Robert Prechter’s Most Important Writings on Deflation

Excerpted from the March 23, 2007 Elliott Wave Theorist

The Biggest Mistake

The most important thing to understand about the financial environment is that credit is not money. Stock
enthusiasts say that “liquidity” will keep the boom going; precious metals and commodity bugs say that “infla-
tion” will continue to rage; and real estate investors rely on “creative financing” to keep prices rising. Every one
of these investment stances depends upon inflation, and every proponent for them is convinced that inflation
is an endless, one-way process. Currency inflation can continue indefinitely, but extensive credit inflation never
does; it always implodes. The American economy—indeed most of the world economy—suffers primarily not from
currency inflation but credit inflation.
The financial markets are signaling an end to credit inflation. Most bonds are rated junk. The leading
commodities—oil, copper, gold and silver—have topped. Real estate is crashing. Banks are tightening mortgage
requirements. The stock market has turned down. All these investments had benefited from the most aggressive
and extensive credit inflation in history. Now they are beginning to respond to the first days of the biggest con-
traction in credit ever. But hardly anyone understands this process. Most economists call the current situation
a “Goldilocks” economy, where everything is just right. This is an irresponsible position, but it is also inevitable
because by definition optimism accompanies major stock market peaks. A vocal minority sees the severe disloca-
tions in debt, deficits and speculation. But instead of warning of a collapse in prices these economists advocate
owning commodities, precious metals, real estate, oil company shares, mining shares and other resource stocks,
all of which are to rise in the environment of perpetual inflation that they envision. In other words, there is
almost no one who advocates holding safe, interest-bearing cash equivalents as protection from the developing
credit implosion and a source of profit while everything else goes down. The only book I know of to advocate
this position is Conquer the Crash.
Credit inflation is the expansion and even the pyramiding of IOUs. Investors issue IOUs to buy stocks,
corporations issue IOUs to expand business, consumers issue IOUs to buy houses and cars, and governments
issue IOUs as if they were throwing beads from a Mardi Gras float. The longer the process continues, the more
IOUs come to be regarded as assets, meaning that borrowers then use them as collateral for more borrowing. As
investment prices rise, they, too, become collateral for more loans. And on it goes, until it doesn’t. When the
house of (credit) cards begins to fall in on itself, the trend turns from inflation to deflation. That’s when credi-
tors turn their focus from lending to collecting and when debtors turn their focus from borrowing to repaying.
But by this time there are too many IOUs, and debtors cannot service them, much less repay them. Falling asset
values and economic contraction thwart efforts to honor the loans. Debtors begin to default. When that hap-
pens, the game is up.
Credit deflation is the most devastating financial event of all. It is rare, and that is why it confounds so many
analysts. The wrong vision leads to confusion. Under the Goldilocks vision, no one can understand why stocks
would fall. Under the inflationary vision, no one can understand why real estate or commodities would fall. An
article in the Financial Times (March 6) says of the latest sell-off in gold, “The performance of gold has been
the most difficult to explain. Traditionally, the precious metal is considered a safe haven in times of uncertainty
and risk aversion and it normally rises when equity markets fall. In fact gold prices have fallen more than 7 per

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Robert Prechter’s Most Important Writings on Deflation March 23, 2007 Elliott Wave Theorist

cent over the past week.” What’s wrong with this view is that the supposed “tradition” is baloney. Gold doesn’t
reliably go up when other things are going down. Gold has been following the stock market on the upside for
three years. If a coincident advance was not an anomaly, why is a coincident decline? In fact, gold and silver have
been going up and down with the Dow even on a daily and intraday basis. This is not inconsistent action; the
only inconsistency is with the theory that gold and silver are always contracyclical and therefore effective disaster
hedges. Sometimes they are, and sometimes they aren’t, but one thing is for sure: They are not deflation hedges,
and deflation is what we face.
The following excerpt, from a March 8 article in the Toronto Star, expresses the difference between currency
inflation and credit inflation. You can feel the looming default disaster throughout this description:
The city’s debt level is skyrocketing and Toronto is falling further and further behind on much-needed repairs,
city council was told yesterday as members approved this year’s capital budget. “It’s difficult for many people
to fathom how deep in debt we are, how much deeper in debt we’re going, and how at the end of this plan
we have (room for) no further debt that we can take on,” Councillor David Shiner said yesterday.
Still, following a day of acrimonious debate, councillors endorsed a $1.432 billion budget that includes ev-
erything from a $3.7 million program to calm neighborhood traffic and add bike lanes, to $2.9 million for
a new meeting room at city hall and more office space for Mayor David Miller’s staff. Miller called it a “city
building” budget. But several councillors said the city is flirting with big trouble by more than doubling its
debt and failing to dig into a huge backlog of repair projects ranging from eroding roads to Toronto Zoo
improvements.
City officials said Toronto’s debt was $1.7 billion in 2005 but will increase to more than $2.6 billion this
year and is expected to balloon beyond $3.1 billion by 2011. This year, the city will spend 12.6 per cent of its
property tax revenues on debt servicing. That figure is expected to rise to 15.4 per cent by 2011. Shiner said
the city’s debt servicing will cost every Toronto household roughly $2,352 over the next five years. “Many
people don’t know how they’re going to afford that, and we don’t have a plan to pay for it,” he said.
But Miller told reporters at the end of the day, “It’s a very good budget.”

This is a microcosm—and a conservative one at that, involving no leverage or derivatives—of what’s happening
everywhere. The size of today’s credit bubble is so huge that it dwarfs, by many multiples, all previous bubbles in
history. The developing deflation will be commensurate with the preceding expansion, so it will also be the big-
gest ever. Staying in traditional investments—stocks, real estate, commodities and most corporate and municipal
bonds—will surely prove to be a deadly decision. It’s not the “Goldilocks” 1950s. It’s not the inflationary 1970s.
And it’s not a “business as usual” extension of the 1980s-1990s bull market. It’s 1929 times ten. Those who can’t
see the difference will suffer the consequences. Those who see it — this means you —will survive and prosper.

