who is spared, which means that the prudent are punished and the thriftless are rewarded, reversing the result from what it would be according to who deserves to be spared or get hurt. In extreme cases, such as when authoritarians assume power, they simply appropriate or take de facto control of your property.
You cannot anticipate every possible law, regulation or political event that will be implemented to thwart your attempt at safety, liquidity and solvency. This is why you must plan ahead and pay attention. As you do, think about these issues so that when political forces troll for victims, you are legally outside the scope of the dragnet.

– Conquer the Crash, Chapter 27

3) Should you invest in commercial bonds?

Short Answer: NO

Long Answer: If there is one bit of conventional wisdom that we hear repeatedly with respect to investing for a deflationary depression, it is that long-term bonds are the best possible investment. This assertion is wrong. Any bond issued by a borrower who cannot pay goes to zero in a depression. In the Great Depression, bonds of many companies, municipalities and foreign governments were crushed. They became wallpaper as their issuers went bankrupt and defaulted. Bonds of suspect issuers also went way down, at least for a time. Understand that in a crash, no one knows its depth, and almost everyone becomes afraid. That makes investors sell bonds of any issuers that they fear could default. Even when people trust the bonds they own, they are sometimes forced to sell them to raise cash to live on. For this reason, even the safest bonds can go down, at least temporarily, as AAA bonds did in 1931 and 1932.

– Conquer the Crash, Chapter 15

4) Should you take precautions if you run a business?

Short Answer: YES

Long Answer: Avoid long-term employment contracts with employees. Try to locate in a state with “at-will” employment laws. Red tape and legal impediments to firing could bankrupt your company in a financial crunch, thus putting everyone in your company out of work.

If you run a business that normally carries a large business inventory (such as an auto or boat dealership), try to reduce it. If your business requires certain manufactured specialty items that may be hard to obtain in a depression, stock up.

If you are an employer, start making plans for what you will do if the company’s cash flow declines and you have to cut expenditures. Would it be best to fire certain people? Would it be better to adjust all salaries downward an equal percentage so that you can keep everyone employed?

Finally, plan how you will take advantage of the next major bottom in the economy. Positioning your company properly at that time could ensure success for decades to come.

– Conquer the Crash, Chapter 30

5) Should you invest in collectibles?

Short Answer: NO

Long Answer: Collecting for investment purposes is almost always foolish. Never buy anything marketed as a collectible. The chances of losing money when collectibility is priced into an item are huge. Usually, collecting trends are fads. They might be short-run or long-run fads, but they eventually dissolve.

– Conquer the Crash, Chapter 17

6) Should you do anything with respect to your employment?

Short Answer: YES

Long Answer: If you have no special reason to believe that the company you work for will prosper so much in a contracting economy that its stock will rise in a bear market, then cash out any stock or stock options that your company has issued to you (or that you bought on your own).

If your remuneration is tied to the same company’s fortunes in the form of stock or stock options, try to convert it to a liquid income stream. Make sure you get paid actual money for your labor.

If you have a choice of employment, try to think about which job will best weather the coming financial and economic storm. Then go get it.

– Conquer the Crash, Chapter 31

7) Should you speculate in stocks?

Short Answer: NO

Long Answer: Perhaps the number one precaution to take at the start of a deflationary crash is to make sure that your investment capital is not invested “long” in stocks, stock mutual funds, stock index futures, stock options or any other equity-based investment or speculation. That advice alone should be worth the time you [spend to read Conquer the Crash].

In 2000 and 2001, countless Internet stocks fell from $50 or $100 a share to near zero in a matter of months. In 2001, Enron went from $85 to pennies a share in less than a year. These are the early casualties of debt, leverage and incautious speculation.

– Conquer the Crash, Chapter 20

Should you call in loans and pay off your debt?

Short Answer: YES

Long Answer: Have you lent money to friends, relatives or co-workers? The odds of collecting any of these debts are usually slim to none, but if you can prod your personal debtors into paying you back before they get further strapped for cash, it will not only help you but it will also give you some additional wherewithal to help those very same people if they become destitute later.

If at all possible, remain or become debt-free. Being debt-free means that you are freer, period. You don’t have to sweat credit card payments. You don’t have to sweat home or auto repossession or loss of your business. You don’t have to work 6 percent more, or 10 percent more, or 18 percent more just to stay even.

– Conquer the Crash, Chapter 29

9) Should you invest in commodities, such as crude oil?

Short Answer: Mostly NO

Long Answer: Pay particular attention to what happened in 1929-1932, the three years of intense deflation in which the stock market crashed. As you can see, commodities crashed, too.

You can get rich being short commodity futures in a deflationary crash. This is a player’s game, though, and I am not about to urge a typical investor to follow that course. If you are a seasoned commodity trader, avoid the long side and use rallies to sell short. Make sure that your broker keeps your liquid funds in T-bills or an equally safe medium.

There can be exceptions to the broad trend. A commodity can rise against the trend on a war, a war scare, a shortage or a disruption of transport. Oil is an example of a commodity with that type of risk. This commodity should have nowhere to go but down during a depression.

– Conquer the Crash, Chapter 21

10) Should you invest in cash?

Short Answer: YES

Long Answer: For those among the public who have recently become concerned that being fully invested in one stock or stock fund is not risk-free, the analysts’ battle cry is “diversification.” They recommend having your assets spread out in numerous different stocks, numerous different stock funds and/or numerous different (foreign) stock markets. Advocates of junk bonds likewise counsel prospective investors that having lots of different issues will reduce risk.

This “strategy” is bogus. Why invest in anything unless you have a strong opinion about where it’s going and a game plan for when to get out? Diversification is gospel today because investment assets of so many kinds have gone up for so long, but the future is another matter. Owning an array of investments is financial suicide during deflation. They all go down, and the logistics of getting out of them can be a nightmare. There can be weird exceptions to this rule, such as gold in the early 1930s when the government fixed the price, or perhaps some commodity that is crucial in a war, but otherwise, all assets go down in price during deflation except one: cash.

– Conquer the Crash, Chapter 18

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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?
• Why is deflation bad?
• Effects of deflation
• Deflationary spiral
• And much more in Prechter’s FREE Deflation Survival Guide.