Softpanorama (slightly skeptical) Open Source Software Educational Society

May the source be with you, but remember the KISS principle ;-) Softpanorama Search

Inflation vs. Deflation Debate

I think that the problem of inflation is essentially a political problem. It is the issue of solvency of the ruling elite.  One way any serious crisis of ruling elite reveal itself is via inflation (or, in other words,  running printing press at full speed no matter what the consequences are, because it has no other options). That means that the monetary policy cannot be studied, or understood, in isolation from the overall policies of the state, especially engagement is costly adventures like optional wars. Talks about Central banks independence are good only for good times. In tough times Central bank behaves as a puppet of central government it always was. That's why most states monopolizes the supply of money within its own territory.  Empires tend to overextend themselves and succumb to inflation.

Monetary, fiscal, military, political, and economic issues are all intertwined. Military adventures  is probably the most common source of inflation as an informal coalition of groups with vested interests in the continuous development and maintenance  of weaponry constitute the important part of elite and that naturally leads to attempts to use its power for pursuing the state interests outside of its borders  (war is a continuation of policy with other means).

The U.S. has a military-industrial complex which, on an annual basis, accounts for 47% of the world's total arms expenditures. The Military budget of the United States for the 2009 fiscal year was more then half-trillion dollars. BTW in the  draft of the address, Eisenhower initially used the term military-industrial-congressional complex, which indicates the essential role that the United States Congress plays in the propagation of the military industry.

While a war usually lead to inflation, the victory against major adversary can lead to disinflation. For example,  low inflation and great stock market run of 1991-2000 was at least partially connected with defeat of the USSR and subsequent looting of xUSSR states as well as extending dollar hegemony to this area; this was once in a century event this added almost a billion consumers, allowing Greenspan's Fed to pursue extremely loose monetary policy. Approximately in 2000 situation changed and reckless policy of the Fed lead to the current situation which in many ways is similar with the situation in which Great Britain has found  itself after the WWI.  

Within the state monetary policy always serves the  needs of the ruling elite. That's the primary, albeit unstated, goal of Fed monetary policy. Similarly it is the primary goal of both state diplomacy and partially state military operations ("war is a racket"). If it also happens to enhance the standard of living of ordinary people (sheeple) that's just a side effect. This idea can help understanding growing  perspectives of dramatic increase of inflation in the USA.

The advice that the Emperor Septimius Severus  to his two sons distills the typical way of conducting monetary policy: "live in harmony; enrich the troops; ignore everyone else." You just need to change "troops" to "haves and have more" (which, of course, includes military establishment) to make this quote very similar to one that was once uttered by world the most famous dyslectic George Bush II.  This is how monetary policy is conducted if we discard all the hypocrisy. See an interesting historical  exposition of this approach applied to Roman empire in Inflation and the Fall of the Roman Empire - Joseph R. Peden - Mises Institute

While the level of inflation is the result of demands of state (wars are usually extremely inflationary events), inflation like GDP is an aggregate metric which often camouflages several often opposite trends. Like GDP contain a lot of harmful for the society economic activity (junk GDP), inflation also can contain some positive and some negative components (food inflation vs. stocks inflation).  Moreover inflation in one sector usually co-exists with deflation in some other sector. For example in 2008 in the USA we saw coexistence of two opposite trends:

• Deflation (cars, houses, computers, laptops, cameras, stocks, hotel prices, gas (Jan - March, 2009)
• Inflation (food, retail items such as clothing, transportation, restaurant prices, car repairs, car parts, gas (May -- June, 2009) etc)
• Some items changed direction and thus camp to which they belong not once but several times several times: Gas first became an inflationary item, then deflationary and now again inflationary item.  Generally 1 cent increase of gas price means 1 billion a year loss for America consumer, so fluctuation in oil price has effect bigger then Obama's stimulus.

In the inflation/deflation debate, I think what most people mean is "their own personal cost of living", in view of income, rather than a macroeconomic concept. Based on Japanese experience, we may well see deflation in big ticket and discretionary items (housing, autos, boats etc..) with modest or no inflation in daily expenses (energy, food, public transportation, etc).

Predicting inflation, especially short term, is notoriously difficult. Dollar may be a currency under pressure but it can strengthen not weaken if US economy proved to be less bad that other major economies. Still one long trend -- growing price of gasoline -- is unmistakable due to depletion of oil reserves. As price of gas should be factored in all modern activities the future belongs to inflation not deflation.  Note that the price of oil in late 2009 is hovering around $70 despite tremendous drop of economic activity.

Still nobody knows what will happen in the USA the next year,  so all the posts reproduced below are a mere speculation. But one thing is certain: inflation in the USA by-and-large depends on the world outside the USA and that ties hands of Bernanke Fed (running printing presses too fast can produce severe Chinese retaliation).  And that is reflected in the position of the dollar vs. euro as the only other major currency. For dollar to strengthen the economic situation in the USA should not be good, it should just be less bad then in  countries of Eurozone.

Here are some ideas distilled from the posts below which look to me, as a programmer, more plausible then others.

• CPI has serious flaws that make it almost unusable as a static measure of inflation, but still useful as a trend (and that means that TIPS are far from being  a perfect protection from inflation) as it does not take into account cost of medical services, underestimates cost of housing (using owner equivalent rent) and allow for substitutions in food basket.  There are also multiple CPI indexes (see Common Misconceptions about the Consumer Price Index Questions and Answers)
  • The headline CPI called All Items CPI for All Urban Consumers (CPI-U). All consumer goods and services, including food and energy, are represented in the headline CPI. Treasury Inflation-Protected Securities (TIPS) returns are based on the All Items CPI-U.
  • Core CPI -- All Items Less Food and Energy. The latter series, widely referred to as the "core" CPI, is closely watched by many economic analysts and policymakers under the belief that food and energy prices are volatile and are subject to price shocks that cannot be damped through monetary policy. Individual income tax parameters and
  • CPI-W All Items CPI for Urban Wage Earners and Clerical Workers which is typically less the CPI-U. It includes several groups with the most important being food and beverages (16.94%), Housing 41.3%, and Transportation (17%).  Social security and federal retirement benefits are updated each year for inflation by the CPI-W
• The economic policy of the US since 1982 has been to stimulate consumption and promote debt based growth based on status of the dollar as a reserve currency. Resulting account deficit in a long term is inflationary.
• There is no risk of hyperinflation  except in case when state falls apart (Weimar republic, former Soviet republics and Eastern European states after the dissolution of the USSR, Zimbabwe, etc).

The author is not a specialist and just try to chart the plausible path as a regular 401K investor (quotes if not specifically acknowledged are taken from  Where Are We Now Five Point Summary « The Baseline Scenario)

• No real reforms: the current elite, whether you call them banksters, financial oligarchy or plutocracy, is still trying to preserve the status quo :

  "More broadly, there is sophisticated window dressing in the pipeline but no real reform on any issue central to (a) how the banking system operates, or (b) more broadly, how hubris in finance led us into this crisis.  The financial sector lobbies appear stronger than ever.  The administration ducked the early fights that set the tone (credit cards, bankruptcy, even cap and trade); it’s hard to see them making much progress on anything – with the possible exception of healthcare."

  ... ... ...

  "The more radical change in the system is needed and that the administration so far is “window dressing.” For the past thirty years the economy has overcompensated at the top and undercompensated at the middle and working levels of society. The current crisis was largely created by this pattern and will not resolve until the wealth created flows more evenly throughout society."

• Despite rhetoric, real-life Washington has tacitly acknowledged the degree to which our national economy has become dependent on the financial sector (finance, insurance and real estate - or FIRE). It will do whatever it takes to keep it afloat.  While financial market stabilized, it remains the Wild Wild West.  That means that stability (low inflation) is less probable (and less profitable for firms like Goldman) then sliding into some extreme. 

  "I’m continually amazed that business is being conducted as if everything is OK. There is no longer any economic logic behind the working of the financial markets, the only thing keeping everything working is inertia. No real change has occurred, no new system, guidelines or regulations to improve a broken system.

  Psychology is a funny thing, somehow the people are made to believe that everything will be fine, so it is, even though the ground under their feet is constantly shifting."

• Debt burden via housing, credit cards, etc still remains a crushing burden for substantial fraction of US  households (house poor).  Most of "house poor" have diminished assets and  access only to higher interest credit, if any.  Growing unemployment with no end in sight (might remain above 10% for least the next coupe of years) deteriorate the situation even faster. This effect is deflationary.  Still consumption in the USA is first and foremost is consumption of upper 10% so it is by definition very resilient to economic shocks.
• No one has offered a credible story for the next engine of growth — an inventory bounce in Q3 2009 is not a recovery, and the stimulus is too small and only dribbling out (even gas prices fluctuations have more impact then stimulus). In case of systemic crisis you can't spend your way out of this crisis. Like Greenspan's policies directly led to the current crisis, excessive spending right now might lead to an even greater crisis in the future.

  I do not see stimulus spending as meaning, in any way, bailing out banks and other criminal organizations. I see stimulus spending, done properly, as spending from the bottom up rather than trying to feed trickle down (piss down is more accurate).
  
  Spending must occur on infrastructure (Remember any bridge collapses recently? Want more?): road and bridge REPAIR and maintenance (not new roads and bridges), NEW passenger rail track separate from the crappy freight track it depends upon now, new/more passenger rail in municipalities and across the nation to help get people out of cars, off the highways, and into more eco-friendly and efficient means of travel, investment spending on alternative energy instead of continuing with coal/oil, MORE funding for college education, etc.
  
  Do NOT spend on billionaires, banks, and hedge funds. Screw them.
  
  CUT military spending and quite most of our 750+ overseas military bases. We'd save billions a year AND still be be spending more than any possible opponent even if we cut "defense" spending (yeah, right, defense) by 50% for starters. British exceptionalism did not die an easy death, and I suspect American exceptionalism will not do so either.... Increase taxes back to what they were on the upper income levels BEFORE Bush/Cheney came along. Then slowly ratchet them back up to where they were under Reagan, at least. They'd STILL be rich, fat, dumb, greedy, and "happy" but they would be paying back into society rather than leeching off of it as if they are some entitled aristocracy.
  
  Anyway, I just don't understand the idea of "recovery". What will so-called "recovery" be based upon? The service industry? Is everyone in the US who isn't in finance supposed to become hotel maids, waiters/waitresses, butlers, Wal-Mart door greeters, and cashiers? Precisely what is there in the USA to based an economy upon that doesn't merely require that everyone borrow up to their necks (using, once again, their homes as ATMs) to buy stuff they cannot actually afford nor need? What is the recovered economy to be based upon? See Economic recovery and the perverse math of GDP reporting - Credit Writedowns

• Artificially low yield creates carry trade which further depresses currency (yen experience).  If people are borrowing dollars to buy other currencies to pay for foreign hard assets, this can accelerate the devaluation of the dollar.
• Conventional oil production has peaked. "What this means is that in a few years, if the money-printers and debt-incurrers can manage to prop up zombie growth for a few more years, and this manages to bring on resumed high oil consumption, this artificially stimulated growth will hit its head on an oil supply ceiling, and that’ll be the end of exponential “growth” once and for all."
• Since GDP is 70% consumer spending that means with continued unemployment, continued foreclosures, will depress GDP for several years...  American consumer is spent. It will take an unusually long time for American consumers to rebuilt their balance sheets (and related confidence) to begin spending again over the longer term.
• Several economists predict inflation:  Inflation is looming on America’s horizon By Martin Feldstein (FT, April 19 2009). While I consider Martin Feldstein a member of Republican "wrecking crew", he is one of the most intelligent members of this gang.
  • ...the primary reason for the negative rate of US inflation is the dramatic 30 per cent fall of commodity prices. That will not happen again. Moreover, excluding food and energy, consumer prices are up 1.8 per cent from a year ago. That is the good news: the outlook for the longer term is more ominous.
  • The unprecedented explosion of the US fiscal deficit raises the spectre of high future inflation. According to the Congressional Budget Office, the president’s budget implies a fiscal deficit of 13 per cent of gross domestic product in 2009 and nearly 10 per cent in 2010. Even with a strong economic recovery, the ratio of government debt to GDP would double to 80 per cent in the next 10 years.
• Market.view Inflation or deflation  (The Economist, Jul 27, 2008)

  But what if the decline in the oil price is the result of a global recession? That would hardly be positive for stock markets. And what if a falling headline inflation rate gives the green light for the central banks to cut interest rates? Coupled with the willingness of the authorities to rescue the banking system, that would suggest a long-term inflationary bias in the economy and thus be bad news for Treasury bonds.

  “Investors should not be distracted or trapped into dismantling portfolio inflation defences by either the current growth slowdown or by the vagaries of the spot oil price,”

  says Tim Bond, head of global asset allocation at Barclays Capital, in his latest note.

• Fiat money and deflation. One school of thinking (Merill Lynch) suggests that most of 2009 will be deflationary, but that inflation could well pick up at the end of 2009 and became  a problem in 2010.  The other promote the view that there can be no substantial deflation in fiat regime as government can always print enough money to suppress deflation. In this sense the only real danger is inflation which tend to wipe out pensioners assets. 
• USA overconsumption vs. China overproduction. The USA currently suffers from overconsumption that was financed by debt and this means that attempts to sustain this overconsumption are more or less doomed and threatens devaluation of the currency.  China is suffering from overproduction, and thus China situation is more close to the USA situation during Great Depression in a sense that it needs to stumulate internal consumption and internal infrastructure build-up.  This duality of overproduction in China and overconsumption in the USA and other Western countries make them more interdependent, but at the same time very different in rational approaches to the crisis.
• Is USA today more like Britain of 20th that the USA of 20th? The USA in the 1920s was the world's biggest creditor, exporter, and manufacturer. This position is more or less analogous to China's economic position now. That means that is we assume classic Keynesian approach it's China who can more benefit from huge stimulus that can increase internal demand. But we need to remember that an important factor for the USA recovery was WWII: at the end of WWII, productive capacity in the next two biggest industrialized nations, Germany and Japan, had been destroyed. The US had effectively no competition for its oversized industrial capacity.  

  Right now USA is in the position very similar to the position of  Great Britain during Great Depression. Like Britain the USA is the country with the world reserve currency. At the same time it is  the country that went into deindustrialization phase similar to war-ravaged Britain and France in 20th.   Also the USA possesses informal empire (see  which make analogy with Britain even more close.    In a new book titled The Limits of Power: The End of American Exceptionalism, Andrew Bacevich argues that although many in this country are paying a heavy price for US domestic and foreign policy decisions, millions of Americans simply continue to shop, spend and satisfy their appetite for cheap oil, credit and the promise of freedom at home. Bacevich writes, “As the American appetite for freedom has grown, so too has our penchant for empire.”
   

• Will any New New Deal be effective ? The New Deal did produce an impressive results with its workfare, including the building of parks and roads, as well as the electrification of rural America.  The question arise, if Obama administration tries to emulate New Deal, to what extent will it be productive?  And what is greater, the risk of deflation or inflation/hyperinflation ? One problem is that you need to buy quite a lot from China to build anything in the USA now. So it's unclear whom you are stimulating.  This time one of the obvious direction is restoration of (electrified) railway system  and public transportation system which was destroyed by auto lobby as well as efforts to produce better hybrid and electrical cars.  But drop in oil price make those program less attractive...
   
• Is there a risk for inflation or even hyperinflation with huge stimulus?  The US budget deficit will reach 10% of GDP next year. And if China and BRIC countries run huge stimulus program they will deplete their foreign reserves which will join the money printed for the USA stimulus. Anyway inflation/hyperinflation right now looks like bigger political and economic risk (note some consider hyperinflation anything above 20% per annum; you do not need to get to Weimar scenarios for hyperinflation). See FT Alphaville Marc Faber Hyperinflation coming to the USA
   
• Financial panics are natural consequences of financial excesses. As John Mill observed: “Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.”  In addition what the media reports as a “flight to quality”, looks more like looting of the developing economies and that might backfire with protectionist measures.
   
• Markets do whatever is necessary to hurt the most people. While most people at the end of 2007 and beginning of 2008 tried to prepare to rampant inflation, at the end of 2008 we have clear (but probably temporary) deflationary trend... To be more correct there is stii deflation of assets like residentail and commercial real estate (despite attempt of re-inflation of stock market -- the major infrastructure project of Obama administration ;-)  along with continued but weaker inflation in prices of goods.  

At the beginning of the year I personally thought that inflation will accelerate and bought TIPS. Big mistake. Now all the talk is about deflation and TIPs dropped more then 10%.

Still  I would agree with the idea that holding regular Treasury bonds is now extremely risky as there are limits on buying of government debt and we might be close to this limit. Yields were also pushed lower by "flight to quality" (or more correctly by looting emerging economies by repatriation of speculative capital ;-). This process is closer to the end then to beginning and there are inflows of capital back into emerging countries. 

Quotes

• Federal Reserve Bank of Philadelphia President Charles Plosser said on May 21, 2009 inflation may rise to 2.5 percent in 2011. That exceeds the central bank officials’ long-run preferred range of 1.7 percent to 2 percent and contrasts with the concerns of some officials and economists that the economic slump may provoke a broad decline in prices. 
   