The Role of the Fed

Most people envision the central bank as a currency inflation machine, a “printing press.” But most of the
time, the central bank is not inflating by way of its press. It does create currency inflation when it monetizes
government debt. It facilitates credit inflation when it panics and lowers its lending rate to below market levels.
As bad as these practices are, their extent pales in comparison to the fact that the Federal Reserve System is a
structure that allows banks to engage in credit inflation. Without the Fed, they couldn’t get away with it. The

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Robert Prechter’s Most Important Writings on Deflation March 23, 2007 Elliott Wave Theorist

Federal Reserve’s paper-money monopoly actively fosters inflation, but once that system is in place, most of
the time the Fed plays a passive role in fulfilling the demands of banks for credit, which fulfills the demands of
borrowers for credit. Many economists say that the Fed manages the rate of inflation at X percent a year, but
this view leads to two errors. First is the belief that once inflation happens, it is permanent. But it is not; credit
expansions lead to collapse. Second is the belief that the Fed is in control. It seems to be in control, and that il-
lusion makes investors complacent about the prospects for deflation; in fact, it makes them militantly deny even
the possibility. But the Fed is not in control, and the coming crash will prove it.

The Illusion of Control

Mike Whitney’s website, The Market Oracle, reports that the Plunge Protection Team has put on its super-
hero outfits:
The Working Group on Financial Markets, also know as the Plunge Protection Team, was created by Ronald
Reagan to prevent a repeat of the Wall Street meltdown of October 1987. Its members include the Secretary of
the Treasury, the Chairman of the Federal Reserve, the Chairman of the SEC and the Chairman of the Com-
modity Futures Trading Commission. Recently, the team has been on high-alert given the increased volatility
of the markets and, what Hank Paulson calls, “the systemic risk posed by hedge funds and derivatives.”

I have no doubt that the PPT exists. Financial powers concocted similar schemes in the collapse of 1929. The
question is whether this gang of four and their bags of credit can actually change the direction of the stock market.
I don’t think so, but we’ll find out eventually. It will be good to keep in mind some of the market’s history with
respect to crashes. I have a rare item: a book of graphs of the Dow’s daily ranges going back 100 years. It shows
that when the market crashed in September and October, 1929, the Dow did not go straight down. It had huge
intraday rallies, most of which were reversed by day’s end. I suspect the same kind of action during wave c. When
the inevitable breathtaking rallies occur, I’m sure we will hear that the PPT is behind them. And maybe it will
be. But the rallies will come at the right junctures in the wave pattern, and they won’t change the major trend.
(For more on the PPT, see pages 367-368 of The Wave Principle of Human Social Behavior.)

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Robert Prechter’s Most Important Writings on Deflation

Excerpted from the April 30, 2007 Elliott Wave Theorist

Investors Are Buying More with IOUs Than Money

When I wrote Conquer the Crash, outstanding dollar-denominated debt was $30 trillion. Just five years later
it is $43 trillion, and most of the increase has gone into housing, financial investments and buying goods from
abroad. This is a meticulously constructed Biltmore House of cards, and one wonders whether it can stand the
addition of a single deuce. Its size and grandeur are no argument against the ultimate outcome; they are an argu-
ment for it.
Figure 1 depicts just one
isolated aspect of the debt bubble
as it relates directly to financial
prices. In 1999, the public was
heavily invested in mutual funds,
and mutual funds had 96 percent
of their clients’ money invested in
stocks. At the time I thought that
percentage of investment was a
limit. I was wrong. Today, much
of the public has switched to so-
called hedge funds (a misnomer).
Bridgewater estimates that the
average hedge fund in January
had 250 percent of its deposits
invested. This month the WSJ
reports funds with ratios as high
as 13 times. How can hedge funds
invest way more money than they
have? They borrow the rest from
banks and investment firms,
using their investment holdings
as collateral. So they are heavily Figure 1
leveraged. And this is only part of the picture. Much of the money invested in hedge funds in the first place is
borrowed. Some investors take out mortgages to get money to put into hedge funds. Some investment firms
borrow heavily from banks and brokers to invest in hedge funds. As for lenders, the WSJ reports today, “…the
nation’s four largest securities firms financed $3.3 trillion of assets with $129.4 billion of shareholders’ equity,
a leverage ratio of 25.5 to 1.” So the financial markets today have been rising in unison because of leverage upon
leverage, an inverted pyramid of IOUs, all supported by a comparatively small amount of actual cash. This swelling
snowball of borrowing is how the nominal Dow has managed to get to a new high even though it is in a raging
bear market in real terms: The expansion in credit inflates the dollar denominator of value, and the credit itself

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Robert Prechter’s Most Important Writings on Deflation April 30, 2007 Elliott Wave Theorist

