Subprime Prophet

But that was then, and now a long cyclical period of low inflation appears to be coming to an end. Commodity prices are at a record once more; gold — the traditional hedge against inflation — is above $900 per ounce and price indices are edging to levels not seen for a few years. Talking to Dr. Disinflation in today's environment, I'm naturally temped to ask whether he believes that inflation is coming back.

Once Dr. Disinflation, always Dr. Disinflation. Shilling dismisses inflationary fears with a wave of his hand, as though shooing away a fly: "There would have been concern about inflation if commodity prices had been feeding into wages. They are not. Besides, the psychology is different today than it was in the 1970s. Back then, consumers were rushing out to spend their money almost as soon as they made it, buying up everything in sight. Now, they seem to be willing to wait for as long as it takes for the prices to come down."

Fear of inflation is certainly unlikely to prevent the U.S. Federal Reserve from easing further. The only problem, notes Shilling, is that it may be facing a conundrum known in economics as "pushing on the string". The Fed has cut interest rates, but the banking system remains clogged up and banks are still reluctant to lend to each other.

Nor will pumping liquidity into the system likely do the trick. Shilling's measure of the liquidity crunch is not the money supply, but derivatives. Producing another chart, he shows that the growth in derivatives over the past decade or so has dwarfed conventional measures of money. The Bank for International Settlements estimates the notional value of derivatives at over $500 trillion.

"Derivatives are completely unregulated," he says. "You and I could create a derivatives contract right here, around this table."

The unwinding of derivatives contracts, which occurs with the decline in value of assets on which those derivatives are based, is what is really causing a liquidity crunch, asserts Shilling.

Commodities BubbleThis brings him back to commodities prices. Not only are they not going to stoke inflation, says Shilling, but he expects them to come down — and to do so with a bang. This, he believes, is the other shoe that is going to drop, and another opportunity to make a killing for savvy investors. Shilling was predicting a collapse in commodity prices at the start of 2007, the same time when he called for a sharp decline in housing prices as well.

Although he — and Paulson — have made a lot of money by shorting the subprime mortgage segment, Shilling believes that this has been only the tip of the iceberg. He points to trouble in the near-prime Alt-A pools of mortgages as a sign that the pricking of the housing bubble is far from over. In fact, he predicts that the nation's house prices will fall 25 percent from their 2006 peaks. This is on average, mind you, with some markets, such as Florida and California, suffering an even greater debacle.

A bold prediction? Undoubtedly so, especially since Shilling himself admits that prior to the current protracted housing crisis, there have only been two instances of two consecutive months of year-on-year house price declines in recorded U.S. history.

And, even if he is correct, there is still the issue of timing. Paulson now looks like a genius, but his funds sustained losses for over a year and he could have easily gone bust had the subprime crisis not arrived, conveniently, when it did. Similarly, Shilling's bearish forecasts at the start of 2007 would have left somebody shorting oil or the Dow with staggering losses in a year when both commodities and stocks set new record highs.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at [email protected]. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.