• "Very little is written about what will happen when all the dollars, built up as foreign central bank and private holdings, get spent. Indeed, we believe that not only will the dollars get spent, but this spending will have massive inflationary implications for America." —Richard Benson
   
• I am 100 percent sure that the U.S. will go into hyperinflation,” Faber said. “The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate.”FT Alphaville  Marc Faber Hyperinflation coming to the USA
   
• The long history of fiat money and the current policy response, much different from the 1930s self-imposed austerity, suggests the longer-term risk is indeed inflationary, not a continuous sharp rise in the value of dollars relative to goods and services (deflation.) But we imagine that readers already can feel the increased value of their dollars against consumer goods prices, and certainly financial asset prices (in portfolios or not). FT Alphaville  “Filling the system full of money is insufficient to threaten a rise in inflation”
   
• One stark lesson from the ongoing financial and economic crisis is that so-called black swans — large-impact, hard-to-predict and seemingly rare events — can occur more frequently than generally believed. With policymakers around the world throwing massive conventional and unconventional monetary and fiscal stimuli at their economies, we think that it is worth exploring the black swan event of very high inflation or even hyperinflation.

  While such an outcome is clearly not our main case, the risk of hyperinflation cannot be dismissed very easily any longer, in our view. We discuss the historical evidence, the conditions that can lead to very high or hyperinflation, and whether and how it might happen again.
  -- Jocahcim Fels and Spyros

  FT Alphaville » Blog Archive » Hyperinflation is a possibility, say Morgan Stanley

Old News ;-)

[Oct 13, 2009] Slow US recovery blamed on low demandStacy-Marie Ishmael

FT Alphaville

Weak demand from battered consumers will be a “major constraint” on the US economy for the foreseeable future, key White House adviser Lawrence Summers said on Monday.

[Oct 13, 2009] Non-slacker at the Fed by Tracy Alloway

Oct 13, 2009 |  FT Alphaville

Reuters columnist Rolfe Winkler points us to a recent speech and presentation by Fed governor James Bullard.

The speech, Winkler says, is a direct refutation of economist Paul Krugman’s ideas that inflation, potentially triggered by extremely low interest rates and unconventional monetary policy, is not a threat so long as there’s a large amount of `slack’ in the US economy. Slack occurs when the output gap is a negative number — when the economy is below its full potential — and in traditional economic theory implies deflationary risks as companies cut prices and jobs to deal with the spare capacity.

But Bullard, for one, is having none of this slack nonsense.

Here’s what he said, as summarised by the St. Louis Fed:

Bullard also cautioned that policymakers should not place too much emphasis on output gap estimates when trying to assess inflation risks in the medium-term.

“I am concerned about a popular narrative in use today—the narrative being that the output gap must be large since the recession is so severe,” he said. “And so, any medium-term inflation threat is negligible, even in the face of extraordinarily accommodative monetary policy. I think this narrative overplays the output gap story.”

He added that measuring the gap is very difficult, both theoretically and practically. He cited research that shows much of the inflationary run-up in the 1970s can be attributed to a misreading of the output gap at the time. “Even if economists were to accept a particular measure, the empirical relationship with inflation is not robust,” he said. In addition, traditional output gap measures do not account for the concept of bubbles.

“It has been popular to describe recent events as a collapse of a bubble in housing. A look at the housing data makes a convincing case,” Bullard said. “But when it comes to calculating traditional output gaps, there is no notion of a bubble. If part or most of the fall in output was a collapsed bubble, then today’s output gap would be smaller than it appears.” This would mean that inflation risks in the medium term are higher than otherwise thought.

Perhaps more important than the Paul Krugman angle — Bullard’s speech, we would add, is also refutation of many of the arguments put forth by Fed chairman Ben Bernanke — one of the foremost proponents of the idea that there is a huge amount of “slack” in the economy.

So, is there a gap in the Fed’s views of the output gap?


EmailDel.icio.usFacebookDigg
Post your own comment
User3312410 Use different pseudonym Enter your comment here By submitting this comment I confirm that I have read and agreed to the FT terms and conditions.
RSS feed Comments
! Report
pegnu Oct 13 22:45 I don't count economists as intellectuals :)
! Report
praxis22 Oct 13 19:24 @Pengu and Friedman wasn't a partisan shill?

Krugman is certainly opinionated, I'll give him that, but people would get bored and have to shout at somebody else if he wasn't. What good is a public intellectual if he doesn't upset people? :)
! Report
TraderMark Oct 13 17:25 Have our leaders already forgotten the late 70s early 80s?

There was a huge output gap but we had raging inflation. Really... are people that dumb or lack any historical precedent?

The main difference now will be wage inflation ... unions were far stronger in America in 70s and early 80s - they have been hollowed out, so if prices begin to spiral the corporations will just say "too bad, we have someone else we can give your job to, and she could be India or China." Thats really the main difference between the 2 eras. But to believe inflation is not possible due to slack economy means you cannot even think back 30 years.
! Report
pegnu Oct 13 14:48 this makes a lot of sense. Economic "output" has been artificially elevated during the past 20 years of bubbles so how does one estimate the supposed "gap?" Krugman is just a partisan shill.
! Report
Jo Oct 13 13:54 Hissy fit from Krugmann (which will bizzarely include the phrase: 'the GOP') in five, four, three.............

[Oct 12, 2009] One Hand Clapping Theory Analyzed

Rising gold price is actually an argument in support of inflation, not deflation.

Mish's Global Economic Trend Analysis

Thus, careful analysis shows the answer to the question: "If nobody recognizes a defaulted debt on their balance sheet, does it exist?" is yes.

Pretending that defaulted debts do not exist is itself the "Sound of one hand clapping". It did not work for Japan, and it will not work here.

[Oct 12, 2009] The Sound of One Hand Clapping - What Deflationists May Be Missing  by Chris Martenson

Our choices now are to either evolve a new economic model that is compatible with limited physical resources, or to risk a catastrophic failure of our monetary system, and with it the basis for civilization as we know it today.

October 9, 2009 | Chris Martenson's Blog

This is a piece that I wrote in response to a request for a guest post over at ZeroHedge. It ran there yesterday garnering some nice attention and a diverse range of comments beneath.

Based on some of those comments, this article represents nothing more than my attempt to find an explanation that matches the data.

---

My central thesis to this crisis, developed a few years before it even hit, is that the economic troubles are the symptoms, while the money system itself is the cause.

My views on this are expressed in the opening of an article that I initially penned in 2006 but updated in 2008:

Within the next twenty years, the most profound changes in all of economic history will sweep the globe. The economic chaos and turbulence we are now experiencing are merely the opening salvos in what will prove to be a long, disruptive period of adjustment. Our choices now are to either evolve a new economic model that is compatible with limited physical resources, or to risk a catastrophic failure of our monetary system, and with it the basis for civilization as we know it today.

In order to understand why, we must start at the beginning. While it was operating well, our monetary system was a great system, one that fostered incredible technological innovation and advances in standards of living, two characteristics that I fervently wish to continue. But every system has its pros and its cons, and our monetary system has a doozy of a flaw.

It is this: Our monetary system must continually expand, forever.

The article above provides the big-picture backdrop that drives my long-term vision and thinking.  I raise it now so that you'll understand that I principally view the economic world through a monetary lens.

The hot topic of the day is "Inflation or Deflation?" and the camps are firmly divided into groups of inflationistas and deflationistas.  When asked which camp I am in, I reply "Yes."  Some would say that puts me in the confusionista camp, but I actually have an explanation for why are living in a world encompassing both.

From a technical perspective, we are absolutely in one of the most powerfully deflationary periods in history, yet, besides housing prices and a few over-produced consumer goods, we find that stocks, bonds, and commodities are all well-bid at the moment.

While we can ascribe some of this to the artificial wall of liquidity (come to think of it, is there any other kind?) currently being thrown into the financial market(s) by the Fed, it leaves hanging the question of why that money is not being completely swallowed into the bottomless black hole that the deflationist camp says lies at the heart of our current financial system.

And they are right; there is a black hole at the center.  If we treat the credit doubling that occurred between 2000 and 2008 (from $26 to $52 trillion) as a normal bubble that will follow the same pattern of decline as numerous historical bubbles, then we might reasonably predict that some $26 trillion of debt will somehow "go away" over the next 6 years.  This is indeed a massive black hole.

Yet everything just keeps perking along.  What gives?

The answer, I believe, requires us to ask a Zen-like question along the lines of, "What is the sound of one hand clapping?"  That question is, "If nobody recognizes a defaulted debt on their balance sheet, does it exist?"

Suppose, for the sake of argument, that there is a world in which banks are allowed by their regulators to pretend their default losses simply do not exist.  And, even more outlandishly, some of these banks are allowed to sell heavily damaged loans to their central bank at nearly their full original price.

What does "deflation" mean in such a world?  Not much, as it turns out.  At least from a monetary perspective, because money is not being destroyed at nearly the rate that would be expected or predicted by the size and rate of the defaults.

This is the world in which we currently live.  Trillions in probable and provable losses quietly exist, out of sight, on the balance sheets of the Federal Reserve and other financial institutions.  If they ever come out of hiding and onto the books, I think the deflationists will be proven correct beyond all doubt.

But let me ask this:  What prevents the authorities from simply storing them out of sight forever?  Or at least long enough to allow the wave of liquidity to work its inevitable magic?  So far, much to my great surprise, they've managed to do exactly that, with hardly a squeak from the mainstream press (although the blogsphere is on the job, as usual).  I am now wondering if they cannot keep this up indefinitely.

So from a purely monetary perspective, money can only be "destroyed" if banks and other financial institutions are compelled to recognize the losses and take a hit to capital.  If the loss is not recognized, no money is destroyed.  At least it is not recognized as gone.

Perversely, when a bank sells a ruined loan 'asset' to the Federal Reserve, it is a double shot of money to the system - the money initially created upon the issuance of the original loan, which is still out there in circulation, and a second bolus when the Fed creates money out of thin air to buy the failing 'asset' from the bank.  One blob of money into the system when the loan is made, another when it is bought by the Fed.  One loan, two blobs of money.  Many have failed to recognize this feature of the Fed's asset purchase programs.

So from this perspective, we could even argue that by employing the 'pretend and extend' strategy, coupled with an aggressive Fed purchase policy, it is possible that more money is being created than destroyed right now.  Which means that from a strictly monetary perspective, I am not yet sold on the idea that money is being destroyed at the rates sometimes implied by the deflationary arguments.

Also, the data is not really in support of that notion either:

Of course, this money needs willing lenders and borrowers, which brings us back to the matter of price deflation.

Out in the real world, where consumers and producers exist, the bursting credit bubble has severely cut off consumers' access to and desire for new credit, and producers have dialed back excessive capacity and cut their prices in order to attract business and survive.

There is no doubt about this process, but here I would argue that falling prices are currently as much a matter of supply and demand as they are a monetary issue.  In other words, the price deflation that we are currently seeing is not a pure monetary phenomenon.

Which means I think we are in a bizarre hybrid world, where deflation should be the order of the day, but it currently is not, because its impacts are being held in abeyance by the simple expedient of pretending the losses do not exist.

My current outlook calls for productive capacity to continue to fall out in the real world, even as the Fed conjures more money into existence in the make-believe world of 'high finance.'  (What are they smoking over there?).

Is this not a recipe for eventual inflation?  More money, but fewer goods and services?  History says 'yes.'

All that said, I would not disagree with the notion that there's another year or three of grinding along (where stock and bond prices are concerned), possibly down, but maybe not, before the monetary/goods imbalance comes charging out of the chute ready to throw off the unwary and trample them in a blistering round of inflation.

But it could be sooner than that.  Or later.  The point here is that we really don't know, and because our monetary system operates on faith, it means that we have to be prepared for the fact that a shift could happen at any time.  Nobody can predict when a school of fish will suddenly turn to the left.  Who knows what final trigger will cause a critical minority to suddenly determine that they'd rather hold things other than paper?

For now, while I understand and appreciate the deflationist argument, the only thing that would convert me fully to that camp would be a sudden return to rigorous application of honest accounting.  If you derisively snorted at that last sentence, then we share the same assessment of the likelihood of that happening any time soon.

In order to answer the main question of this article, we regretfully have to turn to Dadaism* to develop an appropriately absurd non-sequitur:

"What is the sound of one hand clapping?   Insanely high stock and bond prices."

[Oct 10, 2009] Macro and Other Market Musings The Amazing Resilience of the Fed's Inflation-Fighting Credibility

What is even more amazing to me is that the Fed's inflation-fighting credibility has not been harmed by recent developments. The forecasters continue to predict a stable long-term trend inflation rate of 2.5%, roughly the same value that it has been since 1998. Given all the talk about the Fed blowing up its balance sheet and the potential of monetizing the debt this result is nothing less than amazing. It should also give pause to those inflation hawks who only see trouble on the horizon.

ECB:

You give far too much credit to the Federal Reserve.

Yes we all know how much central bankers love to pat themselves on the back - after all they gave us the miracle of the Great Moderation, except that they didn't. Arguably the inflation decline - which is not confined to the US but also seen in Europe - was more due to the decimation of union-dominated industries which were an engine of wage cost-push inflation that central banks validated.

These industries shift to Asia, giving us low-cost imports that helped to reduce goods market inflation. But as we know asset price inflation continued rampantly, courtesy of the Federal Reserve.

[Oct 9, 2009] The Game - Part I Queen of Hearts - Eric Janszen - iTulip.com

[Oct 1, 2009] Rosenberg: “We are certainly in a deflationary state”

Mish's Global Economic Trend Analysis 

Fueled by overcapacity, shrinking credit, reduced corporate spending and falling consumer demand, Deflation is taking root in global economies.

Consumer prices fell at their fastest clip ever last month in Japan, which has been fighting a losing war against deflation for much of the past two decades. Germany, Europe's biggest economy, has now suffered through four consecutive months of sliding prices, and the rest of the region that uses the euro is not faring much better.

That deflation should be such a threat may run counter to market fears that inflation will quickly follow the massive, and costly, global effort to fight the financial crisis. But many observers see deflation as the greater threat.

“We are certainly in a deflationary state,” said David Rosenberg, chief economist and strategist with Gluskin Sheff and Associates in Toronto. “Of that, there's no doubt. I think people still have no clue as to just how weak the economy is,” Mr. Rosenberg said.

Remove the “impressive medication” administered by governments, and most economies are at a virtual standstill.

The U.S. economy faces a decade of stagnation, he said. “That's a perfectly plausible scenario.”

If and when it does hit, “deflation will last until we see the next secular trend of expanding household balance sheets, and that is some time away,” Mr. Rosenberg said.

I concur with Rosenberg except on his apparent definition of deflation. He seems focused on prices which is only one of many symptoms of deflation.

One confusing aspect in the article is that on one hand he says “We are certainly in a deflationary state” on the other he says If and when it does hit...

There is no if.

The odds that deflation hits are 100% given that we are in deflation now and have been for some time. Moreover, a "decade of stagnation" with the US hopping in and out of recession/deflation is not just a possibility but rather a likelihood.

From a practical standpoint, the debate about deflation should be over. On December 11, 2008 in Humpty Dumpty On Inflation I listed a perfect scorecard of 16 items one would expect to see in deflation and all were happening.

The only debate comes from those using impractical measures of inflation and deflation. As a prime example, please consider Daniel Amerman vs. Mish: Reflections on the Great Inflation/Deflation Debate.

Moreover, it should have been clear we were in deflation as early as March 17, 2008. Three factors made it clear: a collapse in treasury yields, a collapse in asset prices, a collapse in credit marked to market. See Now Presenting: Deflation! for additional details.

Yesterday inquiring minds were reading Bill Gross Bets On Deflation. However, when it comes to Bill Gross, a reasonable person must always be concerned how much he is talking his book, hoping to unload it.

[Sep 30, 2009] Don’t fear the inflation, Goldman says by Tracy Alloway

Sep 30, 2009

Goldman Sachs is putting an end to the deflation vs inflation debate, once and for all!

In a 30-page research note out on Wednesday, the bank comes down firmly on the side of (moderate) deflation in the near-term.

Here, GS analyst Andrew Tilton says, is why:

• Inflation is already low, with the core CPI down to 1.4% on a year-over-year basis and the overall CPI in deflation territory.

• Excess capacity in the economy is huge, probably at least 6% of GDP and possibly at its highest level since the Great Depression.

• Spare capacity is likely to persist for years [see below table]. While the financial crisis and recession probably have reduced the economy’s production capacity somewhat, we do not see strong evidence for persistently lower growth of capacity going forward. Even if we assume substantially above-trend real GDP growth of, say, 5% per year, it will take more than three years to get back to equilibrium in the labor market and two in the manufacturing sector. Our own assumptions of a somewhat slower recovery suggest it could well take more than five years to reach equilibrium in the labor market and nearly as long in housing.

• Monetary policy is arguably too tight despite a near-zero funds rate and unconventional easing. Our own calculations using estimated Taylor rule parameters, as well as those in recent research from the San Francisco Fed, point to an `appropriate’ funds rate of -5% or below.
   
• The default path of current policy is for removal of stimulus. Fed asset purchase programs are scheduled to end within the next several months and its balance sheet will begin to shrink after that point, while the growth impact of fiscal stimulus is already peaking.