goes to buying more stocks, bonds and commodities. The buying raises prices, and higher prices provide more
collateral for more borrowing. And all the while real stock values, as measured by gold, have quietly fallen by more
than half! Seemingly it is a perpetual motion machine; but one day the trend will go into reverse, and the value
of total credit will begin shrinking as dollar prices collapse.
The investment markets are only part of the debt picture. Most individuals have borrowed to buy real estate,
cars and TVs. Most people don’t own such possessions; they owe them. Credit card debt is at a historic high. The
Atlanta Braves just announced a new program through which you can finance the purchase of season tickets.
Can you imagine telling a fan in 1947 that someday people would take out loans to buy tickets to a baseball
game? Instead of buying things for cash these days, many consumers elect to pay not only the total value for each
item they buy but also a pile of additional money for interest. And they choose this option because they can’t
afford to pay cash for what they want or need. Self-indulgent and distress borrowing for consumption cannot go
on indefinitely. But while it does, the “money supply”—actually the credit supply—inflates. But it is all a temporary
phenomenon, because debt binges always exhaust themselves.
As far as I can tell, virtually everyone else sees things differently. Countless bulls on stocks, gold and com-
modities insist that the process is simple: the Fed is inflating the “money supply” by way of its “printing press,”
and there is no end in sight. The Fed is indeed the underlying motor of inflation because it monetizes govern-
ment debt, but the banking system, thanks to the elasticity of fiat money, manufactures by far the bulk of the
credit—credit, not cash. If you don’t believe credit can implode and investment prices fall, then why did the
housing market just have its biggest monthly price plunge in two decades, and why is the trend toward lower
prices now the longest on record? If you don’t think credit and cash are different, then why are the owners of
“collateralized” mortgage “securities” beginning to panic over the realization that their “investments” are melting
in the sun? Lewis Ranieri, one of the founders of the securitized mortgage market, recently warned that there are
now so many interests involved in each mortgage that massive cooperation among lawyers, accountants and tax
authorities will be required just to make simple decisions about restructuring a loan or disposing of a house, i.e.
the collateral, underlying a mortgage in default. In the old days, the local bank would suss things out and come
to a quick decision. But now the structures are too complex for easy resolution, and creditors are hamstrung
with structural and legal impediments to accessing their collateral. The modern structures for investment are
so intricate and dispersed that a mere recession will trigger a systemic disaster. When insurance companies and
pension plan administrators realize that they can’t easily and cheaply access the underlying assets, what will their
packaged mortgages be worth then? And what will happen to the empty houses as they try to sort things out?
This type of morass relates to debt. Cash is easy; either you have it or you don’t.
The gold and silver markets know the difference between money inflation and credit inflation. Gold has made
no net progress in the past year and in fact for the past 27+ years. Silver is languishing, still trading 75 percent
below its high in dollar terms, making it by far the worst investment of the past quarter century. Flat-out currency
inflation would have a powerful tendency to show up immediately in gold and silver prices. Credit is another
matter. Gold prices reflect the fact that an increase in debt is not the same as an increase in cash. New cash is here
to stay; debt expansion can morph into contraction. Thriving creditors, moreover, do not want metals; they want
interest. And credit is voracious, eating up debtors’ capital at a rate of 5 percent a year. When the debtors become
strapped, they sell other assets, including gold, to get cash to pay their creditors. Eventually, creditors with falling
income due to default will join the ranks of those with less money to buy things. But most investors don’t see it

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Robert Prechter’s Most Important Writings on Deflation April 30, 2007 Elliott Wave Theorist

our way; in April, for the second

time in wave b, the DSI reached
90 percent bulls among traders in
both gold and S&P! When else
in history has it happened? Try
never. Although the past few years
show that there can be periods of
exception, markets usually do not
reward a lopsided bulk of inves-
tors with the same outlook.
But there is a much more
important event for believers in
perpetual inflation to explain:
the trend of yields from bonds and
utility stocks. In the 1970s, prices
of bonds and utility stocks were
falling, and yields on bonds and
utility stocks were rising, because
of the onslaught of inflation. But
Figure 2
in the past 25 years bond and util-
ity stock prices have gone up, and yields on bonds and utility
stocks (see Figures 2 and 3) have gone down. Once again,
this situation is contrary to claims that we are experiencing a
replay of the inflationary 19-teens or 1970s. Those investing
on an inflation theme cannot explain these graphs. But there
is a precedent for this time. It is 1928-1929, when bond and
utility yields bottomed and prices topped (see Figure 4) in an
environment of expanding credit and a stock market boom.
The Dow Jones Utility Average was the last of the Dow aver-
ages to peak in 1929, and today it is deeply into wave (5) (see
Figure 5) and therefore near the end of its entire bull market.
All these juxtaposed market behaviors make sense only in
our context of a terminating credit bubble. This one is just a
whole lot bigger than any other in history.
Some economic historians blame rising interest rates into
1929 for the crash that ensued. Those who do must acknowl-
edge that the Fed’s interest rate today is at almost exactly the
same level it was then, having risen steadily—and in fact way
more in percentage terms—since 2003. So even on this score
the setup is the same as it was 1929. Remember also that in Figure 3

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Robert Prechter’s Most Important Writings on Deflation April 30, 2007 Elliott Wave Theorist

1926 the Florida land boom collapsed. In the current cycle, house
prices nationwide topped out in 2005, two years ago. So maybe it’s
1928 now instead of 1929. But that’s a small quibble compared to
the erroneous idea that we are enjoying a perpetually inflationary
goldilocks economy with perpetually rising investment prices.
As to whether the Fed can induce more borrowing by lowering
rates in the next recession, we will have to see, but evidence from
the sub-prime and Alt-A mortgage markets as well as ratios like the
one in Figure 1 suggest more strongly than ever that consumers’ and
investors’ capacity for holding debt is maxing out. I see no way out
of the current extreme in credit issuance aside from the classic way:
a debt implosion.
Nevertheless, we must also recognize the fact that the market is
a dynamic system. It does not seek equilibrium or revert to a mean.
It has no limits as oscillators do. Optimism and pessimism are not
bounded. So hedge funds could go to 3x leverage, or 5x, or 100x.
Total dollar-denominated debt could go to $50t., or $60t., or $400t.
And the Dow could go to 20,000. But further credit expansion would
Figure 4 merely mean postponement of the implosion, not negation. The size
of the bubble will simply relate to
the size of the collapse.

Figure 5

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Robert Prechter’s Most Important Writings on Deflation

Excerpted from the July 13, 2007 Elliott Wave Theorist (written at the all-time peak in DJI plus DJT)

The Credit Crunch

In light of recent developments in mortgage-backed bonds, please take a moment to read this excerpt, espe-
cially the underlined portions, from Conquer the Crash:
Chapter 15: Should You Invest in Bonds?
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.
Conventional analysts who have not studied the Great Depression or who expect bonds to move “contra-
cyclically” to stocks are going to be shocked to see their bonds plummeting in value right along with the stock
market.
The Specter of Downgrading
The main problem with even these cautionary graphs is that they do not show the full impact of downgrades.
They show what bonds of a certain quality sold for at each data point. Bonds rated AAA or BBB at the start
of a depression generally do not keep those ratings throughout it. Many go straight to D and then become
de-listed because of default. Figure 15-1 does not take the price devastation of these issues into account. Like
keepers of stock market averages who replace the companies that fail along the way, keepers of the bond aver-
ages of Figures 15-2 and 15-3 stand ready to replace component bonds whose ratings fall too far. As scary as
they look, these graphs fail to depict the real misery that a depression inflicts upon bond investors.
High-Yield Bonds
When rating services rate bonds between BBB and AAA, they imply that they are considered safe investments.
Anything rated BB or lower is considered speculative, implying that there is a risk that the borrower someday
could default. The lower the rating, the greater that risk. Because of this risk, Wall Street, in a rare display of
honesty, calls bonds rated BB or lower “junk.” They appear to have “high yields,” so people still buy them.
That very yield, though, compounds the risk to principal. In a bad economy, companies and municipalities
that have issued bonds at high yields find it increasingly difficult to meet their interest payments. The prices
of those bonds fall as investors perceive increased risk and sell them. The real result in such cases is a low yield
or a negative yield, particularly if the issuer defaults and your principal is gone.
Today’s “High-Grade” Bonds
Don’t think that you will be safe buying bonds rated BBB or above. The unprecedented mass of vulnerable
bonds extant today is on the verge of a waterfall of downgrading. Many bonds that are currently rated invest-
ment grade will be downgraded to junk status and then go into default. The downgrades will go hand-in-hand

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Robert Prechter’s Most Important Writings on Deflation July 13, 2007 Elliott Wave Theorist

with falling prices, so you will not be afforded advance warning of loss. When the big slide begins, I doubt that
the rating services will even be able to keep up with the downgrades at the rate that they will be required….
As we will see in Chapter 25, you cannot rely on bond rating services to guide you in a crunch.

Chapter 25: Reliable Sources for Financial Warnings

Safety Ratings for Financial Institutions
The most widely utilized rating services are almost always woefully late in warning you of problems within
financial institutions. They often seem to get news about a company around the time that everyone else
does, which means that the price of the associated stock or bond has already changed to reflect that news. In
severe cases, a company can collapse before the standard rating services know what hit it. When all you can
see is dust, they just skip the downgrading process and shift the company’s rating from “investment grade”
to “default” status.
Examples abound. The debt of the largest real estate developer in the world, Olympia & York of Canada, had
an AA rating in 1991. A year later, it was bankrupt. Rating services missed the historic debacles at Barings
Bank, Sumitomo Bank and Enron. Enron’s bonds enjoyed an “investment grade” rating four days before the
company went bankrupt. In my view, Enron’s bonds in particular were transparently junk well before their
collapse. Why? Because the firm employed an
army of traders in derivatives, which is an ab-
solute guarantee of ultimate failure even when
it’s not a company’s main business.
Sometimes there are structural reasons for the
overvaluation of debt issues. For example, in-
vestors buy the debt offerings of Fannie Mae,
Freddie Mac and the FHLB because they think
that the U.S. government guarantees them. It
doesn’t. [Worse,] the bonds that these compa-
nies issue are exempt from SEC registration
and disclosure requirements because they are
simply presumed to be safe. Managers of these
companies are going to be utterly shocked when
a depression devastates their portfolios and
their earnings. Investors in these companies’
stocks and bonds will be just as surprised when
the stock prices and bond ratings collapse. Most
rating services will not see it coming.

Today the mortgage market is leading the charge

in our scenario. The latest news reports tell not only
of the devastation to debt portfolios but also of the
worthlessness of the rating services for protecting
investors and even their complicity in covering up the
Figure 2
collapse in the true value of many mortgages.

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Robert Prechter’s Most Important Writings on Deflation July 13, 2007 Elliott Wave Theorist

Conquer the Crash was finished in March 2002. Look at Figure 2 and notice that the fewest debt downgrades
of the decade occurred that year. As CTC said, as an investor you cannot wait until problems are obvious to act;
by then it’s too late. You have to anticipate problems and then get out of the way before they happen.
As for the price of mortgage debt, Figure 3 tells the story, thanks to the diligence of Markit Group Ltd., whose
work has brought some transparency to this field. The lower line denotes the price of subprime mortgages, and
the middle line shows prices of “alt.-A,” the mid-grade mortgage paper. The top line prices prime mortgages, the
ones whose payers have some equity and a good source of income. But these graphs rely on dealers for prices,
and many of these mortgages are not trading. So even these data do not show the true extent of losses. There is
a big lag between what everyone in the industry suspects is the real price and what happens to the index. As Pete
Kendall says, “It’s a surreal world where prices are lagging actual values.”

Figure 3

The rating services fulfilled their usual role:

Fortune July 5 2007: 11:16 AM EDT (Fortune Magazine) [excerpt]
The three credit-rating agencies - Standard & Poor’s, Moody’s (Charts), and Fitch - may be the next ones to
see their good names dragged through the mud. The reason? Ohio attorney general Marc Dann is building a
case against them based on the role he believes their ratings played in the marketing of risky mortgage-related
securities.