 

Nevertheless, Goldman’s Tilton gets why investors are worried about inflation, and the bank itself is not oblivious to the possibility, given the massive unconventional fiscal and monetary policies undertaken by the Federal Reserve. In fact, Tilton says, there are a few inflationary warnings signs investors should be looking out for. Here they are, as summarised by FT Alphaville:

1. Evidence that Fed independence is being fundamentally compromised. If for example, the Fed’s official mandate to foster “maximum employment, stable prices, and moderate long-term interest rates” was somehow diluted or changed. In fact, giving the Fed an additional mandate is not beyond the realms of possibility given that Congress considered adding “preservation of financial stability” to the Fed’s list of official responsibilities in the aftermath of the financial crisis. The more mandates, Goldman says, the more possibility there is of a conflict of interest or a reduced focus on any given one.

2. A sharp shift in  household and/or  business inflation expectations. Given that inflation fears can become a self-fulfilling prophecy, Goldman Sachs thinks this is a very important thing to watch. In particular the Reuters/University of Michigan survey of household inflation expectations over the next five to 10 years. However, the bank thinks that even if inflation expectations were to rise, this would only be a problem if the Fed did not act quickly.
 

3.  Rapid capacity destruction. As Goldman noted earlier, there’s a lot of overcapacity in the system — something the bank thinks will take years to clear. If, however, businesses start aggressively cutting capacity (closing down factories, etc.) this could quickly trim the amount of spare capacity in the system.

Inflationistas — keep your eyes peeled.

Deflationistas — consider your corroboratory appetite slaked — for today anyway.

Related link:
Deflation dead and deader, Federal Reserve-style - FT Alphaville

Guest Post: The Case for Inflation By George Washington

September 28, 2009

As I have recently pointed out, there are strong arguments for ongoing deflation.

But even deflationists think that – after a period of deflation – we might eventually get inflation. For example, in October, I guessed 1 1/2 to 2 years of deflation, followed by inflation.

Moreover, noted deflationist Martin Weiss – after predicting for 27 years straight that we’ll have deflation – has now changed his mind, and thinks inflation is a greater short-term threat than deflation.

For these two reasons – and to make clear that the inflation versus deflation debate is complicated and includes many factors – this essay will focus on the arguments for inflation.

Faber and the Dollar

PhD economist Marc Faber said in May:

“I am 100% sure that the U.S. will go into hyperinflation.”

Faber said he thinks – in the medium-term – we could have high levels of inflation (and see this and this).

Faber’s argument is that a weakening dollar will lead to inflation (as every dollar will buy less goods and services).

Government Printing

The government has injected trillions of dollars into the economy in the form of TARP bailout funds and other programs. Indeed, the government’s own watchdog over the TARP program – the special inspector general – said that number could be $23 trillion dollars in a worst-case scenario.

The basic argument for inflation is – as everyone knows – that the government has injected so much money into the economy (through bailouts, quantitative easing, purchase of treasuries, etc.) that there will be a lot more dollars chasing the same number of goods and services, which will drive up prices. In other words, the supply is the same, but demand has increased.

Indeed, the U.S. has also provided huge sums of dollars to foreign central banks. Could dollars given abroad cause inflation inside the U.S.? Yes – because some proportion of those dollars will be spent by citizens in those countries to buy stocks, commodities, goods and services within the U.S.

Three well-known advocates of the inflation argument are Rogers, Buffet and Schiff.

Specifically, billionaire investor Jim Rogers said we are facing an “inflationary holocaust”.

Warren Buffett said:

The policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

And Peter Schiff has argued for years that hyperinflation will wipe out the value of the dollar, so people should get all of their money out of dollars and into foreign currencies and assets.

But is all this government printing and quantitative easing really enough to cause inflation?

The back-of-the-envelope figures I’ve seen bandied about say no. Because of the massive destruction of credit (which – as Mish has repeatedly pointed out – must be included in discussions of inflation versus deflation), the government would probably have to print one-and-a-half to two times as much as it already has in order to create inflation.

The government could still do so. Yes, it would be suicidal for the dollar and might cause foreign buyers of U.S. treasuries to stop buying, but the boys in Washington could – if they were crazy enough – increase the money printing and quantitative easing to the point where inflation actually kicks in.

Will they do so? Summers, Geithner and Bernanke have proven themselves willing to do a lot of crazy things over the past year, so I wouldn’t rule the possibility out altogether.

Indeed, when the Option Arm, Alt-A and commercial real estate mortgages start defaulting in earnest, there will be a lot of pressure on Washington to “do something”. But again, doubling the amount of money printing would turn the dollar into monopoly money, and so there will be a lot of pressure not to turn America into Zimbabwe.

Devaluing the Dollar

Many commentators also argue that the U.S. is intentionally devaluing the dollar in order to increase trade.

And – as everyone knows – the dollar might tank even if the boys don’t intentionally devalue it into oblivion. Just look at the amount of printing and easing which has already been done, the tidal wave of debt overhang, and the lack of fundamental soundness in the giant banks, the financial system, and the U.S. economy as a whole.

Moreover, some people argue that the dollar carry trade will drive inflation. Specifically, they argue that we’ll get “spec-flation”, meaning that investors will buy dollars and – in a carry trade – use the dollars to invest abroad. This will devalue the dollar, creating inflation.

And, importantly, the U.S. is quickly losing its status as the world’s reserve currency. Therefore, the “premium” on the value of the dollar for its status as reserve currency will also fade, and the value of the dollar decline.

For these and other reasons, Faber and other inflationists would argue that the dollar will continue to substantially decline and inflation will therefore kick in (Note: Mish is still a dollar bull, and so doesn’t concede this point).

Unemployment

I have previously argued that the rising tide of unemployment will contribute to deflation for some time.

However, Edmond Phelps – who won the Nobel Prize for Economics in 2006 – and PIMCO Chief Executive Officer Mohamed El-Erian both say that the “natural unemployment rate” has risen from 5 to perhaps 7 percent.

What is the natural unemployment rate? It just means that if unemployment falls below that a certain percentage, then inflation will be created.

So if the natural unemployment rate has risen, that may mean that we will get inflation sooner (when unemployment falls to 7%, instead of when it falls all the way back to the previous peg of 5%).

End of Foreign Bond Purchases?

Tiger Management founder and chairman Julian Robertson warns that – if foreign purchasers stop buying U.S. treasury bonds – inflation will strike:

If the Chinese and Japanese stop buying our bonds, we could easily see [inflation] go to 15 to 20 percent,” he said. “It’s not a question of the economy. It’s a question of who will lend us the money if they don’t. Imagine us getting ourselves in a situation where we’re totally dependent on those two countries. It’s crazy.

Bottleneck Inflation

Finally, Andy Xie argues that “bottlenecks” can cause inflation. Specifically, Xie argues that inflation in a single key market – say oil – can cause inflation, even in a weak economy.

Conclusion

As I have argued for a year, we will probably have a period of deflation followed by inflation. I still believe that.

When inflation will kick in is the million dollar question. The inflation camp argues that inflation will kick in any second now without any warning. In the deflation camp, David Rosenberg argues for years of deflation, and Dr. Lacy Hunt argues for decades of deflation.

Bottom line: In my opinion, the question is when, not if.

But in investing, being too early is being wrong. Someone who is positioned for inflation decades too early will get creamed. Likewise, someone who is betting on deflation for 20 years will get hurt if inflation kicks in next month.

Note: Remember that we could also get mixed-flation. In other words, inflation in some asset classes and deflation in others. Indeed, given that speculators drove up the price of oil last year, it is possible that – especially in a stagnant economy – speculators could drive up the prices of some asset classes and drive others down.

More on this topic (What's this?)

Inflation Pressures Fall (The Technical Take, 9/25/09)

[WSJ] Investors Flock To TIPS For Inflation Hedging (Index Universe, 9/24/09)

ARE WE ABOUT TO SINK INTO A DEFLATIONARY HOLE? (THE PRAGMATIC CAPITALIST, 9/11/09)

Inflation Rates for Each Decade Since the 1920's (Shocked Investor, 9/10/09)

24 Comments:

 

 DoctoRx says: 

Nice capsule of views. I suspect the PTB will continue to give the worst of both flations: inc costs of toothpaste and food and inc home values that lag financing costs so that homeowners continue to be made serfs.

IMHO the cries for hyperinflation are too apocalyptic.

Japan here we come?

 

 mikkel says:

I long ago came to the conclusion that both camps could be correct simultaneously and lead to the result that you note at the end. Basically anything that has a global scope (imports, commodities, etc.) could increase dramatically in price as foreigners start turning away from the dollar, but there won’t be credit or wage activity to support domestic inflation.

Thus housing and other asset classes will continue deflating, continuing the crippling of our financial system, but the high cost of energy and materials will negate any benefits. That would pretty much be the worst of all worlds.

On the other hand, it’s so hard to predict because that assumes strong demand internationally, and in reality our consumption decreases are already putting too much strain on the rest of the world. If that scenario did occur — leading to even more currency adjusted consumption decreases — then it would probably not last very long as the globe would be crippled by excess capacity again.

 

 Stevie b. says:

September 28, 2009 at 3:06 pm

Perhaps “inflation” needs to be clarified a little? I can see inflation in e.g. raw resource prices and perhaps some import prices, but as we’ve seen for many years, wage inflation is another matter. In today’s ultra-competitive world, the move towards greater global levelling of wages still has a fair way to go, which means a declining standard of living with slower growth for the developed economies. This will be no bad thing, as anything else will just lead to an immediate, growth-choking surge in e.g. energy prices. Slower growth would instead allow for the full development of alternatives.

 jimh says:

September 28, 2009 at 4:19 pm

Hmmm, “may cause inflation”? I suggest you use the same inflation calculator that was used in the Carter administration. You know, the one that actually includes food and energy. If that is done, we already got nice inflation of 7-10%/yr. If you print more and get inflation that shows up with the current calculator, which massages the numbers very well, it will be bad – way worse than the “official” inflation number.

Look at prices in the last thirty years. Do they comport with the “official” rate of inflation? Hell no. Get ready for a biiiig surprise.

 jimh says:

September 28, 2009 at 4:25 pm

To StevieB: I disagree. Just because there is mitigation in the growth of wages, or an explosion in energy prices, does not mean there will be no inflation or a slower rate of it. Its called diminution of living standards. Nothing says the costs can't increase so much that much of what we take for granted as to personal lifestyle, won’t just simply go away. If energy and food increase a bunch then more will be spent on those things and less on discretionary goods slowing overall growth, but not necessarily slowing overall prices.

 zanon says:

September 28, 2009 at 4:45 pm

The Government has been printing lots of money (running big deficits) but all that money is being saved. US households have a lot of catch-up to do in the savings arena.

If households save all the money that is printing, how will that cause deflation?

 john haskell says:

September 28, 2009 at 5:08 pm

Well I went ahead and read the rest of the piece anyway.

1. To mention potential reduction in foreign bond purchases without mentioning actual increases in domestic bond purchases is just stupid.

2. People have been talking about the dollar “quickly losing its status as the world’s reserve currency” since before I was born (1971, Smithsonian Accord). Pathetic.

3. You quote Julian Robertson saying the US could have inflation as a result of a funding crisis. But for some strange reason you don’t quote his 1995 prediction that inflation in Japan was a sure thing. Hmm, why not?

 PPrboy says:

September 28, 2009 at 5:16 pm

first lets get our definitions straight

inflation/deflation = increase/decrease in money supply & credit

when referring to changes in asset prices a better term is increase/decrease to avoid confusion and mingling of terms.

increases in prices occur when demand is greater than supply (econ 101). With high unemployment and low production utilization rates (< 80% is a common cutoff) there is little demand and plenty of room to increase production before price increases across the board become a problem.

With financial assets being swapped around, ie fed funds for all kinds of financial instruments good, bad and ?, there is no inflation. Since they swapping of good for bad is lagging we are seeing deflation, not inflation.

 Bob_in_MA says:

September 28, 2009 at 7:11 pm

Sorry, that was blogdom at it’s worst–high on hyperbole, low on facts.

“Moreover, noted deflationist Martin Weiss – after predicting for 27 years straight that we’ll have deflation – has now changed his mind, and thinks inflation is a greater short-term threat than deflation.”

So, this idiot predicted something for 27 years and was wrong year after year. Now he predicts the opposite, and suddenly you assume his thinking is clear?

•  George Washington says:

  September 28, 2009 at 7:58 pm

  Bob_in_MA:

  Your criticism is accepted. However, among those actively debating inflation versus deflation, this is big news.

  Reply

 bob says:

September 28, 2009 at 7:31 pm

Schiff- Why does anyone listen to him? Oh, he’s running for the senate? That’s what this country needs, another asshole “fund manager” from Connecticut in the senate.

If he gets elected will he sell all of his foreign holdings?

Every time I hear him my head hurts, all he does is whine, maybe he does have a future in the senate.

Can the money supply be shrinking (deflation) and consumer prices keep rising (not Inflation, rising prices)? That is the world I see from here.

As so many in the last few years have pointed out, inflation (and deflation) is always and everywhere a monetary phenomenon. I am not one to quote Austrians that often, it hurts.

Show me the money.

 constantnormal says:

September 28, 2009 at 7:44 pm

And to those who insist that inflation cannot occur so long as we have high unemployment and low capacity utilization, the old “can’t push a string” argument — please review the definition of stagflation.

I know of no way to say exactly when inflation will be visited upon us, but it seems likely that it is baked into our future at this point. If I were to guess, I would say it will arrive when we hit bottom in our ability to reduce spending, or at least we are unable to keep cutting personal spending at a pace sufficient to stave off rising prices. As soon as spending stabilizes, we may see the wolf of inflation crash through the door and occupy the same space that we do.

 D says:

September 28, 2009 at 8:13 pm

Where is the deflation? I don’t doubt that deflation is happening, but it isn’t widespread. The dollar is worth less than it was a year ago. That is inflation, not deflation.

 Sivaram Velauthapillai says:

September 28, 2009 at 8:54 pm

You cannot have both inflation and deflation unless you use some narrow definition. In other words, if you define money supply as money plus credit, you will either have deflation (contraction in money supply) or inflation (expansion of money supply). You cannot have both.

Those who are expecting both inflation and deflation are using some narrow definition. For instance, some talk of price inflation or asset inflation. You can clearly have price inflation in certain goods while the whole economy is undergoing deflation, and vice versa.

Since I’m an investor (a small, newbie, investor with admittedly a dubious record ) I care about inflation vs deflation from an investment point of view. If you are an investor, you have to go with the first, true, definition i.e. money supply = cash + credit. Narrower definitions such as price inflation are almost useless because in a normal economy you always have price inflation and price deflation at all times. For instance, cost of something like television or communications has constantly deflated in the last 30 years, while cost of education has constantly inflated.

Asset inflation, price inflation, inflation in terms of gold, or other definitions that people cook up, are also dependent on short-term supply & demand so it isn’t very useful to investors. For instance, there could be a serious hurricane damage in the Gulf tomorrow and energy (particularly natural gas) prices may skyrocket. Since energy is a big component of the CPI basket, you can be sure the price inflation, as measured by CPI, will instantly go up. But that is useless to investors because it is (i) hard to predict and (ii) not reflective of long-term fundamentals. Similarly, if you measure inflation by, say, gold, one can never be sure if it is due to short-term (or medium-term) supply & demand or fundamental inflationary changes in the economy. If there is hype over gold (i.e. bubble) then you may perceive long-term inflation when in fact it may not be.

Unless you are very good at betting on specific markets, you will probably struggle if you bet on both inflation and deflation. To see how useless believing in both can be, consider the following: what would you do with (high quality) bonds if you believe there will be inflation and deflation at the same?

•  George Washington says:

  September 28, 2009 at 8:58 pm

  Sivaram Velauthapillai,

  I completely agree. I believe that the most accurate definitions of inflation or deflation include money supply plus the amount of credit (Mish – as one of the main proponents of this view – has repeatedly and for years made this argument).

  But since many investors think in terms of prices, I wanted to address that point of view as well.

 Hugh says:

September 28, 2009 at 9:03 pm

As I like to point out, Buffett is a wonderful investor but he is not an especially good macroeconomist. The same could be said of most of the others cited.

El-Arian irritates me. Maybe it’s Pimco people in general. What is a “natural” unemployment rate? Does El-Arian ever lay out what the parameters are for defining it or the change in it, besides the BS one we all understand? Wages have been flat for 30 years. Every time employment has put upward pressure on wages, the Fed has intervened to prevent this dreaded “inflation”. To keep up, we saw first more workers per household and then assumption of greater and greater debt. Meanwhile the Fed never saw anything wrong with the resultant transfer of wealth to investors. Since most of this money could not be re-invested productively, it was used to fuel a succession of bubbles.

Rising wages, just like high corporate and marginal tax rates somehow managed to co-exist with economic growth prior to the Reagan Revolution. The result was a strong and stable middle class that had the resources to drive the economy without sinking deeply into debt to do it. Yet as thoroughly discredited as the current economic and financial approach has been by events, this spurious association between wages, employment, and inflation continues and gets a respectful hearing.

 

 Hugh says:

September 28, 2009 at 9:09 pm

A further note. As I keep trying to explain, oil prices are not going up because of supply and demand. There is and has been an oil glut. Glut means prices should decrease. What we are seeing and have seen since 2004 is excess speculation by non-commercials like Goldman and Barclay’s. Read the 2006 Conrad-Levin report:

http://levin.senate.gov/newsroom/supporting/2006/PSI.gasandoilspec.062606.pdf

or invite someone like Michael Greenberger at Maryland to write a piece explaining it.

 

 Max says:

September 28, 2009 at 9:15 pm

If inflation was an issue, the bond market would be all over it.

Guest Post- Deflation-By George Washington

How Bad Could It Get?

The biggest deflation bears are rather pessimistic:

• David Rosenberg says that deflationary periods can last years before inflation kicks in

• Renowned economist Dr. Lacy Hunt says that we may have 15-20 years of deflation

• PhD economist Steve Keen says that – unless we reduce our debt – we could have a “never-ending depression”

These are the most pessimistic views I have run across.  Most deflationists think that a deflationary period would last for a shorter period of time.

...

Debt Overhang and Deleveraging
 

Steve Keen argues that the government’s attempts to increase lending won’t work, consumers will keep on deleveraging from their debt, and that – unless debt is slashed – the massive debt overhang will keep us in a deflationary environment for a long time.

Mish writes:

An over-leveraged economy is one prone to deflation and stagnant growth. This is evident in the path the Japanese took after their stock and real estate bubbles began to implode in 1989.

...Of course, most people who are arguing we will have deflation for a while believe that we might eventually get inflation at some point in the future.

Pension Crisis

Pension expert Leo Kolivakis writes:

The global pension crisis is highly deflationary and yet very few commentators are discussing this.

Collapse of the Shadow Banking System

Hoisington’s Second Quarter 2009 Outlook states:

One of the more common beliefs about the operation of the U.S. economy is that a massive increase in the Fed’s balance sheet will automatically lead to a quick and substantial rise in inflation. [However] An inflationary surge of this type must work either through the banking system or through non-bank institutions that act like banks which are often called “shadow banks”. The process toward inflation in both cases is a necessary increasing cycle of borrowing and lending. As of today, that private market mechanism has been acting as a brake on the normal functioning of the monetary engine.

For example, total commercial bank loans have declined over the past 1, 3, 6, and 9 month intervals. Also, recent readings on bank credit plus commercial paper have registered record rates of decline. The FDIC has closed a record 52 banks thus far this year, and numerous other banks are on life support. The “shadow banks” are in even worse shape. Over 300 mortgage entities have failed, and Fannie Mae and Freddie Mac are in federal receivership. Foreclosures and delinquencies on mortgages are continuing to rise, indicating that the banks and their non-bank competitors face additional pressures to re-trench, not expand. Thus far in this unusual business cycle, excessive debt and falling asset prices have conspired to render the best efforts of the Fed impotent.

mannfm11 says:

People seeking to gain from inflation are going to be shocked and in many cases will add to the fuel for deflation. The entire trade is inflation, including the barreling back into the stock market. The Fed is doing nothing more than swapping non-interest bearing liabilities for interest bearing assets. Thus the backing of the cash in accounts has moved from direct to indirect backing of the assets the Fed now holds. The actions of the Fed are not creating deposits, that is unencumbered deposits in banks to spend.

If there is new leverage, much of it is due to falling capital in banks. If a bank has $50 billion and $1 trillion in loan assets, its leveage is 20 to 1. If it loses $10 billion, this leverage goes to 25 to 1. Also, if new capital is put into the banks, it is merely a shift of deposits to owners equity, which of course depresses the money supply. This leaves even less money to service the debt and provide liquidity for instruments such as money markets. The true problem here is the massive increase of socalled liquid assets against a more stable amount of socalled sovereign cash. Most of the money assets created by the Fed were already created deposits, but not liquid between banks. The crunch was about liquidity between banks. The deflation has already started and those that fail to see this are going to find out later. Andy Xie, who was cited in this article as one who sees inflation, created the best reason of all for deflation, the ending of the Chinese residential building boom. He makes a case it has a maximum of 5 years before China is totally residentially built out. All countries of economic importance are entering a time of population busts.

As far as the price of oil? In 1980 it was supposed to top $100 and increasing by 1990. Gas was supposed to be $5 a gallon. Here we are 30 years later and it took a speculative panic aided and abetted by Goldman Sachs and company to get it there.

Hugh says:

I see stocks and commodities as bubbles built up by Fed and Treasury policies. They are not sustainable and everywhere else as far as the eye can see are deflationary pressures. I would add tapped out consumers as another source of deflation. A facilitator of deflation has been the lack of any responsible, effective financial and economic policy out this Administration or the previous one to address the deteriorating fundamentals in the real economy.

K Ackermann says:

I think a sharp leg down in the market could have a strong psychological impact. Companies are grinding along, hoping the green shoots they hear about show up soon.

If companies get the sense that there is not going to be an improvement, they will start digging in for the long haul by cutting costs.

We have avoided cyclical deflation so far, but if there is a sense of having to dig in for a long time, then we may actually witness something we only read horror stories about.


 

[Sep 19, 2009] Pomboy: Deflation, Not Inflation, Is The Greater Threat

By Barry Ritholtz - September 19th, 2009, 12:30PM

I am a big fan of Stephanie Pomboy’s economic commentary, even though she has steadfastedly managed to duck my meeting her every chance she gets — conferences, dinners, drinks — I even heard she once hid behind a column in Vail to avoid me ; )

No matter, I still find her work outstanding. Her most recent commentary on Deflation was right up mny alley. Its discussed extensively in Abelson’s Barron’s column this weekend:

“THE INDOMITABLE STEPHANIE POMBOY, who beguiles us week-in, week-out with her feisty, funny and very much with-it MacroMavens commentary, is a member of the small but hearty camp (number us among them) who believe that the immediate threat is deflation, not inflation.

As, among other things, the glistening rise in gold and the heavy shorting of long-dated Treasuries strongly suggest, she notes, the popular investment view is pretty fixated on inflation. And Stephanie mulls whether Jeff Lacker, president of the Federal Reserve Bank of Richmond, “isn’t sure the Fed will be able to make a graceful exit before all inflation hell breaks loose,” shouldn’t we all share his concern? Her answer is a qualified “no.” Qualified because she believes there’ll be inflation, but it’ll be in assets, not goods.

For she’s convinced the consumer’s new-found prudence is no passing fancy, but a behavioral sea change, and that the repair of consumer balance sheets so badly thrown out of whack by a quarter of a century of credit overindulgence will continue. So while equities and commodities, as their recent explosive runs demonstrate, may run hog-wild, the massive decline in consumer credit represents a daunting barrier to a kindred climb in consumer prices. Yet despite mounting evidence of the new frugality on the part of the populace, Stephanie points out, retail stocks are posting their strongest relative performance since March 2007, and junk spreads are the narrowest since October 2002. “Investors,” she shakes her head, “are discounting an environment in which retail sales register 3%-style annual gains.”   (emphasis added)

As we noted recently, its even worse than that. The markets have, as is their occasional wont, decoupled form the fundamental economic reality.

Pomboy continues:

To notch such an increase, she gauges, retail sales, now declining at an annual rate of $331 billion, would have to make a U-turn and rise $470 billion! As she says, “An $800 billion swing? You’d have to be certifiable to bet on that.”

Stephanie felt “there’s no way professional investors are betting real money (even if it’s other people’s money) on such an outcome. Is there?” So she went back to the drawing board hoping to arrive at a less frightening conclusion.

Specifically, she turned to what she calls the “broadest proxy of risk appetite,” namely stocks versus bonds, to discover what types of gain in overall consumer spending it implied. The divergence between the two, she explains, is at extremes last seen when consumer spending was chugging along at a 6% clip.

“To reach that milestone today,” she sighs, “would require one whiplash-inducing U-turn if ever there was one, with the present $165 billion annualized decline in spending giving way to a $779 billion gain.” Even these days, that’s a big number.

If the demand for credit revives or employment and income begin to grow, neither of which seems to us likely to happen anytime soon, Stephanie says that’ll be the time to start worrying about inflation in the traditional sense. At the moment, the only serious inflation is in stuff like financial assets, because all the surplus “liquidity” that has been pumped into the economy has nowhere else to go.

She tabs the equity rally as exceedingly long in the tooth. Earnings expectations, she submits, “have never been so far afield of economic reality, and the market’s banking on a $1 trillion spending swing over the next 12 months.”

I cannot disagree with anything she has stated, except the historical factors that suggest that Bear Market rallies that follow collapses can easily run 18-24 months.

Cursive Says:

“At the moment, the only serious inflation is in stuff like financial assets, because all the surplus “liquidity” that has been pumped into the economy has nowhere else to go.”

This one sentence explains the last 7 months in the markets, – equity, bond or commodity. Everything up, dollar down. Does this liquidity have to be removed to reverse the direction of the markets? If it is the dollar carry trade, probably not, as a reversal in the dollar will squeeze all other speculative positions regardless of liquidity. Bank losses, when finally disclosed and recognized, will also eventually offset this excess liquidity. Fighting the FR has been a losing proposition for the last 7 months. Now, the FR is at a crossroads on the dollar. It’s do or die time for the USG currency. Defend it or risk complete collapse. Either move would be negative for the current speculative positions.

drey Says:

“It’s do or die time for the USG currency. Defend it or risk complete collapse. Either move would be negative for the current speculative positions.”

…and good for gold – either way.

maynardGkeynes Says:

We need to distinguish the risk of deflation vs. inflation, meaning which is more likely, versus the risks of LOSSES FROM deflation or inflation, in the sense of how much either scenario will hurt you as a saver or investor. Deflation may be more likely, but how bad could it be? Even in Japan, I’m not sure it ever went above 1 or 2 % a year. Not good, but a rounding error for portfolios these days. On the other hand, inflation, if it comes, has the potential to be devastating. It can wipe you out in short order. Think about our parents with their 4% passbook accounts in the 70s. They got killed. In short, even if “the risk” of inflation happening may be less than that of deflation, the “risk of loss” from inflation is magnitudes higher. Hence, the interest in gold, commodities, and TIPS.

How the Common Man Sees It:

That drop in retail sales rate is in the same territory as the MEW ATM numbers of past years so it may not even be physically possible for it to happen

As for earnings, we do have another one of those seasons on the horizon don’t we? I’ll bet everyone with bull horns on are not looking forward to what is coming up next. This could be where the next set of nasty surprises start to come from. I think this earnings season will begin to tell us where we truly do stand going forward. I think now we will begin to see if the stimulus has either run its course or truly produced green shoots. I know what I’m expecting, though I will be interested to see how non-American markets perform.

And to think we had all those corporate executives dumping stocks over the last little while

….lots to think about going forward….

DL :

Commodities will go higher. However, consumers will remain frugal until credit flows easily again…. and that could be several years in the future.

km4 Says:

September 19th, 2009 at 2:03 pm
Very keen insights from Stephanie Pomboy

this one is particularly insightful….

She tabs the equity rally as exceedingly long in the tooth. Earnings expectations, she submits, “have never been so far afield of economic reality, and the market’s banking on a $1 trillion spending swing over the next 12 months.”

I found this other one from Dec 2008…

She sees only two potential outcomes of our present interventionist fling: Higher interest rates or devaluation of the currency. She picks the latter, seeing a weaker dollar as being the choice Bernanke’s Fed will make. As soon as interest rates start to climb significantly, they will begin a program of Treasury purchasing to prevent it, which will in turn lower the dollar.

primordial_ooze Says:

There is a great analysis of the situation here:
http://www.leap2020.eu/GEAB-N-37-is-available!-Global-systemic-crisis-In-pursuit-of-the-impossible-recovery_a3797.html

davossherman@gmail.com

Inflation ISN’T how much stuff costs. Inflation is simply the money supply increasing, which leads to a devalued dollar which can, depending on the asset class lead to higher prices.

Those in the deflation camp:

A.) Believe that inflation is higher prices or

B.) Believe that the Ponzi credit being destroyed will deflate the money supply and strengthen the dollar.

I’d be able to agree with B. save for the fact that our deficit has gotten out of the cage, we take in 2 trillion and piss out 4 trillion. We can only borrow a portion of the difference, the rest Bennie the Paper Hanger counterfeits. Ergo the reason our dollar is headed down the shitter.

Andy T Says:

September 19th, 2009 at 2:44 pm
Seems like a clear-thinking economist we should add to the select list of 2-3 we should pay attention to. Consumers have retrenched, and it is no passing fancy….

Of course things have stabilized…the Sheeple still have to eat, drink, buy clothes for the kids, etc…

But, that’s not the makings of good economy. You need people buying crap they don’t need to have a good economy. Embrace the new America….frugality is “cool” and being a saver is “in.”

(The Cold Stone Creamery nearby, which had been in business for several years, and was located in a good outdoor mall, just shutdown….guess novelty ice-cream stores that overcharge are hitting a rough patch…)

dead hobo Says:

September 19th, 2009 at 2:48 pm
I believe I wrote the same stuff here on several occasions, sometimes in considerable detail. But they said it better and with numbers.

dead hobo Says:

September 19th, 2009 at 2:52 pm
Re Barrons: It doesn’t matter how the economy or markets turn out, They will have printed a story that predicted it at one time or another (and most other possibilities), and run a cover story about their forecasting prowess when one eventually hits. Still, thanks to them for tagging along with me and adding to the flow of information.

Cursive Says:

September 19th, 2009 at 2:55 pm
@ drey / DL

Gold and commodities are dollar denominated assets. Deflation, i.e. a drop in money supply, should strengthen the dollar. A stronger dollar should translate to lower commodity prices.
 

[Aug 6, 2009] Wages and Salaries Fell 4.7%, Most On Record

Mish's Global Economic Trend Analysis

Inquiring minds are reading American Incomes Head Down, Threatening Recovery in Spending.

“Consumers have started to change their behavior and they are going to save more,” said Richard Berner, co-head of global economics at Morgan Stanley in New York and a former researcher at the Fed. “You have pressure on wages, you have employment still declining.”

Wages and salaries, which drive recoveries in spending, fell 4.7 percent in the 12 months through June, the biggest drop since records began in 1960, according to Commerce Department figures released yesterday. The Obama administration’s tax cuts, extended jobless benefits and a one-time Social Security bonus have helped mask the damage done by the worst employment slump since the Great Depression.

[Aug 6, 2009] China Warns Developed Nations of Inflation, Currency Threats - Bloomberg.com

Aug. 6 | Bloomberg

China’s central bank warned that monetary easing by developed nations threatens to cause “severe” inflation and currency volatility.

“Failure to manage the degree of easing may lead to concerns about mid- and long-term inflation and exchange-rate stability,” the People’s Bank of China said in a quarterly monetary policy report, posted on its Web site yesterday.

[Aug 6, 2009] The debt-inflation myth, debunked by UBS  by Tracy Alloway

Aug 04, 2009 | FT Alphaville

Here’s an interesting counterpoint to the theory that governments are attempting to inflate their way out of their financial crisis-related debt dilemmas.

It comes courtesy of UBS economist Paul Donovan, who argues:

While most investors today acknowledge that deflation is likely to be a feature for the OECD economies during the second half of 2009, inflation pessimists cling resolutely to the belief that inflation will inevitably return. “Fiscal deficits are rising dramatically” goes the argument. “Governments will have to create inflation to reduce debt:GDP ratios, as they have done in the past.”

The problem with the idea of governments inflating their way out of a debt burden is that it does not work. Absent episodes of hyper-inflation, it is a strategy that has never worked. Government debt: GDP burdens tend to be positively correlated with inflation. Market mythology has created the idea that inflation will help reduce government debt ratios. The facts do not support the myth. OECD government debt rises as inflation rises. Meaningful reductions in government debt will require a low inflation future.

To wit — this chart, which purportedly shows year-on-year levels of inflation on the x-axis and change in government debt (as a per cent of GDP) over one year on the y-axis. The two axes cross each other at the 5 per cent inflation level because that’s deemed, by UBS, to constitute a genuine inflation shock.

The point then, is that there aren’t many instances in the lower right-hand quadrant, which would coincide with relatively high levels of inflation and a decline in government debt as a proportion of GDP. The picture is much the same, according to UBS, over a two-year period too.

But why? Here’s Donovan again:

The fundamental obstacle to governments eroding their debt through inflation is the duration of the government debt portfolio. If all outstanding debt had ten years before it matured, then governments could inflate their way out of the debt burden. Inflation would ravage bond holders, and governments (with no need to roll over existing debt for a decade) could create inflation with impunity, secure in the knowledge that existing bond holders could do nothing to punish them. In the real world, of course, governments roll over their debt on a very frequent basis. As a result, governments are vulnerable to higher debt service costs if market interest rates change. If markets move to price in the consequence of higher inflation by raising nominal interest rates, then the debt service cost will rise and increase the debt. Thus a period of high inflation will tend to raise both the numerator and the denominator of the debt:GDP ratio.

As an example, the US can expect to roll over almost 45 per cent of its debt in the next 12 months and some 55 per cent over the course of the next two years. So according to UBS, if there is an inflation surge in the next 12 months, the US government would expect that to be reflected in higher borrowing costs — thus negating any ’sympathetic’ inflation-impact on its national debt. There’s also the issue of TIPS, or index-linked (inflation-linked) securities.

Add to that the notion that real yields tend to also rise in times of uncertain inflation — by as much as 100 to 150bp, according to UBS’s analysis, as investors demand a premium for the uncertainty — which further adds to government borrowing costs.

Thus, according to UBS, the problem governments face is that high inflation is likely to generate higher nominal and higher real interest rates. This means the rate of increase in debt servicing costs will probably exceed the rate of increase in nominal GDP, as a result of the higher inflation, and voila — you have very little government benefit associated with stronger inflation, according to the bank.