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Robert Prechter’s Most Important Writings on Deflation July 13, 2007 Elliott Wave Theorist

“The ratings agencies cashed a check every time one of these subprime pools was created and an offering
was made,” Dann told Fortune, referring to the way the bond issuers paid to get their asset-backed securities
(ABSs) and collateralized debt obligations (CDOs) rated by the agencies. [So they are] among the people who
aided and abetted this continuing fraud,” adds Dann.
Ohio has the third-largest group of public pensions in the United States, and they’ve got exposure: The Ohio
Police & Fire Pension Fund has nearly 7 percent of its portfolio in mortgage- and asset-backed obligations.
Moody’s says that Dann’s accusations are nonsense. “We perform a very significant but extremely limited role
in the credit markets. We issue reasoned, forward-looking opinions about credit risk,” says Fran Laserson,
vice president of corporate communications at Moody’s. “Our opinions are objective and not tied to any
recommendations to buy and sell.” She further points out that while some securities have lost significant
value, none have actually defaulted.
Dann and a growing legion of critics contend that the agencies dropped the ball by issuing investment-grade
ratings on securities backed by subprime mortgages they should have known were shaky. “The rating drives
everything,” adds Sylvain Raynes, a former Moody’s analyst and currently a principal at R&R Consulting, a
firm that examines these securities.
Regardless of whether a lawsuit materializes, the ratings agencies already seem to be policing themselves. Of
the pool of securities created from 2006 subprime mortgages, Moody’s has downgraded 19 percent of the
issues they’ve rated and put 30 percent on a watch list.

Here is an addendum from a Bloomberg report from July 11:

“I track this market every single day and performance has been a disaster now for months,” said Steven Eis-
man, who helps manage $6.5 billion at Frontpoint Partners in New York, during a conference call hosted by
S&P yesterday. “I’d like to understand why you made this move now when you could have done this months
ago.”

But readers of Conquer the Crash are not surprised, and we didn’t own any such debt.
Some readers of Conquer the Crash took exception to this statement, from Chapter 9:
[F]inancial values can disappear into nowhere…. The “million dollars” that a wealthy investor might have
thought he had in his bond portfolio or at a stock’s peak value can quite rapidly become $50,000 or $5000
or $50. The rest of it just disappears. You see, he never really had a million dollars; all he had was IOUs or stock
certificates. The idea that it had a certain financial value was in his head and the heads of others who agreed.
When the point of agreement changed, so did the value. Poof! Gone in a flash of aggregated neurons.

This warning is being borne out today. Read this except from a Bloomberg news report of July 11:
As delinquencies on home loans to people with poor or meager credit surged to a 10-year high this year, no
one buying, selling or rating the bonds collateralized by these bad debts bothered to quantify the losses. Now
the bubble is bursting and there is no agreement on how much money has vanished: $52 billion, according to an
estimate from Zurich-based Credit Suisse Group earlier this week that followed a $90 billion assessment from
Frankfurt-based Deutsche Bank AG.

Do you see that line, “money has vanished”? It’s not really money; it’s financial value, but it didn’t move from one
asset to another. It just disappeared.

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Robert Prechter’s Most Important Writings on Deflation

Excerpted from the August 26, 2007 Elliott Wave Theorist

Can’t Buy Enough…of That Junky Stuff, or, Why the Fed Will Not Stop Deflation
We hear it every day: “What about the Fed?” The vast majority of investors and commentators seems con-
fident that the Fed’s machinations make a stock market collapse impossible. Every hour or so one can read or
hear another comment along these lines: “the Fed will provide liquidity,” “the Fed is injecting money into the
system,” “the Fed will be forced to bail out homeowners, homebuilders, mortgage companies and banks,” “the
Fed has no choice but to inflate,” “the government cannot allow deflation,” “the Fed will print money to stave
off deflation” and any number of like statements. None of them is true. The Fed is not forced to do anything;
the Fed has not been injecting money; the Fed does have choices; the government does not control deflationary
forces; and the Fed will not print money unless and until it changes its long-standing policies and decides to
destroy itself.
A perfect example of one of these fallacies recently exposed is the widespread report in August that the Fed
had “injected” billions of dollars worth of “money” into the “system” by “buying” “sub-prime mortgages.” In fact,
all it did was offer to stave off the immediate illegality of many banks’ operations by lending money against the
collateral of guaranteed mortgages but only temporarily under contracts that oblige the banks to buy them back
within 1 to 30 days. The typical duration is 3 days. Observe three important things:
1. The Fed did not give out money; it offered a temporary, collateralized loan.
2. The Fed did not inject liquidity; it offered it.
3. The Fed did not lend against worthless sub-prime mortgages; it lent against valuable mortgages issued
by Fannie Mae (the Federal National Mortgage Association), Ginnie Mae (the Government National
Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation). The New
York Fed is also accepting “investment quality” commercial paper, which means highly liquid, valuable
IOUs, not junk.

As a result:
1. The Fed took almost no risk in the transactions.
2. The net liquidity it provided—after the repo agreements close—is zero.
3. The financial system is still choking on bad loans.
4. Banks and other lending institutions must sell other assets to raise cash to buy back their mortgages
from the Fed.