Donovan’s conclusion:

The idea that governments can readily inflate their way out of their debt problems is a misnomer — arising, perhaps, from confusion between the fate of the individual bondholder and the response of the collective market. An individual holder of a long duration bond will lose out as a result of inflation. However, modern governments can not rely on markets to remain collectively indifferent to inflation. Inflation will raise the nominal cost of borrowing (of course) but through the inflation uncertainty risk premium it will also add to the real cost of borrowing.

The higher debt service cost becomes a problem for a government that is pursuing an inflation strategy because government debt does have to be rolled over. Unless a government is willing to pursue hyper-inflation as a strategy, raising inflation will not reduce the government debt burden. Indeed, history indicates that the reverse result will be achieved.

So caveat hyperinflation. Not sure that will appease the uber-inflation hawks, really.

Related links:
Sticky inflation, redux - FT Alphaville
Inflationistas, Deflationistas and Goldilockeans - FT Alphaville
JPM says mild inflation good for stocks too - FT Alphaville

This entry was posted by Tracy Alloway on Tuesday, August 4th, 2009 at 9:23 and is filed under Capital markets. Tagged with Deflation, government bonds, inflation, quantitative easing, ubs.

User3186595

The author misses the point. Once the market realizes that the sovereign has no intention/will to cut spending (on entitlements and other structurally embedded programs) or raise taxes, then high inflation will result. Yes, interest rates will rise on rollover debt, but the solutions to reverse that problem (tax increases and spending decreases) will not be implemented and, so, the sovereign will pay the higher rate with printed money.

bigD

@charles monneron: it took a world war for people to accept inflation. This time it may be the other way around: it will take inflation for people to accept to go to war. I fear for the social (unintended) consequences of inflation.

@mojomogoz: amen to that!

Andrew Marsh

This argument seems more relevant to non-reserve currency Govts
where the demand for bonds is more elastic, and policy mis-measurements
are checked more forcefully by the markets.

In a world denominated in U.S. Dollars, the demand for (in this case) U.S.
govt bonds is less elastic and therefore, less restrained by market forces, leaving the bond market
vulnerable to tectonic demand shifts.

An example would be China or the Corp World deciding to demand Non-Dollar demoninated bonds, (U.S. issued bonds in Yuan, or Samurai bonds).

The resultant run on the currency (U.S. Dollar) would drive the demand for real returns to such a level that it would force a significant realignment of policy, but unlikely in time before a default on the bond market has occurred.

Khawla Al Roomi

The chart's x + y axes should both intersect at 0, this is misleading otherwise!

Mr Z Nik

19:47 Donovan has completely ignored the fact that Governments are rolling over their debt using QE.

A Reader

Mojomogoz is right. Is that chaos coming down the line?

User4003854

I don't see what myth UBS is debunking. Haven't markets already pushed up the cost of LT debt in anticipation of inflation, and interest rates?

Gipfelkreuz

(1) There is a difference between what governments "should" have learned from past experience and what they actually do (because they think, yes, this time it´s different)

(2) As already commented below, "correlation is not cause and effect". So increasing debt and increasing inflation may not mean that debt increases despite inflation, but maybe inflation is created because of increasing debt.

mojomogoz

The US govt isn't in charge any longer

Attitude_Check

Pyotr has identified the reason the UBS author gets it exactly wrong. Note that for high inflation, the debt increase begins to taper closer to 0, and in all cases is less than the infaltion rate. So in REAL terms inflation DOES decrease Government debt.

praxis22

I remember several years ago coming across an annotated slide from an economics course about inflation and asset bubbles, where it said something like, "in principle, inflation is the enemy, and governments must allow the assets to deflate and cut debt. However in practise governments usually do both"

Which I took to mean that inflation is allowed to rise even while debt is cut, and assets are left to deflate.

I just don't see how in weak labour market you can create wage inflation, so I guess we'll just have to hope for debt forgiveness where senior bond holders take a haircut or something.

pyotr

There aren't many data points in the bottom-right quadrant because in periods of hign inflation debt, measured in nominal terms, would still increase despite maybe coming down in real terms.

JP

I agree to a certain extent with Corrigan once you put a REAL (ie starting at 0) axis on Mr Donovans chart you can see the real picture

finchy

The last sentence should have continued:
"...to keep the real economy ticking over"

Pretty much in agreement with what others below have said.

finchy

Donovan is looking at the problem from the wrong angle. The question to ask is...

If a country's economy is facing stagflation or a recession+[asset price boom], will the government put pressure on its central bank to maintain loose monetary policy?

Mark Cowell

Inflation is the expansion of paper money. Price inflation or deflation is a symptom of the increase or decrease in the supply of money. Why does a loaf of bread cost more. Is it because of scarcity of ingredients or manufacturing inefficiency or simply that the paper pounds are less valuable

charles monneron

Regarding TIPS, it is only 10% of the issuance, so it doesn't have a big impact on the capacity of the government to inflate its way out of trouble. I hope TIPS issuance will remain marginal : that will reduce the government temptation to fiddle with CPI indices.

It is wrong to say that the strategy never work. It obviously did in post WW2 USA, where inflation came lower than long term rate. Debt to GDP ratio was substantially reduced in a few years. It required deep rooted collaboration between Federal Government and Federal Reserve but it definitely happened.

I think Mr Donovan underestimates two aspects of the problem :

1) investment is a relative sentiment game : Even if real long interest rates are negative, bonds can still be an attractive proposition if the investing public fears that other "risk assets" (like real estate or equity or foreign investments) are going to fare worse.

2) institutional framework can change dramatically (and will !) : the investable universe could be narrowed by the implementation of tax policies, bankruptcy policies, or exchange controls. Therefore the "arbitrage" opportunities toward better return assets that should lead to higher interest rates could not be implemented.

@bigD : all financial obligation WILL NOT be honored in real terms. It is not a question of being socially unworkable or not. It will happen because the real wealth that is potentially producible, especially with a greenhouse gas constraint, doesn't match the expectations of future consumption that are backed by existing financial commitments. As far as this is concerned, we are still in the denial stage right now and far from acceptance. Incidentally, it is the this stage that will lead investors to willingly accept investing in negative real interest government debt. It will happen when investors will have exhausted all investment bubbles opportunities, and been badly burned in the process : Only the school of hard knocks can turn greed into financial prudence !

Corrigan

sporry - that should read: 'high levels of GOVERNMENT spending'

Corrigan

Of course, what Mr. Donovan has really done here is to adduce evidence that economies with high levels of spending tend to be, ipso facto, inflationary (applying the current misdefinition of the term to mean CPI rises) and that the monetary excess (the proper definition) which gives rise to this pathology tends to be more prevalent when the government has a bigger footprint.

We could also argue that this latter is one thing the Deflationistas entirely miss: viz, that monetizing government debt can easily swamp private sector unwillingness to borrow by allowing those banks reluctant to lend to anyone other than Leviathan a ready outlet for their creation of spendable deposits

puzzled from north london

Where is this mythical government that is able to inflate or hyper-inflate in isolation from other countries? if UK (hyper-) inflates sterling goes to hell in a hand basket

Cabin Fever

 @Skwosh and@pengu
Yes, I agree too. ..and the inflationary picture is made all the more likely by the global competitive pressure on the world's resources which will continue to inflate the price of essentials. whereas Western goverrnments would like some wage inflation there must be a risk that this wont happen and we will have an inflation that takes from the consumer and gives to the food supplier, energy producer etc. rather than inflation that takes from the lender and gives to the borrower.

stomper

i agree with skwosh - i think the UBS bloke is kind of missing the point. the real point of high inflation is to erode household debt (since they are the voters) and exchange it for govt debt and much higher taxes sometime in the future. hence the chances of the govt being re-elected in the short-term go up and the problems are just shuffled off into the future for someone else to worry about. for a politician, this is a no-brainer.

Skwosh

I agree with pengu: I thought the whole point of the ‘inflate your way out of it’ route was to try to save the *real* economy, not the government. Create wage/price inflation in the real economy and the debt burden on households and businesses is reduced. Households and businesses are the fundamental engine of economic growth- they are the ultimate source of tax revenue- and if you don’t save them then you’re not really saving anything. The role of government in this context is to effectively ‘absorb’ the debt in a relatively safely way so at to allow the real economy to recover- and then pay the debt off once the economy can generate the real growth required to do so. Wouldn’t you *expect* a ballooning government debt to GDP ratio during such a period?

bigD

(Hyper-)inflation will only increase the future cost of unfunded liabilities (think state pensions and healthcare obligations). If the aim is to abolish these in all but name, through honouring all financial obligations in nominal terms only, but eroding them in real terms, it will work financially but not socially. If not, it is going to cause a financial burden that will bankrupt sovereign nations. Inflating your way out of problems is a myth.

smartrs

The market is voting with its feet on the risk that the central banks slip up, with a preference for short term debt relative to long term debt. Over the last year, the 1y5y spread on the UK swap curve has steepened 116bp (5y is up 61bp although 1y is down 55bp), to stand at a whopping 249bp.

Maybe there is a tipping point here, where once the curve gets steep enough, it becomes cripling to issue at the long end and it encourages further steepening, like the falls in the equity market last October.

Nately

Other than the markets (which are clearly on happy pills), it's all so depressing. "No choice" but to reinflate the bubble to try to support the debt-laden consumer/banks/keep the housing market pumped up. And it's working; but ultimately means complete disaster down the line.

Wonder if the marture of high inflation and high real interest rates can be avoided

pegnu

10:11 I don't understand the focus on government debt. What about private sector debt which is at record levels? Would moderate inflation help that?

Correlation does not mean cause and effect and, anyway, I see no significant correlation in that figure at all - what are they talking about?

VP

10:11 Not sure of his logic, unless he also considers the UK banks and whether inflation helps them. I suspect it does, because it helps those indebted to them.

Agree with the theory but can't consider the UK national debt in isolation, without considering we're on the hook for RBS, LLOY & (ultimately) BARC's multi-trillion b/s's. If inflation helps out them, then it helps the UK govnt debt.

Crow

Excellent post.

Plenty of deflationary numbers coming out of Asia now, all attributed to falling oil price. When does the oil price explanation run out?

The Next Inflation When, Why and So What - Economix Blog - By Casey B. Mulligan

This member of neo-classical Chicago academic mafia forgot about china... Inflation does serve as a tax on savers. I wonder how the Chinese will feel about paying this tax? Another problem is that any inflation will crush people on fixed incomes, or those who managed to husband resources while others were squandering theirs - and instead bail out the culprits who bought into irrational exuberance in the first place. The benefits from inflation which Professor Mulligan cites (e.g., bailing out underwater mortgagers) are better understood as a government sponsored transfer of wealth from savers to speculators.

June 24, 2009 | NYTimes.com

Significant inflation is on the horizon. However, this inflation will have some large benefits and, in any case, cannot be blamed on the Obama administration’s deficit spending.

Many economists and bond market commentators complain that inflation is on the horizon. One of the culprits, they say, is the large amount spent by the Obama administration on the fiscal stimulus, and potentially to be spent on health care reform. They claim that federal spending increases demand and thereby increases prices.

Even if it were true that stimulating demand would create inflation, this blame is misplaced because the fiscal stimulus has not, and health care reform will not, significantly stimulate demand. Even before the “stimulus” spending started, it was clear to me that the larger effect of the fiscal stimulus would be to reduce private demand and raise public demand, without much effect on total demand.

The recent evidence has already begun to confirm the minimal aggregate impact of the fiscal stimulus: The unemployment rate in May was  nowhere near as low as what the Obama administration had claimed it would be as a result of a passing a stimulus bill.

Despite some notable exceptions — such as interwar Germany — there is little or no correlation between government spending and inflation rates. Thus, even if the stimulus law and forthcoming health care laws increased total demand, there is still no guarantee that inflation would result.

The second purported culprit is the steep increase in the quantity of money.

The red line in the chart below illustrates this perspective — it measures the monetary base (that is, the value of currency, coin and Federal Reserve deposits) in each month through July 1930, normalized so that October 1929 is 100 (for example, the value of 98 in April 1930 means that the monetary base was 98 percent of what it was in October 1929). The blue line measures the monetary base for 2008-9. Unlike 1929, the monetary base surged in October, November and December, for a cumulative increase of about 50 percent.

Source: St. Louis Fed; Casey B. Mulligan

With a couple of caveats, such a large expansion of the monetary base should increase prices in the economy — that is, create inflation.

One caveat is that, although the monetary base surged more than six months ago, the inflation has not happened yet. Part of the reason for the weak short-run link between inflation and the monetary base is that, these days, banks seem willing to hold excess reserves at the Fed. Second, it is conceivable that the Federal Reserve could contract the monetary base before inflation resulted.

But that raises the question: Will the Federal Reserve contract the monetary base enough — and with the right timing — to prevent inflation?

Some argue that the Federal Reserve does not have the political fortitude to endure the high interest rates that would supposedly result from such a contraction. I doubt that much endurance would be required, though, because the low interest rates that were created by the base expansion were so short-lived — such would be the length of time that a monetary base contraction would raise interest rates.

“Inflation will likely be a deliberate choice to reduce the housing market’s drag on the wider economy.”

More importantly, the Federal Reserve, and bankers more generally, recognize that some inflation would alleviate, although not fully erase, some of the damage done by the housing market to the wider economy.

Specifically, inflation would raise the prices of a great many commodities, goods and services, among which would be the price of housing. Higher housing prices would pull a number of mortgages out from under water — the case when more is owed on a mortgage than the market value of the house that collateralizes it — and thereby reduce the number of foreclosures.

The positive effects of inflation are why it is unlikely that there will be enough support at the Fed for reducing the monetary base in a way that would be consistent with low inflation. The inflation we will probably see in the coming months and years will not be an accidental byproduct of big government spending, or an inability of the Federal Reserve to appreciate that money growth creates inflation.

Rather, inflation will probably be a deliberate choice to reduce the housing market’s drag on the wider economy.

Casey B. Mulligan is an economics professor at the University of Chicago.

Kasriel: ‘greater risk for the global economy…is inflation’

Posted by Edward Harrison on 1 June 2009 at 4:52 pm   

So we can put a check by Paul Kasriel’s name for inflationistas because he has come out today with a report saying he believes it is inflation over the medium term which is the greatest risk to the economy.

I will not keep you in suspense. I believe that the greater risk for the global economy in general and the U.S. economy in particular is inflation, not deflation. I arrive at this conclusion both on secular and cyclical grounds.

For the record, I believe deflation is the greater risk right now.  However, when the reflation play takes hold (and I believe it will do by Q4 or Q1 at the latest), inflation will be the real threat. So I agree with Kasriel.  Think $100 oil or higher for starters.  Commodities are going to be a good play all around.   Kasriel identifies secular and cyclical reasons inflation is a problem over the medium-term.  Secular reasons would include a higher Fed Funds rate, disappointing productivity growth, and higher defence spending.  Cyclical concerns for the U.S. include the positive relationship between the output gap and inflation, and the exchange rate correlation to inflation. There are other factors too like the re-emergence of Japanese consumer demand and the rising levels of government debt. 

The global markets are on to this trade as the dollar has sold off massively as have U.S. government bonds.  I do think these moves are pre-mature because disinflationary or deflationary forces (household de-leveraging, the destruction of shadow banking, and the implosion of real estate valuations, both commercial and residential) still have the upper hand in the U.S. economy.  Nevertheless, inflation is coming. It’s only a question of time.

Source

Greater Risk over Next Five Years – Inflation or Deflation? (PDF) – The Econtrarian, Paul Kasriel, Northern Trust

The Automatic Earth Debt Rattle, November 29 2008 Inflation deflated

There are many things we have discussed here frequently that come up as questions in the comments because we are attracting new readers all the time. I thought it would be a good time to answer those questions en masse, so that there would be a URL to point to if the same questions should come up again.

The basic point is that we here at TAE are expecting deflation. Although inflation and deflation are commonly thought of as descriptions of rising or falling prices, this is not the case. Inflation and deflation are monetary phenomena. The terms represent either an increase or a decrease, respectively, in the supply of money and credit relative to available goods and services. Rising prices are often a lagging indicator of an increase in the effective money supply, as falling prices are of a decrease. There is an important distinction to be made between nominal prices and real prices, however. Nominal prices can be misleading as they are not adjusted for changes in the money supply and so do not reflect affordability. Real prices, which are so adjusted, are a far more important measure.

Nominal prices typically rise during inflationary times as there is more money available to support higher prices, but prices need not rise evenly, and some prices may fall, depending on other factors. In real terms the picture would be quite different, as increases would be smaller and decreases would larger. When nominal prices fall despite inflation, it means that the price in real terms is plummeting. For instance, global wage arbitrage allowed the price of imported goods to fall drastically in real terms. In deflationary times, nominal prices typically fall across the board, but prices need not fall in real terms, and, in cases of scarcity, may well rise.

The easy availability of cheap credit has conveyed a considerable amount of price support - price support that will be progressively withdrawn as credit tightens. Prices will fall, but the collapse of credit will cause purchasing power to fall faster than price, leading to the apparent paradox of nominally cheaper goods being less affordable in the future than nominally more expensive goods are today. Moreover, there are likely to be substantial changes in relative prices between essentials and non-essentials. As a much larger percentage of a much smaller money supply will be chasing essentials such as food and energy, there will be relative price support for those items. In other words, while everything is becoming less affordable due to the collapse of purchasing power, essentials such a food and energy will be the least affordable of all, whatever the nominal price. People commonly speak of unaffordable prices as a result of inflation, but do not realize that deflation can have the same effect, only much more abruptly.

Thanks to a credit boom that dates back to at least the early 1980s, and which accelerated rapidly after the millennium, the vast majority of the effective money supply is credit. A credit boom can mimic currency inflation in important ways, as credit acts as a money equivalent during the expansion phase. There are, however, important differences. Whereas currency inflation divides the real wealth pie into smaller and smaller pieces, devaluing each one in a form of forced loss sharing, credit expansion creates multiple and mutually exclusive claims to the same pieces of pie. This generates the appearance of a substantial increase in real wealth through leverage, but is an illusion. The apparent wealth is virtual, and once expansion morphs into contraction, the excess claims are rapidly extinguished in a chaotic real wealth grab. It is this prospect that we are currently facing today, as credit destruction is already well underway, and the destruction of credit is hugely deflationary. As money is the lubricant in the economic engine, a shortage will cause that engine to seize up, as happened in the 1930s. An important point to remember is that demand is not what people want, it is what they are ready, willing and able to pay for. The fall in aggregate demand that characterizes a depression reflects a lack of purchasing power, not a lack of want. With very little money and no access to credit, people can starve amid plenty.

Attempts by governments and central bankers to reinflate the money supply are doomed to fail as debt monetization cannot keep pace with credit destruction, and liquidity injected into the system is being hoarded by nervous banks rather than being used to initiate new lending, as was the stated intent of the various bailout schemes. Bailouts only ever benefit a few insiders. Available credit is already being squeezed across the board, although we are still far closer to the beginning of the contraction than the end of it. Further attempts at reinflation may eventually cause a crisis of confidence among international lenders, which could lead to a serious dislocation in the treasury bond market at some point. If a debt-junkie economy can no longer easily raise funds, then interest rates would rise substantially and spending at home would be drastically cut. This would be the financial equivalent of hitting the 'emergency stop' button on the economy, as it would cause a far larger rash of defaults than anything we have seen so far. We are not there yet though. Currently the dollar is benefiting from an international flight to safety, and it will probably continue to do so for some time, despite temporary counter-trend pullbacks from time to time.

We have seen a pattern of ebb and flow of market liquidity since February 2007, when the credit crisis arguably began. A constellation of market trends has largely moved in synch with liquidity. As liquidity falls, equities fall, bond yields fall (and prices rise), commodities fall, precious metals fall, real estate falls and the dollar rises, as cash becomes king. When we see market rallies, in contrast, rallies in bond yields, commodities, and metals are also common, and the dollar experiences a pullback. We appear to be beginning a market rally at the moment, which should lead to precisely this set of trend reversals. Such a rally is only temporary relief however. It may last for a couple of months, but then the decline should resume with a vengeance.

We have a very long way to fall, and the deleveraging process is likely to play out over several years. During this time we can expect to be mired in a worse depression than the 1930s, as the excesses that led to our current situation are far worse by every measure than were those of the Roaring Twenties. Unfortunately, we are much less prepared to face such an occurrence than were our grandparents. Our expectations are far higher, our knowledge and skill base is much less appropriate, we are far less self-sufficient and we have a structural dependency on cheap energy. This will be a very painful time. Deflation and depression are mutually reinforcing, leading to a vicious circle of decline that is very difficult to escape. It will be over when the (small amount of) remaining debt is acceptably collateralized to the (few) remaining creditors. At that point trust will begin to rebuild.

For a longer and more detailed explanation of the credit bubble and deflation see The Resurgence of Risk - A Primer on the Develop(ed) Credit Crunch. This an article I wrote in August 2007 that was recently rerun on The Oil Drum, where I used to be an editor.

U.S. Consumer Prices Gain 0.7%; Core Rate Rises 0.2% (Update2) - Bloomberg.com

U.S. Consumer Prices Gain 0.7%; Core Rate Rises 0.2% (Update2) 

By Courtney Schlisserman

July 15 | Bloomberg

The cost of living in the U.S. rose more than forecast in June, led by a jump in energy costs that overshadowed slower price gains for other goods.

The consumer price index increased 0.7 percent after a 0.1 percent advance in May, the Labor Department said today in Washington. Excluding food and energy costs, the so-called core index rose 0.2 percent. Compared with a year earlier, prices fell 1.4 percent, the biggest drop since January 1950.

Declines in consumer spending and business investment are forcing companies to boost incentives or keep a lid on prices in order to move merchandise, and preventing them from passing higher energy costs on to customers. A surge in gasoline costs in recent months is now abating, indicating inflation may moderate as the year progresses.

“The risks are still to the downside” for prices, said Rudy Narvas, an economist at 4Cast Inc. in New York, who correctly forecast the increase in core prices. “Energy prices have come off. At the same time, we have an incredible amount of slack in the labor market -- and, with wage growth not there, pressure on prices will be” low, he said.

A separate report today showed that manufacturing in New York state shrank at the slowest pace in more than a year this month. The Federal Reserve Bank of New York’s so-called Empire Index was minus 0.6, compared with minus 9.4 in June.

Treasuries, Stocks

Treasuries slid, sending the yield on benchmark 10-year notes up to 3.51 percent at 8:36 a.m. in New York, from 3.47 percent late yesterday. Futures on the Standard & Poor’s 500 Stock Index advanced 1.2 percent to 912.50.

Economists forecast consumer prices rose 0.6 percent, according to the median of 74 projections in a Bloomberg News survey. Estimates ranged from a 0.2 percent increase to a 1 percent increase.

For the core index, prices were up 1.7 percent from a year earlier. That compares with a 1.8 percent increase in the 12 months ended in May.

Energy costs increased 7.4 percent in June. Gasoline prices soared 17 percent.

Gasoline prices have come down this month, according to figures from AAA, with regular pump process ending July 13 at $2.52 a gallon, compared with an average $2.64 in June. Also, the price of crude-oil futures closed yesterday at $59.68 a barrel on the New York Mercantile Exchange, compared with $72.68 on June 11.

Producer Prices

Labor said yesterday that a 6.6 percent increase in the cost of energy led to wholesale prices gaining twice as much as anticipated. Gasoline soared 18.5 percent and home heating oil rose 15.4 percent, yesterday’s report showed.

Food prices, which account for about a seventh of the CPI, were unchanged in June, after a 0.2 percent drop in May.

Cost increases for ingredients and packaging will slow this year, helping to boost profit, General Mills Inc. Chairman and Chief Executive Officer Ken Powell said July 1. Powell said he expects “little or no” price growth this year as input-cost gains slow from 9 percent in 2008.

General Mills, the Minneapolis-based maker of Cheerios and Hamburger Helper, raised prices in fiscal 2009 by 8 percent to counter higher commodity expenses, Chief Financial Officer Don Mulligan said in a telephone interview.

Three Measures

The CPI is the broadest of the three monthly price gauges from Labor because it includes goods and services. The cost of goods imported into the U.S. rose 3.2 percent in June, the government said last week. Wholesale prices increased 1.8 percent, Labor said yesterday.

Almost 60 percent of the CPI covers prices consumers pay for services ranging from medical visits to airline fares and movie tickets.

The increase in the core CPI was led by gains for automobiles. New and used vehicle prices rose by 0.4 percent. Car costs may decline in coming months as carmakers slash prices or increase incentives to revive demand and reduce inventories, analysts said.

Auto industry figures released earlier this month, which are used to calculate gross domestic product, showed a drop in sales in June. Purchases declined to a 9.7 million annual pace from a 9.9 million rate in May, according to data from Woodcliff Lake, New Jersey-based Autodata Corp. Commerce Department figures yesterday showed a 2.3 percent gain in sales at car dealers and auto-parts stores in the same month.

Rents, which make up almost 40 percent of the core CPI, rose. Owners-equivalent rent, a category used to track housing costs, increased 0.1 percent, the same as in the previous two months.

Fed policy makers said in their policy statement after meeting June 23-24 that they expect “inflation will remain subdued for some time.”

[Jul 8, 2009] What's next Inflation or deflation - MSN Money

Grant starts off by quoting the Bureau of Labor Statistics regarding the fact that May's 1.3% drop in the Consumer Price Index was the largest decline since April 1950:

"It's a funny deflation, though. Deflation, to us, is too much debt chasing too little income. One symptom of deflation is falling prices. In a proper deflation, prices fall broadly, not narrowly. Seventeen months into the Great Depression, the CPI had fallen by a cumulative 8.1%. This time around, December 2000 to date, it's risen by 1.8%."

Grant then notes that although the steel industry is operating at a capacity utilization rate of below 50%, AK Steel (AKS, news, msgs) was raising prices for the second time since May. "If deflation it be, it's deflation light," he says.

As Grant's colleague Ian McCulley points out, "If we are truly in a sustained deflation, price decreases will eventually spread." And Jim notes: "It hasn't happened yet. Core CPI, which includes food and energy, is 1.8% higher than it was last year. Though its rate of rise has slowed (a year ago, it was rising at an annual pace of 2.3%), it continues to hold above the level to which it sunk during the great deflation scare of 2002-2003."

McCulley proceeds to observe that the Cleveland Fed has its own alternative measure of CPI and that by virtue of its calculation methodology, "it is thus a less volatile price index than headline CPI, and is currently rising by 2.4% year-over-year."

That's not all. Many folks believe that with the economy operating so far below its potential output and with high levels of unemployment, inflation can't possibly happen.

Grant says that would be "a perfect theory, if not for the existence of so many countervailing facts. Bolivia recorded a monthly inflation rate as high as 120% in 1984-86 with unemployment rates in the mid- to upper teens. Bulgaria recorded a monthly inflation rate as high as 242.7% in 1997 with unemployment rates ranging between 12.5% and 13.7%. The greatest hyperinflation of them all was not the 1920-23 German affair but the Hungarian calamity of 1945-46, which occurred in a war-ravaged economy operating well below pre-1939 levels of resource utilization."

Grant sums up his thoughts on the inflation front as follows: "What strikes us is what small effect a mighty debt collapse has had. It makes you fear -- almost -- for prosperity."

Let's hope all of those salient points will assist folks in deciding whether they think we will see deflation or inflation in the future.

Troubled times

Monday, July 06, 2009 5:48:32 AM

Natural resources that are in limited supply, but general demand, will rise in price, but the engine of American consumption--and by extension, world consumption--cheap and available credit--is gone.  Also, wages are certainly not going up and many, many people are unemployed.  There is nothing to generate home sales.  "Inflation"  is a broad measure.  Perhaps a better set of terms to describe "what's going to happen" is "a general decline in the standard of living."  This would translate to expensive food and gasoline and materials, but houses for sale just sitting there unsold for long periods of time and people downscaling their standards for cars, clothes, vacations, and everything else.  The middle class will erode into a sort of "upper lower class" and the upper class will condense into a more rarified and exclusive semi-royalty. 

FTD1

#13

Monday, July 06, 2009 6:12:12 AM

Using the CPI to measure inflation ignores the substitution effect.  The CPI is adjusted for the substitution one supposedly makes when buying goods (i.e if steak is to expensive we buy hamburger).  It's no longer a true gauge of the cost of the same basket of goods and thus understates inflation.  To truely gauge inflation / deflation look at consumables / discretionary spending vs asset prices.

DennisAOK

#18

Monday, July 06, 2009 6:58:10 AM

I think the article makes a point - inflation is the greater threat - and I agree with it.   You cannot put this much money into the system without raising the price level.

wt1947

#20

Monday, July 06, 2009 7:12:43 AM

When the price osf gas goes up, consumers stop buying cars, traveling and retreat to savings, then you have a fragile economy.  Consumers live beyong their means, teterring on the brink of disaster daily and so when a recession hits it is catastophic and consumers loose their wealth and get deeper in debt.  It is like a business with poor cash flow that borrows from a company at high interest rates only to get deeper in debt and finally go under.

I see people daily buying Cadillacs, living in a house worth 80,000 dollars, no savings, eating at restaurants every night with credit cards at 30%  and growing.  Never a care in the world about the future and all the while talking like Rush Limbaugh about the evils of Medicare and social security.

MousePusher

#22

Monday, July 06, 2009 7:18:01 AM

Inflation/Deflation... that truely is the question? The article is a little light but most experts are trending toward a slight deflationary period followed by an upswing into inflation, which may even top what happened in the 70'S. Ingenious actually... set the rate so high then retract the currency so it actually burns out Inflation. It was murder on the building industry, by in large, nonetheless, it did the trick. I hope we don't hit that wall again... but how can we avoid it. there are no more bullets left in the Fed's or Treasury's guns to use. We've printed more money than in the entire history of our country that has been spent in the past.

If anyone has eyes on this energy bill, most of these distiguished representatives, the key players, have all invested heavily in the companies that will benefit the most from this bill, a little insider investing.... and at OUR EXPENSE!

TARP I, bought the banks, TARP II, why was that passed... it doesn't kick in for 3 years? Omnibus (aka Earmarks Bill), America Save the Planet (Cap & Tax Bill- on tech that has big question marks... FIRSTCALL...

I agree that advances have been made and could be implimented but to base our economy on a "Model T" mentality while needing an energy supply that of a finely tuned Mustang running on all eight cylinders would be disaterous and ill thought out. We The People, the true board members of the USA, are struggling to make it each month; proven tech should be implimented)  and now a solution to rid us of the so-called problem of the "Baby boomers" United Healthcare; And this all has to be done RIGHT NOW!!!!!!!!!!!!!!!!! WHY?????????!!!!!!!!Trillions of dollars, spending on an unprecidented level. There use to be over 40 countries that would buy our debt... now you can count them on one hand. If one "calls the note" we are finished. Treasury issues notes and the Fed buys them.  Pathetic!!

We now have 5 sets of books for the FEDERAL GOVERNMENT.... hmmmm.... How does the IRS want things reported by companies and personal; ONE SET OF BOOKS.

Everyone needs to stop thinking about if's but when.... inflation is coming. Be prepared. 

 

Blinder: Why Inflation isn't the Danger

Blinder was one of Greenspan's cronies and as such has a zero or negative credibility.

Alan Blinder isn't worried about inflation:

June 21, 2009  | Mark Thoma

Why Inflation Isn’t the Danger, by Alan S. Blinder, Economic View, NY Times: Some people with hypersensitive sniffers say the whiff of future inflation is in the air. ... Concluding that the Fed is leading us into inflation assumes a degree of incompetence that I simply don’t buy. Let me explain.

First, the clear and present danger, both now and for the next year or two, is not inflation but deflation. ... Core inflation near zero, or even negative, is a live possibility for 2010 or 2011.

Ben S. Bernanke ... and his colleagues have been working overtime to dodge the deflation bullet. To this end, they cut the Fed funds rate to virtually zero last December and have since relied on a variety of extraordinary policies known as quantitative easing to restore the flow of credit. ... But quantitative easing is universally agreed to be weak medicine compared with cutting interest rates. So the Fed is administering a large dose — which is where all those reserves come from.

The mountain of reserves on banks’ balance sheets has, in turn, filled the inflation hawks with apprehension. ... Will the Fed really withdraw all those reserves fast enough as the financial storm abates? If not, we could indeed experience inflation. Although the Fed is not infallible, I’d make three important points:

• The possibilities for error are two-sided. Yes, the Fed might err by withdrawing bank reserves too slowly, thereby leading to higher inflation. But it also might err by withdrawing reserves too quickly, thereby stunting the recovery and leading to deflation. I fail to see why advocates of price stability should worry about one sort of error but not the other.

• The Fed is well aware of the exit problem. It is planning for it... It might miss and produce, say, inflation of 3 percent or 4 percent at the end of the crisis — but not 8 or 10 percent.

• The Fed will start the exit process when the economy is still below full employment and inflation is below target. So some modest rise in inflation will be welcome. The Fed won’t have to clamp down hard.

...But if the inflation outlook is so benign, why have Treasury borrowing rates skyrocketed in the last few months? Is it because markets fear that the Fed will lose control of inflation? I think not. Rising Treasury rates are mainly a return to normalcy.

In January, the markets were expecting about zero inflation over the coming five years, and only about 0.6 percent average inflation over the next decade. The difference between then and now is that markets were in a panicky state in January, braced for financial Armageddon; they have since calmed down.

My conclusion? The markets’ extraordinarily low expected inflation in January was both aberrant and worrisome — not today’s. As long as expected inflation doesn’t rise much further, you should find something else to worry about. Unfortunately, choices abound.

Selected comments

ken melvin says...

Some very smart people worry about deflation. I look about and see small businesses paying half their gross and households half their income for rent, which I attribute this to over priced assets. So, the consumer product made in China for $2 costs $10, and the neither consumer. who is also the householder, nor the retailer is any better off. In fact they are worse off. For them, there is less profit from their efforts. The margin went to the big boxes or to the investor class.

Wage increases not being on the horizon, the price of assets needs come down. So, I think think some deflation is in order.

Posted by: ken melvin | Link to comment | Jun 21, 2009 at 05:09 AM

John says...

Deflation and large fiscal deficits are easy to avoid. The government simply needs to introduce a value added tax (VAT) and set it according to the deflation rate. Deflation at 2% pa? No problem - set VAT at 2% and get instant price stability. Plus the government gets money to help balance the budget.

Posted by: John

Scott says...

John, why don't you think our government will not implement the VAT system? Seems easy enough right?