These points are crucial to a proper understanding of the situation. The Fed is doing nothing akin to what most of the
media claims; like McDonald’s, it is selling not so much sustenance as time, in this case time for banks to divest
themselves of some assets. But in the Fed’s case, that’s all it’s selling; you don’t get any food in the bargain.
As I have said before, the Federal Reserve may be large and complex, but it is a bank. It has private owners:
member banks, whose shareholders can be anyone. (For an excellent primer, see http://www.libertyunbound.
com/archive/2004_10/woolsey-fed.html.) The Fed’s stockholders exploit the banking system through access to
easy loans and the Fed’s 6%-guaranteed stock dividends. Member banks do not want to see their nurturing en-
terprise destroyed. Although Bernanke probably received distress calls from mortgage lenders, he probably also

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Robert Prechter’s Most Important Writings on Deflation August 26, 2007 Elliott Wave Theorist

got calls from prospering member banks saying, “Don’t you dare buy any of that crap and put it in the long-term
portfolio.” Nor is it likely to do so. Member banks may make mortgages and lend to consumers, but the Fed
doesn’t; comparatively, it’s highly conservative.
In the early 1930s, as markets fell and the economy collapsed, the Fed offered loans only on the most pris-
tine debt. Its standards have fallen a bit, but not by much. Today it will still lend only on highly reliable IOUs, not
junk. And it doesn’t even want to own most of those; it takes them on only temporarily as part of a short-term
repurchase agreement.
The Fed’s power derives from the value of its holdings, which are primarily Treasury bonds, which provide
backing for the value of the Fed’s notes. What would a Federal Reserve Note be worth if it were backed by sub-
prime mortgages? The real value of U.S. Treasury debt is precarious enough as it is, but at least it has the taxing
power of the government behind it. But if the Fed bought up the entire supply of sub-prime mortgages, its notes
would lose value accordingly. So will the Fed bail out mortgage companies, as the optimists seem to think? No,
it won’t. Those who think the Fed will buy up junk with cash delivered by helicopter are dreaming.
Ironically, of course, the Federal Reserve System and the federal government—both directly and via creations
such as privileged mortgage companies and the FDIC—have fostered all the lending and the junk debt that resulted.
But these entities want only to benefit from the process, not suffer from it. As we will see throughout the bear
market and into the depression, the Fed is self-interested and will not brook losses in its portfolio. Those who
own the bad loans, and perhaps some foolish government entities that try to “save” them, will take losses, but
the Fed won’t.
One might imagine various schemes by which the government would guarantee such mortgages, but if it
did, the mortgages would in effect become Treasury bonds. The problem, as others have pointed out, is that
government guarantees on bad debt would simply encourage more of it. Unless the government decides to freeze
the mortgage lending industry, which would have its own devastating repercussions, it cannot pull off a bailout
scheme.
What must the banks do with their “grace period” of a few days that the Fed’s repo agreements provide?
They have to raise the cash to buy back the IOUs that the Fed agreed to hold for them. How does a bank raise money?
By selling assets. Thus begins the downward spiral: Contracting credit causes asset sales, which cause collateral
values to fall, which causes lenders to curtail lending, thus contracting overall credit, which causes assets sales,
and so it goes. Thus, the Fed is not staving off deflation; at best, it may have helped—momentarily—to make it
more orderly. But the selling of assets has begun regardless.
One of the Fed’s just-accessed “tools” is its authority to suspend various lending restrictions. As Fortune
(August 24) just reported, a week ago the Fed, in an unprecedented move suggesting growing panic, suspended
the limit on the percentage of capital that Citigroup and Bank of America can lend to their affiliated broker-
age firms. With that permission, these banks immediately raised their loans from the previous maximum of 10
percent of their total capital to an enormous 30 percent, and they have permission to go higher if they want.
Observe that the Fed did not lend to the brokers. It merely authorized these banks to do it. The banks, though
obviously desperate to shore up their brokerage divisions, just as necessarily believe that their loans will be paid
back, which means that they are bullish on the stock market and most other financial markets. But what will
happen when markets fall further and the banks’ depositors get wind of the fact that their money has been lent
to speculators with leveraged market positions? The Fed, which greased the loan scheme by financing the loan

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Robert Prechter’s Most Important Writings on Deflation August 26, 2007 Elliott Wave Theorist

to these banks (not the brokers) through its discount window, now has a claim on these banks’ assets. It will be
utterly fascinating to see what the Fed decides to do when these big banks finally call the Fed and say that if it
calls in its loans, they will go bankrupt. I’m betting that the Fed, perhaps after a few more frantic calls to other
creditors for help, will eventually call in the loans anyway.
Does the Fed have secret tools to stave off deflation? Yes, to the same extent that Hitler, hiding in a bunker
in 1945, had secret weapons to stave off the Allies. The Fed has only one tool: to offer credit, and its arsenal is
depleted because it will offer credit only on terms good to itself. And borrowers will borrow only if they think they
can pay back the debt after selling assets. You can bet that the Fed is lending only to banks that it believes have
the necessary assets to survive its loans’ repayment provisions. If not, well, it will be the FDIC’s problem. The
Fed is not engineering a system-wide bailout; it is just re-arranging deck chairs.
Interest rates are higher than they were in 2002. Many people say that the Fed therefore has lots of room to
bring rates down and keep the economy inflated. Do lower interest rates cause recovery? No, they simply reflect
a crashing market for credit. The market makes interest rates rise and fall, and the Fed’s rates typically just follow
suit. Sometimes central banks force the issue, as when the Fed in the final months of 2002 lowered its discount
rate to 0.75 percent, staying a bit ahead of the decline in T-bill yields. But its systematic rate drops didn’t stop
the S&P from losing half its value in 31 months. When the Japanese central bank lowered rates virtually to zero
in the 1990s, doing so likewise did not prevent Japanese real estate prices from imploding and the Nikkei from
proceeding through its biggest bear market ever by a huge margin. Rates near zero, then, did not constitute a magic
potion. Zero was simply the price of loans at the time; nobody wanted them. So the “room” the Fed presumably
has may or may not matter. If the market decides to take rates to zero or below, the Fed will simply follow and
then have no power.
The Fed does not “inject” liquidity; it only offers it. If nobody wants it, the inflation game is over. The
determinant of that matter is the market. When bull markets turn to bear, confidence turns to fear, and fearful
people do not lend or borrow at the same rates as confident ones. The ultimate drivers of inflation and deflation
are human mental states that the Fed cannot manipulate. The pattern of the stock market’s waves determines the
ebb and flow of these mental states, and now that a bear market has begun, nothing will stop the trend toward
falling confidence and thus falling asset prices, credit deflation and economic depression.
The truth is that the Fed’s supposed tools of adding liquidity, such as the limit suspension just granted to
the big New York banks, are formulas for total disaster. The terrible secret is that every one of the Fed’s tools is
nothing but a mechanism to make matters worse. Just because it has taken 74 years to get to the point at which this
fact is once again about to become obvious does not mean that it wasn’t true all along. The Fed is short-sighted,
and its schemes to foster liquidity for short term crises have served, and are continuing to serve, to insure the
ultimate collapse of most of the nation’s banking system. The storm clouds are getting dark, so that time may
have arrived.
The market is certainly poised for a panic. Confidence has held sway for 2½ decades, during which time
investors have become utterly unconcerned with risk. They hold a number of misconceptions that foster such
complacency. The day the Fed lowers one of its rates or engineers a major temporary loan and the stock market
goes down anyway is the day that investors will become utterly uncertain of what they believe about market cau-
sality, and panic will have no bridle. Sadly, Ben Bernanke will be blamed for the debacle, when all he will have
been guilty of is serving an immoral monopoly, bad timing and failing to understand the forces at work. The
third item pertains to almost everyone.