Ken, in Hoboken we have been affected by massive job losses, corporate cuts, etc just as much as NYC on a smaller scale. Real estate prices are coming down a bit but the debt to income ratio on just housing is crazy and not sure how people are going to sustain. A broker making 100k this year is living at the Maxwell, paying a 8k per month mortgage or renting for $4500. Not to mention, Kings charges $50 for a ham sandwhich. Yes, deflation is in order

Posted by: Scott

dw says...

John, not sure that VAT would help. deflation is happening (and will continue) as the consumer can't afford or won't buy the products (leading to less demand).

And since incomes have been going down for a long time and the economy was buoyed only by easy credit (which is now gone).

At the point that prices match up with incomes again, deflation might stop (depending on incomes stopping their current decent)

Posted by: dw

Mattyoung says...

Inflation where and for who?

"In 1997 the Bureau of Economic Analysis (Dept of Commerce) released a study that showed that the average nonfederal worker earned $48,000 per year compared to an average salary of $77,000 for federal civil servants. When fringe benefits were cranked into the equation, the BEC said, total federal compensation (the value of pay and job-related and lifetime retirement benefits) was an average of $116,000 compared to only $57,000 for the private sector. "

At least as the report was read by a Wash Times Op Ed.

With unemployment for government workers at around 5%, the government sector is likely to see a wage increase of a 2-3% this year.

So, in standard Krugman form, we are agglomerating about Washington DC. This seems to put a lie to the concept of stimulus if by stimulus we mean activating the whole economy. Multipliers are very low, much less than one, and every dollar of stimulus will likely grow Washington DC faster than the remainder of the economy. This is not crowding out, this is simply the rest of the economy sending surplus workers to Washington because the private sector cannot use them until the oil problem is solved.

If we don't solve the oil problem then eventually all those government goods piling up in inventory will be devalued.

Posted by: Mattyoung

cm says...

ken melvin makes a good observation, and I think it can be safely generalized into an assertion that the real cost of living is still going up.

If that's not technically inflation, then only because the inflation metrics have been massaged to exclude ever more price categories.

Then there are enough local anecdotes of pay cuts in the 10-20% range, furlough days, layoffs, pay grade demotions, bonus cuts, pay freezes, hiring freezes, increased healthcare premiums/copays and reduced coverage, pressuring people to be "more productive", etc.
 

Posted by: cm

Bruce Wilder says...

MY: "Multipliers are very low, much less than one . . ."

Evidence?

Posted by: Bruce Wilder

ECONOMISTA NON GRATA says...

I am amused by Alan Blinder's concise argument, yet myopic views on cause and effect. His assertions are unsubstantiated by evidence and thus can be dismissed with a mere shrug of the shoulders.

All the tangible evidence screams "fraud".

Ciao,

Econlicious

Posted by: ECONOMISTA NON GRATA

Mattyoung says...

Bruce,

Evidence was cited, the low unemployment rates in and around the nation's capital compared to the rest of the nation. High multipliers would have the opposite effect, increasing employment elsewhere at the expense of agglomeration in the capital. (Unless you are in the Yglesias/Galbrathian camp which believe increasing efficiency comes from expanding the government sector)

Posted by: Mattyoung

anne says...

"With unemployment for government workers at around 5%, the government sector is likely to see a wage increase of a 2-3% this year."

Huh? Where, where, where, where, where?

Posted by: anne

anne says...

"With unemployment for government workers at around 3%, the government sector is likely to see a wage increase of a 2-3% this year."

"With unemployment for government workers at around 5%, the government sector is likely to see a wage increase of a 2-3% this year."

"With unemployment for government workers at around 7%, the government sector is likely to see a wage increase of a 2-3% this year."

"With unemployment for government workers at around 9%, the government sector is likely to see a wage increase of a 2-3% this year."

This is utter nonsense.

Posted by: anne

anne says...

"So, in standard Krugman form, we are agglomerating about Washington DC. This seems to put a lie to the concept of stimulus if by stimulus we mean activating the whole economy. Multipliers are very low, much less than one, and every dollar of stimulus will likely grow Washington DC faster than the remainder of the economy. This is not crowding out, this is simply the rest of the economy sending surplus workers to Washington because the private sector cannot use them until the oil problem is solved.

"If we don't solve the oil problem then eventually all those government goods piling up in inventory will be devalued."

This is agglomerating nonsense.

Posted by: anne |

Mattyoung says...

The link is from an op ed in the WJS, but the author is reviewing recent employment statistics from the BLS:

http://online.wsj.com/article/SB124458850503399823.html

Unemployment for the region around the federal government has dropped from 5.9% to 5.6%; while the rest of the nation has risen from 8% to 9.5%.

With inflation at 1%, and employment shifting from other regions to the Capital, a very reasonable estimate would be a 2-3% rise in employee salaries for government.

What Senator Warner says:

"In a speech to GWI's conference last week, former venture capitalist and now Democratic Senator Mark Warner of Virginia saw nothing but green for most of Washington's public-private economy. "The federal government's level of activity in the economy is unprecedented," he said, adding that new stimulus projects and investments in green technology in particular look like a jackpot for the region. As Mr. Warner put it to the Washington Business Journal, "It helps to be where the money is."

There is this:

"Congress is advancing a budget that could change a 2% raise proposed by Obama for 1.9 million non-military federal workers to at least 2.9% — which is the amount the president proposed for military employees." Reported by Govcentral.com.

I could go on, but the regional unemployment news is sufficient. It tells us that the jobs being added are in the Washington DC area, plain and simple, straight from the BLS. Moving workers to the capital is not stimulus, it is agglomeration. Maybe we have a different definition of terms. Government white collar workers are likely to see the full 2-3% raise, UC professors have already been informed of an 8% pay cut. That is a government worker to government worker comparison by region.

Let me cite again the effort to revitalize the US government as the ultimate guarantee of the major world currency [dollar] banks, a global responsibility that was not explicit prior to the 2008 crash.

Posted by: Mattyoung | Link to comment | Jun 21, 2009 at 02:54 PM

Mattyoung says...

And this, done by Bush in Dec 2008.

"2009 Federal Pay Raise: 3.9% Increase for Federal Employees 2009 Pay Tables Now Available"

Source: http://www.myfederalretirement.com/public/194.cfm

And McCullagh of CBSNEWS and his analysis of the 2010 budget shows an increase in the Federal Workforce of by 2% (this is excluding the Census temporary work force).

The bulk of this increase is likely to go to the Washington corridor.

So, once again, referring to the Krugman trade theory, an agglomeration is not a national stimulus. An agglomeration is a proven concentration of economic activity with firm to firm increases in efficiencies of scale dominated by a narrow geographical region. Where is the evidence, other than change of names, that we are undergoing a stimulus?

Posted by: Mattyoung | Link to comment | Jun 21, 2009 at 03:09 PM

Mattyoung says...

So, Anne, how does your tricky economic theory explain that piling more people in Washington make is cheaper to transport a bag of groceries in Fresno CA. As near as I can tell from Anne's theory is that something magical happens, the higher economic activity in Washington mysteriously drops the price of gasoline in California.

I don't see it.

Posted by: Mattyoung

anne says...

Fine:

"Unemployment for the region around the federal government has dropped from 5.9% to 5.6%; while the rest of the nation has risen from 8% to 9.5%."

Not fine:

"With unemployment for government workers at around 5%...."

http://data.bls.gov/map/servlet/map.servlet.MapToolServlet?survey=la

June 20, 2009

Unemployment Rates by State, 2009

May *

District of Columbia 10.7
Maryland 7.2
Virginia 7.1

* Seasonally adjusted

Posted by: anne

anne says...

http://data.bls.gov/map/servlet/map.servlet.MapToolServlet?survey=la

January 15, 2009

Unemployment Rates by State, 2008

December *

District of Columbia 8.2
Maryland 5.4
Virginia 5.0

* Seasonally adjusted

Posted by: anne

anne says...

http://data.bls.gov/map/servlet/map.servlet.MapToolServlet?survey=la

January 15, 2009

Unemployment Rates by State, 2007

December *

District of Columbia 5.8
Maryland 3.6
Virginia 3.3

* Seasonally adjusted

Posted by: anne | Link to comment | Jun 21, 2009 at 03:34 PM

anne says...

"Unemployment for the region around the federal government has dropped from 5.9% to 5.6%; while the rest of the nation has risen from 8% to 9.4%."

http://data.bls.gov/map/servlet/map.servlet.MapToolServlet?survey=la

June 20, 2009

Unemployment Rates by State, 2009

May *

District of Columbia 10.7
Maryland 7.2
Virginia 7.1

Unemployment Rates by State, 2008

December *

District of Columbia 8.2
Maryland 5.4
Virginia 5.0

Unemployment Rates by State, 2007

December *

District of Columbia 5.8
Maryland 3.6
Virginia 3.3

* Seasonally adjusted

Posted by: anne

Mattyoung says...

Use comparative stats, Anne, because you do not have to explain what absolute masurement (u3,u6) you are referring to.

From the same data source, we have:

Maryland Virginia at 7-7.2 with Oregon 12.4 and California around 11.5. Michigan at 12.4, Florida at 10.2. Illinois is at 10.1,

This disparity based on the same statistic.

Yes, I now you want to include the district itself, which you know to be an outlier because of its special political status,

You own statistics source backs me up, the government sector is doing almost twice as well as the other economic centers.

It is you, Anne, you and the economic policies you support going about the business of delivering Washington backed financial services to the rest of the world, exactly what you complain about you support. Calling it a temporary stimulus does not make it, sorry.
 

Posted by: Mattyoung | Link to comment | Jun 21, 2009 at 04:26 PM

mrrunangun says...

Prof. Blinder is a sensible guy. The US in particular and the world economy in general are caught between powerful inflationary (Central bank created) and deflationary forces (bankster bank created). We don't know which will win out or if Dr. Summers and Dr. Bernanke are smart enough or lucky enough to get it just right. A little inflation would be better for most people than a little deflation. A lot of either would be bad for all but nimble speculators.

The central banks are trying to fill in the vacuum created by the vaporization of capital due to unrecoverable loans made by the banking system. The banks owe that money back to the citizenry, the Chinese and other countries, and private foreign parties. The US government does not want to leave any of them holding the bag, so it is taking the banks' liabilities onto the government balance sheet.

The results of policy changes are difficult to predict because changes in the policies of countries other than the US can have positive or negative effects on those results. Those countries may make unpredictable policy mistakes themselves or misperceive how the Fed is doing its job and make policy changes unfavorable to the US based on such perceptions. Poor US policy choices over the past 20-odd years have left it hostage to such. The Fed does not really know just how much capital has been vaporized by the banksters and so does not know very precisely how much capital is/will be needed to fill the void.

Posted by: mrrunangun 

Lafayette says...

Blinder: The markets’ extraordinarily low expected inflation in January was both aberrant and worrisome — not today’s. As long as expected inflation doesn’t rise much further, you should find something else to worry about. Unfortunately, choices abound.

What amuses me about this sort of comment is that, intuitively, one thinks that there is a "Markets God" up there somewhere pulling the levers like in a medieval puppet show.

Just what consists of this word "markets" (plural). I submit that, as regards the money market, there is only one for the dollar and its interest rates. But, there are multiple market agents. Meaning multiple buyers and sellers, who make bets on future variations of interest rates and even future exchange rates (for foreign holders of dollar instruments).

Yes, their assessments of those two variables can change daily. Those estimations/judgments can change daily even hourly. Though I have no formal proof, I suspect that it is the long-term behaviour of GDP actors (those who generate products and services) and their government overseers that determines the faith or lack of it in a country's money.

For instance, why do markets have an innate faith in the dollar? Because our corporate and government leaders have demonstrated pragmatic management of the dollar over the past sixty years since Bretton Woods -- and this despite the colossal failure instigated by the SubPrime Mess of 2008.

One cannot say that for all countries. Europe has built considerable trust in the Euro, but its underlying economic sclerosis leads people to believe that the dollar, all factors considered, is a better bet.

And Blinder would do better to underscore the fact, methinks, that it is the foreign holders of dollars that are perhaps more important in the money-market equation than other, more internal, factors of which we reckon the Fed controls.

If economic stimulation does not show solid traction by the beginning of next year ... expect mounting pressure on the dollar from abroad. And so, what's the other "game in town"?

Good question. For which I have no spontaneous answer. But .... why not the renminbi?

Posted by: Lafayette

Sundar Srinivasan says...

I am not worried about inflation. It's too early to worry about that. But I am rather worried about deflation and what policymakers would do if they develop a premature worry about inflation!

Posted by: Sundar Srinivasan

FT Alphaville » Blog Archive » More dollar deliberations

Posted by Izabella Kaminska on Jul 01 19:13.

Wednesday’s dollar dive  (as illustrated below by the movements of the dollar index) is, according to some reports, being put down to yet more rather non-dollar friendly signals from China.

Specifically, Reuters reported that China has now asked to debate proposals for a new global reserve currency at next week’s Group of Eight summit in Italy. From Reuters:

A European source with knowledge of preparations for the summit also said China had raised the subject of a reserve currency debate and that it might be mentioned during the meeting, though the source added: “Any country at the meeting can raise issues they see fit.”       “But whether there is a specific mention in the communique remains open,” said the European source, adding that sherpas would discuss this further in preparatory talks on Friday.

The question though remains, what possible alternatives exist? For example, while the euro may look an attractive option, there really isn’t the issuance of high-quality paper to satisfy the sort of supply China would be looking for in terms of investment.

Furthermore, any flight to euro-denominated assets would only strengthen the euro, an outcome the ECB and European governments would heartily seek to avoid in the current environment. In short, it’s not in Europe’s interests to try and attract those flows, and it makes no sense to encourage them by beefing up  issuance.

The other option being pitched, of course, is expansion of the IMF’s special drawing rights (SDR) basket to include the Chinese renminbi, the Brazilian real and even other commodity currencies like the Russian rouble, the Canadian and Australian dollar. This, on account of the above, makes much more sense for Europe, as it opens up a whole new weightings game in global reserves. While the euro would still strengthen versus the dollar in this scenario, it wouldn’t lift the euro too much beyond where it stands now in terms of other global currencies.

But even here there is a limit. There are only so many SDRs. Accordingly, the biggest and best diversification tactic for the time being, or at least until the US position on inflation is clear, will be an ever growing switch into commodities.

RGE’s Nouriel Roubini, for one, has recently cast his attention on the phenomenon. Regarding the position of the dollar-surplus holding countries and their concerns over the prospective inflationary debasement of the dollar, he noted:..they will not sit idly waiting for this to happen: they are already diversifying into gold, into resources (as China purchases mines and energy, mineral and commodity resources all over the world) and into shorter term maturity US Treasuries that have less market risk than longer term Treasuries. With two-thirds of US Treasuries, being held by non-residents and the average maturity of such government debt down to 4.5 years, the risk of a refinancing crisis and disorderly fall in the dollar will increase over time unless the US presents a credible plan for medium term fiscal consolidation.

But what’s really interesting is Roubini’s reference to how inflation is becoming increasingly justified as a US policy tool and means for solving the crisis. In other words, the notion that inflating one’s way out of the crisis makes perfect sense and should even be encouraged. As he put it (emphasis FT Alphaville’s):
Increasingly it is clear that unless such reduction in fiscal deficits occurs the incentive to continue monetizing them will increase. In the short run such massive monetization has not been inflationary as money velocity has collapsed and as the slack in goods and labor markets is still rapidly rising. But over time - late 2010 and 2011 - deflationary pressures will lead to an increase in expected inflation and then in actual inflation if monetization of persistently large fiscal deficits continues. Indeed some in the US argue that wiping out the real value of public debt and dealing with the private sector debt deflation through a bout of double digit inflation may be the most desirable way to reduce the overhang of public and private debt.

While such arguments have many flaws as inflation will have serious collateral damage one cannot rule out that the US will use inflation and depreciation as a way out of its public and private debts. Greenspan’s concerns about the long term inflationary effects of large US budget deficits - expressed today in a FT op-ed - go along the same lines. Thus, our creditors’ nervousness about the eventual debasement of the US dollar has some increasing validity.

In which case, it’s no surprise the likes of China are getting jittery.

[Jun 25, 2009] Warren Buffett to CNBC U.S. Economy In Shambles .. No Signs of Recovery Yet - Warren Buffett Watch - CNBC.com

Is he talking his own book -- overloaded with stocks.

Taking a firm position in an ongoing debate in the financial markets, Buffett says he's not concerned about deflation, but thinks inflation will be a problem in coming years.

TRANSCRIPT

BECKY:  It continues to be?  You don't think any of the urgency has come away?

BUFFETT: No, I don't think the urgency has come away.  The urgency has moved away from a total meltdown of the financial sector which we faced last fall.  I've never seen anything like that.  But I would give enormous credit to the people there.  (Federal Reserve Chairman) Bernanke did a fabulous job.  We were right at the point where people lost faith in money-market funds, when commercial paper stopped being issued.  People would be having a problem meeting their payroll, very big companies, if that hadn't gotten addressed very quickly.  And I give credit to people for doing that.  So that part, we've moved past that particular period.  We haven't got the economy going again.

[Jun 11, 2009] Deflation v. Inflation

Sudden Debt

The debate rages on in the financial blogosphere: will the current crisis ultimately be resolved through a period of cataclysmic deflation or in a hyper-inflationary auto da fe, Weimar-style? (Typical of human reactions when emotions run high, very few talk about middle-of-the-road alternatives.)

What do I think? First, some background to set the stage.