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Robert Prechter’s Most Important Writings on Deflation August 26, 2007 Elliott Wave Theorist

The Fed Is Not Smart Enough To Stop Deflation, Even If It Could

The dab of grease on the gears in the form of the recent discount-rate cut did not come as part of the Fed’s
normal policy. According to a Bloomberg article of August 17, the surprise discount rate cut was “an extraordinary
policy shift.” In other words, the Fed did not know what the hell was going on. It was caught off guard and had to react.
In fact, right through July the Fed’s spokespeople were all saying that the number one threat to the economy was
inflation! Like virtually all futurists, the Fed’s economists extrapolate trends to derive forecasts. They never look
at underlying indications of coming trend change. That’s fine; it helps those of us who at least try to do so. But
the idea that the Fed comprises a group of masterminds who “get it” at some deep level and can thereby control
things is miles off the mark. For more on this theme, see the “Potent Directors Fallacy” discussion in The Wave
Principle of Human Social Behavior.

A Deflationary Spiral
It is beginning to dawn upon people how a deflationary spiral works. As explained in Conquer the Crash,
to satisfy creditors, debtors will sell all they can, even their best assets, to raise cash. That’s one reason why gold
and silver are not going up. When the sub-prime mortgage market crashed, guess what: other bonds, including
supposedly safe municipal and corporate bonds, also fell. Most commentators believe that forced liquidation is
the only reason that perfectly good investments fell in price. As one report dated August 24 said, “There’s really
no credit-related reason behind the decline.” But CTC is on record predicting that a large portion of currently
outstanding corporate and municipal debt will become worthless. Every trend has to begin somewhere, and its
ultimate outcomes are never evident at the start of a move. By the end of the price decline in these bonds, when
a bit of glue on the back of them will aid their use as wallpaper, observers will finally postulate why the bear mar-
ket started in the first place. Even if most of the recent price declines are due to forced sales, those sales in turn
are decreasing the total value of investments, which in turn will curtail individuals’ and companies’ economic
activity, which will lead to an economic contraction, which will stress the issuers of such bonds to the point that
they will be unable to make interest payments or return principal. In other words, whether investors understand
it now or not, the forced sale of bonds is itself enough reason to sell them also on the basis of default risk.
Despite my description, this process is not linear. Every step of the way seems to have an immediate causal
precursor, but like credit inflation, credit deflation is in fact an intricate, interwoven process, whose initial impetus
is a change in social mood from optimism toward pessimism. If you are still on the fence about this idea, ask yourself:
What changed in the so-called “fundamentals” between June and August? The answer is: absolutely nothing. Interest
rates did not budge; there were no indications of recession; there were no changes in bank lending policies; there
were no chilling government edicts. The only thing that changed was people’s minds. One day sub-prime mortgages
were a fine investment, and the next day they were toxic waste. There was no external cause of the change; it was
an endogenously caused and regulated change, as all aggregate financial changes are. According to socionomic
theory, the stock market is a sensitive indicator of such changes in mood. This is why EWT has continually said
that the financial structure will hold up as long as the stock market rises. A downturn occurred in mid-July, and its
consequences in terms of negative social mood are becoming swiftly evident. Remember, C waves (see Elliott Wave
Principle, Chapter 2) are when optimistic illusions finally disappear and fear takes over. Sounds like now.

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Robert Prechter’s Most Important Writings on Deflation

Excerptee from the October 19, 2007 Elliott Wave Theorist

Falling Interest Rates in This Environment Will Be Bearish

You cannot pick up a newspaper, turn on financial TV or read an economist’s report without hearing that
the Fed’s latest discount-rate cut is bullish because it indicates the Fed’s decision to “pump liquidity” into the
system. This opinion is so completely wrong that it is hard to believe its ubiquity.
First of all, the Fed does not “decide”
where it wants interest rates. All it does
is follow the market. Figure 17 proves it.
Wherever the T-bill rate goes, the Fed’s
“target rate” for federal funds immedi-
ately follows. That’s all there is to it. If
you refuse to believe your eyes, then listen
to the chairman; Alan Greenspan is very
clear on this point. On September 17, a
commentator on CNBC asked, “Did you
keep the interest rates too low for too long
in 2002-2003?” Greenspan immediately
responded, “The market did.” Rates were
not “too low” or the period “too long,”
either, because the market, not the Fed,
made the decision on the level and the
time, and the market is never wrong; it is
what it is. If investors in trillions of dollars
worth of U.S. Treasury debt worldwide
had demanded higher interest, they
would have gotten it, period.
Second, falling interest rates are al-
most never bullish. All you have to do to
Figure 17
understand this point is look at Figure
18. Interest rates fell persistently through three of the greatest bear markets in history: 1929-1932 in the Dow,
1990-2003 in the Japanese Nikkei, and 2000-2002 in the NASDAQ. The only comparably deep bear market
in the past 80 years in which interest rates rose took place in the 1970s when the Value Line index dropped 74
percent. Economists all draw upon this experience, but they ignore the others. Today’s environment of extensive
investment leverage and an Everest of debt in the banking system is far more like 1929 in the U.S. and 1989 in
Japan than it is like the 1970s. Why is a decline in interest rates bearish in such an environment? Because it means
a decline in the demand for credit. When people want less of something, the price goes down. The recent drop in
rates indicates less borrowing, which means that the primary prop under investment prices—the expansion of
credit—is weakening. That’s one reason why stock prices fell in 2000-2002 and why they are vulnerable now. This

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Robert Prechter’s Most Important Writings on Deflation October 19, 2007 Elliott Wave Theorist

is the opposite of “pumping liquidity”; it’s a slacken-

ing in liquidity.

The Big Bailout Bluff

Last week, a consortium of the USA’s three
largest banks—Citigroup, Bank of America and
JP Morgan Chase—agreed to create a super fund
(called M-LEC) of $80 billion “to buy distressed
securities from SIVs [Structured Investment
Vehicles].” Of course, like the Fed’s loans for
only the very best paper, the super fund will buy
only high-quality mortgages, not the sub-prime
or Alt-A stuff.
Do you think this plan will work? First let’s
examine what the SIVs did to get themselves in
trouble. As AP (10/16) reports,
The SIVs used short-term commercial
paper, sold at low interest rates, to buy
longer-term mortgage-backed securities
and other instruments with higher rates
of return. With the seizure of the credit
markets, many SIVs had trouble selling
new commercial paper to replace upcoming
obligations on older paper.

Their plan, in other words, was the equivalent of

a perpetual motion machine: “Money for Noth-
ing,” as the song title goes. But the world does Figure 18
not work like that. Oversized interest rates often
mean that the investment is in fact sucking money out of principal. Sometimes investors can get away with the
gambit for awhile, but eventually somebody pays the bill. The collapse in sub-prime mortgages and in the commer-
cial paper that supported them has simply adjusted the value of the principal to make up for the outsized returns
that these investors got over the past five years. But guess what: The money that banks owe on their commercial
paper didn’t change. Sounds like trouble. And here is what are they are doing about it:
This time around, the banks hope to not only prevent credit problems from spreading, but also are bailing
themselves out. (AP, 10/16)

This idea is the equivalent to trying to levitate yourself by pulling on your legs. These banks are going to offer
more commercial paper to buy mortgage assets; in other words, they are going to borrow more short-term money
in order to buy long-term assets from themselves! That is, if they can borrow the money in the first place. One
of the casualties in the rout was the commercial paper market; investors are realizing that it backs a lot of lousy
mortgage debt, so they are backing away from investing in the commercial paper that backs the mortgages.

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Robert Prechter’s Most Important Writings on Deflation October 19, 2007 Elliott Wave Theorist

The last time banks colluded to hold up an entire market was October 1929. It didn’t work.
If you have any exposure to illiquid mortgage investments, look upon this superfund as a gift. As soon as
these banks pledge to buy one of your long-term, mortgage-backed securities, sell it to them.
What collateral will these banks use to back the $80 billion in commercial paper they hope to sell to finance
this scheme? They can’t use mortgages, because the market doesn’t want them. As one article says, “Analysts
say that investors have all but stopped buying SIV-affiliated commercial paper.” Will the new commercial paper
become obligations of the banks? There appears to be no other alternative. In other words, depositors’ money
may end up backing this paper. One thing seems certain: The banks are digging themselves deeper into a hole.
If you still have deposits in debt-laden banks despite our entreaties, you might want to take this late opportunity
to move them. For suggestions on where to deposit funds for safety, see Conquer the Crash.
On July 9, the CEO/Chairman of Citigroup said, “When the music stops, in terms of liquidity, things will
be complicated.” Now wait a minute. We keep hearing that the Fed will shore up all their debts with perpetual
liquidity, so how do you explain this comment? Answer: The bankers know better. Liquidity, formerly the solu-
tion, is now the problem, and the bankers know it.
The only solution that bankers, regulators, politicians and the Fed can think of is to do more of what they
did to get into the problem in the first place: create more debt. They know of no other response. When the big
bankers met via conference calls, “Besides hearing from senior executives from each of the big banks, the group
also sought ideas from others.” In other words, they are flailing for a solution to a problem that has no solution
aside from taking measures to make it worse. I still think there is no better analogy to a system-wide credit binge
than a person who keeps going only by gulping down amphetamines. He will collapse if he stops taking them,
but if he keeps taking them he will ultimately die. Bankers always choose to ingest more speed. Their choice is
to collapse now or die later. They always choose later. But they cannot avoid the inevitable result.
Speaking of the inevitable result, Bloomberg reports that a mortgage fund managed by Cheyne Capital
Management Ltd. has just announced that it will fail to pay the interest immediately due on the commercial
paper it issued to buy mortgages. Here’s the problem: If it tried to pay the interest, it would have to sell assets to
raise the money. If it were to sell assets in an illiquid market, they would fall in value, making the collateral in
the fund worth less. I’ll bet this company can’t wait for that call from the managers of the new super fund, that
is, if it owns any top-rated mortgages.
Can you see how exquisite the conundrum is for the “investors” who lent money to this firm? If they ask for
their rightful interest, their principal will fall. If they don’t ask for interest, they have no income. If they can’t sell
the assets, in truth they have no principal.
The emperor has no clothes, but so far the stock market floats merrily unconcerned in a haze of unprec-
edented optimism. Someday that optimism will melt as fast as it did in the mortgage market.

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