In the past few decades we experienced rapid asset inflation, combined with relatively mild consumer price inflation. Many perceived this to be a good development - and up to a point it was. After all, who doesn't want to see their wealth increase while paying low prices for goods?

Trouble is, you can't have it both ways for too long because asset prices must reflect a reasonable multiple of the income they produce ("rents"). Income derived from assets must be high enough to provide a competitive current return and to offset the risk of holding them. That is to say, dividends from shares, interest from bonds and rents from real estate must have reasonable yield ratios.

How do we know when assets reach unreasonable levels, i.e. how do we define a bubble? Greenspan claimed that it was impossible to do so and that we could only identify bubbles after they burst. Obviously, I disagree.

Apart from observing crowd psychology (i.e. maniacal behaviour), I believe the best fundamental indicator of a bubble is the relationship between earned income and debt. Don't forget that asset prices and debt levels are opposite sides of the same card: it takes lots of "money" (debt) to inflate asset prices. Debt, on the other hand, must be comfortably serviced out of earned income: wages, salaries, etc. When the two are considerably out of balance then the debt-asset bubble must and will pop.

Furthermore, things get really ugly when debt and asset prices rise very fast, as happened after 2000 (i.e. Sudden Debt). Earned income then has no chance to catch up to debt in an orderly fashion and the result is debt default and destruction, with a commensurate plunge in asset prices. That's exactly what is going on right now, of course.

Let's look at this relationship more closely. Below is a chart indexing home prices (Case-Shiller National Home Index), share prices (S&P 500), average hourly wages and household debt per working person. Obviously, assets and debt got way out of balance against income, particularly about 10 years ago.

 

High Debt + Low Wages = Asset Deflation, Eventually (Data: FRB St. Louis, S&P, BLS)
 

Notice how asset prices have now corrected to a significant degree, but household debt still remains high. That's because the Fed and Treasury are furiously pumping in public debt into banks' balance sheets to avert (and mask) household debt defaults. But this is a fool's errand: in the end all debts, private and public, must be serviced out of earned income. And since income is extremely unlikely to rise suddenly, debt must also come down, sooner or later.

A few months ago this blog's masthead used to proclaim: "We hold this truth to be self-evident: We cannot solve a debt crisis by issuing more debt". By definition, therefore, the only way to resolve this crisis is to allow debt to be destroyed in as orderly a fashion as possible, taking as long as possible in order to avert social consequences.

My view, thus, is that we are in for a long period of persistent asset/debt deflation that will eventually bring debts and asset prices into closer balance with incomes. At least that should be the aim of our policy makers. But, truth be told, I am not sure at all that they see things this way...

Time will tell.
 

Tiago said...

The issue is: how do the several existing powers perceive this crisis and how will they interact among themselves?

I think there is a massive attempt to maintain the status quo. But the the status quo is unmaintainable (at least for those who believe that growth is unsustainable).

One of the reasons for maintaining the status quo is that it is of the interest of people who have a tight grip on power (e.g., banksters). Call it class-warfare if you want.

But another (coming from well intended people, who care for the public good) is just wrong analysis: I was shocked with todays Bob Reich post. People are still completely hooked to the permagrowth way of thought. Bob should know better.

Good intentions might prove disastrous if based on wrong analysis.

But What do I Know? said...

Great analysis, Hell. The problem is that things haven't gotten bad enough to change; i.e., there are plenty of decision-makers who believe that we can go back to the "good old days" of five to ten years ago if we just do some tinkering around the edges and get people to believe again. Their efforts are being undermined by those that know the end is inevitable and are looking for ways to shelter themselves from the storm--I suppose there are those who are doing the former in public and the latter in private.

The shame of it all is that nothing really bad has happened yet--if we would take some pain now it would soften the blow down the road.

On Margin said...

Hell - Is there an "easier" way out of all this? Create inflation which creates wage growth - while the nominal cost of fixed rate debt stays the same? If as a whole the American consumer is over levered the politically palatable solution seems like inflation (money printing). I am obviously appalled by this, but I don't really have a vote. As a country, we like easy solutions - seems like inflation rather than debt reduction from restructuring is the easier of the two.

Thai said...

@Hell re: "the only way to resolve this crisis is to allow debt to be destroyed in as orderly a fashion as possible, taking as long as possible in order to avert social consequences"

Not to defend the people in power one bit, but isn't the key word in your posting today orderly?

At least key if you want to look at this from our leaders point of view?

Our brains' do have flawed heuristics when it comes to investment behavior. Our brains are irrational at times.

Work in prospect theory has shown people feel more than twice as much pain from a $100 loss (or the potential of a $100 loss), than pleasure from a $100 gain (or the potential gain).

All this debt is going to be destroyed one way or another but a massive debt destruction via deflationary credit crunch might not be nearly as orderly as the very same process via inflationary credit crunch.

Order is our leaders primary job.

I understand that if you are the skin of an organism that is in shock with hypotension, you are not going to be all that happy that the brain told the circulatory system to shunt blood away from you to other core organs. But the point is to keep the organism whole in the end.

Daniel in Paris said...

I certainly do not buy into the hyperinflation. The 1970s scenario is enough for me.

Except for a few bad memories and nurturing the neocon ideology, Volcker did it.

However may I ask why the current government that is unable to tighten budget or monetary policy, at least one of the two items, would be able to do it within 10 years. Doe Obama really want to wait for all baby-boomers to have quit work to start the painful payback efforts! That cast some doubts on the payment.

What prevents the administration to tighten now? Are they really expecting some kind of miraculous better times to do so? What better times ? The end of current wars is an acceptable answer. But who has anything like a decent agenda on this.

I recently re-read Rueff, a French economist than most of us here ignore in spite of his brilliant successes. Not as academic but via effective policy-making.

Rueff is adamant on the fact that fiscal policies are the key to balanced external accounts. In view of the aggregate level of debts, balanced public accounts, at all levels, should become a top priority. Not a simple temporary outcome of the current deflationary burst.

I have the feeling that the "fiscal expectations" are currently extremely low in the US. I am under the impression as well that there is a perception that balanced public budgets are deemed illegitimate. Am I wrong?

Combined with massive spending, this is certainly enough to trigger something that could approach hyperinflation. The countries that went this way were decent ones. Even the Weimar was a decent regime held by very decent gentlemen. But the payments for reparations for France and Belgium were deemed illegitimate. No way that the German people would accept to pay anything like reparations. No way to get it to accept anything like a tax-based pay-back.

On the one hand, would could believe inflation could reach Weimar level? But on the other one, in view of the current political climate, I find no possible positive outcome to the current situation. What am I missing?

Greenie said...

"Hell - Is there an "easier" way out of all this? Create inflation which creates wage growth - while the nominal cost of fixed rate debt stays the same?"

That's what the Fed is trying - 'lift all prices little bit so that debt feels less burdensome', isn't it?

Here is the problem. When an economy goes out of balance, inflation will push the sectors in the same out of balance manner. For example, last year we had huge oil bubble (oil=140) that finally broke the back of the consumer. See what happened since Dec. Government's attempts to inflate made oil price rise the fastest, and home prices not move at all. There is no way for the government to increase wages, but they can cut taxes. All tax cuts by Obama, however, got nullified by rising cost of oil. Also, Ben's attempt to bring down mortgage rates through purchase of MBS made treasury rates go up - resulting frozen mortgage market.

The market is a bitch for manipulators.

marcus said...

The government wants inflation, the financial "Wizards" want a new asset class to inflate and wrap "innovative products" around. Two powerful entities that will cooperate to get what they want. Stagflation anyone?

What is there left to inflate? Commodities? Maybe investment in Chinese and Indian domestic consumption and growth to complete the cycle. Scary thought huh kids?

Thai said...

Greenie is right. But it is also a case of steering our economy vs. foreign competitors.

A carbon tax is politically difficult because of ideology but somehow playing with monetary policy is not as difficult.

So if the Fed inflates commodities prices more than income, it will crimp our economy. But it will also cause commodity consumption relative to income to drop and the 900 lb commodity gorilla is oil and most of our oil comes from abroad.

If our oil consumption drops then our balance of payments drop as well AND the there is a strong boost to mostly domestic energy conservation industries (say LED lighting, smart grids, etc...).

I am sure there are a thousand other loops I am missing but my point is these things will work themselves out either way.

The issue for the politicians is really just an issue of confidence and order, e.g. getting people to believe it is not the end of the world while they do work themselves out.

June 11, 2009 12:45 PM

 

mich said...

Somehow debt doesn't disappear without repaying or defaulting. I don't see the former happening much so it's going to be mostly the latter.

Looks like the people who took the gamble are trying to spread the losses around as much as possible in as many forms as possible instead of taking responsibility and eating it themselves.

Savers (I'm talking global here; pension funds, price inflation, meh, you all know) and (future)taxpayers are of course easy targets. They do get unhappy and angry though.
What a waste.

June 11, 2009 4:30 PM

 

yoski said...

"in the end all debts, private and public, must be serviced out of earned income. And since income is extremely unlikely to rise suddenly, debt must also come down, sooner or later."

Not necessarily. The FED could theoretically print enough money to give everybody $1 million and all debts will be paid and we have inflation Weimar style.

The first attempts at this are the $8K bonus for first time home buyers. Now they (Dodd & Co.) are talking about expanding this nonsense to $15K for everybody. Cash for clunkers were owners of gas guzzlers get rewarded $4500 in tax dollars. This is the leading edge of pumping money which was created of out thin air (or at minimum could be created out of thin air) into the economy.

So far most of the money government spends is borrowed from suckers around the world. Eventually those suckers will either refuse to buy our debt (see Russia & China) or demand higher yields. Higher yields not only sink over extended home debtors but can do the same to governments. Eventually some very unpleasant truth will be forced on the big spenders in Washington.

Default or print up the difference. In the end there's no other way out, only those 2 options exist. Knowing how our poiliticians operate they'll opt for printing up the difference. That scenario is still many years out, but at the current rate we might get there sooner than later.

June 11, 2009 7:06 PM

 

Anonymous said...

perhaps part of the problem is resulting from globalization that brought about wage stagnation in the developed countries. While wages stagnate, the desire to keep up with the jones persists, and the solution is to increase debt.

Would there be a chance that policy makers can induce wage inflation? Via protectionism perhaps?

June 11, 2009 10:30 PM

 

Daniel in Paris said...

policy makers can induce wage inflation? Via protectionism perhaps?

No way than you can induce wage inflation of any kind in the current monetary statu quo! The peggings and monetary manipulations have to stop or we reverse to some fixed decent exchange system.

As long as we continue this way, industry will migrate to Asia. What sensible person would propose their children to work in anything relating to industry - aka transferable goods or services - here?

This problem is not about US debts. Debts are now spread all around the world now. Including in countries with no debt tradition aka Southern Europe.

Do not forget to include in the list the crazy level of debt currently funding the superb level of industrial over-capacity in China.

Of course, US and UK debts belong to the premier league since they boasted reserve-level fiat currencies and add a capitalist historica base...

This problem is first and foremost a monetary one. Debt is an outcome of the monetary system in place. Not the opposite even if there a feedback loop.

Currencies are an even more crucial infrastructure to economics than roads and banks... Their manipulation is even worse.

The so-called wage-price loop of the 50-and-60 was not the main feeder for the massive European inflation. Euro-dollars were in the driver seat. As much as unions.

June 12, 2009 5:31 AM

 

Big67 said...

"The so-called wage-price loop of the 50-and-60 was not the main feeder for the massive European inflation. Euro-dollars were in the driver seat. As much as unions."

Euro-dollars in the 50ties and 60ties?

June 12, 2009 7:03 AM

 

Daniel in Paris said...

"Euro-dollars in the 50ties and 60ties?"

Yes they built up consistently during that period on persistent and intense external US deficits. The associated dollar seigneurage triggered both an industrial boom in Europe - thanks America - and a significant part of local inflation.

This inflation remained under control and noone would argue now that the overall effect of the initial Brettons Woods system was not positive.

But the "fiat money as a reserve" system found its limits for the first time then during the 70s. Volcker made the trick. The US industry found a new youth.

But the problem is now up again on a much larger and trickier scale with China and pegging accross Asia to make it worse.

A l'aide Monsieur Triffin!

June 12, 2009 11:29 AM

 

Thee earl of obvious said...

Building on Anon 6/11 10:30 Do we got China by the nads or they have us?

What if they decide to increase wages and simultaneously invoke drastic protectionism policies. Then they would make everything and be able to buy everything ala the post war U.S.

June 12, 2009 12:54 PM

 

Edwardo said...

Yes, indeed, the asset deflation that we have seen to date in shares and housing/real estate dwarfs anything that has been created on the inflation front. If the game were called today, deflation would win the deflation/inflation contest in a rout. All this despite the authorities Quantitative Easing (monetization) experiments.

Clearly the QE gambit has failed as long rates, rather than staying low, have instead crept steadily crept, endangering any chance of putting a floor under R.E. which is essential to the banks balance sheets as all those credit derivatives are backed by real estate.

So, what now? Will the authorities, realizing that they are fighting a losing game, what with their attempts at keeping rates low, backfiring, reverse course. NO!

Despite the thesis that folks like Karl Denninger put forward, where yesterday's buying of the 30 year is some sort of harbinger that The Fed is about to reverse course on its QE, sopping up liquidity, and allow liquidation to occur, I would argue that draining liquidity has enormous political consequence that The Fed, namely Ben Bernanke, will not want to face.

To wit:

How do you justify reversing course when you have acknowledged countless times that the present economic downturn is still in force? If one's efforts via QE are literally causing credit to become more expensive anyway, which is deflationary, then why bother to be the bad guy who takes the punch bowl away. Let it be seen that you tried everything you could and that things simply did not work out.

What I am trying to say is deflation is coming because if the Fed continues their QE, rates go higher driving a stake through the stock market, business activity and last but not least R.E.

If the Fed says no more QE let things go we will get the same as the prop is taken away.

Caveat: How do we get hyper-inflation out of this?

We get it because our currency and bond market are shunned as investors realize that the entire nation is becoming California and we have no money to make good on bonded obligations.

The other way our bond market and currency collapse is because of the wild card factor which involves the revelation of massive fraud and manipulation at the highest levels of government.

At that point, when it is discovered, once and for all, that for example, the Fed is doing all sorts of in violation of its mandate...

http://zerohedge.blogspot.com/2009/06/zero-hedge-exclusive-is-state-street.html

we have capital flight. At that point a Weimar event becomes more than possible, it becomes likely.
I would further posit, that such an evolution could happen far more quickly than one might imagine.

June 12, 2009 1:59 PM

 

Edwardo said...

Sorry for my last post, what with its poor punctuation and various other problems.

The main point is that hyper-inflation could come as a result of a runaway deflation where confidence disintegrates to a critical degree in the nation's ability to raise revenue to pay for its already bonded obligations.

How it happens is that bond markets in all time durations are shunned causing the government to have to engage in pure unsterilized printing operations.

June 12, 2009 2:11 PM

 

Anonymous said...

Why no wage infation?

Indians taking white collar jobs.

Chinese taking blue collar jobs.

Mexican taking student and nigger jobs.

Only jobs left over are jobs as part of the ponzi scheme.

June 13, 2009 3:32 AM

 

marin belge™ said...

The main point is that hyper-inflation could come as a result of a runaway deflation where confidence disintegrates to a critical degree in the nation's ability to raise revenue to pay for its already bonded obligations.

How it happens is that bond markets in all time durations are shunned causing the government to have to engage in pure unsterilized printing operations.

Austrian economists will argue, along with Von Mises, that once a certain level of debt is reached, only hyperinflation and deflation can occur.

I'll add possibly in sequences. Unmanageable ones. That's in view of their most articulate writings that I'll buy into the above.

Not even paying the time to read again what Greenspan and Bernanke wrote on their so-called "handling" of interest rates.

Why are inconsistent economists with systemic failure as a background the joystick in hand whilst Volcker is left in the background? We all know the answer. The country would not like the cure. But there no other one.

June 13, 2009 4:31 AM

 

David Merkel said...

Good post. I have been sounding the same themes over at my blog. This ain't gonna end well, but the critical question is how it won't end well, and when.

June 13, 2009 8:13 AM

Thai said...

Edwardo, you probably already read this but I thought I would pass it along in case you missed it.

Regards

June 13, 2009 10:07 AM

 

Anonymous said...

Has this possibility crossed anyone's thinking?:

"...the banks’ free reserves at the Fed are just shy of $950 billion. This is off of a base measure of around $8 billion to $10 billion before August 2007. It’s a monster number. The Fed has created an awful lot of potential spending power. The money will show up as inflation when the banks withdraw it through the Fed and make loans, which would trigger the spending. I think the only way of avoiding it would be to pull a nationalization-style trick, not that I’m advocating it, but the Fed does think this way. They could say to the banks, “Remember that $950 billion that you had for your reserves? We’re now converting it into mandatory 10-year Treasuries, and that’s that.”

June 13, 2009 3:27 PM

 

Bazily said...

I still don't see how wage inflation happens in this inflationary cycle with 10% unemployment.

June 13, 2009 10:37 PM

 

Nate said...

First off, hyperinflation (in the USA, that is) is not possible short of some massive unforeseen war (that we lose). Weimar style hyperinflation was caused by the fact that Weimar held debt in foreign currencies, not their own. All of our debt is in dollars.

Hyperinflation does foreign holders of treasuries no good. What would the dollar inflate with respect to? There is no other reserve currency. Maybe in 50 years something else will crop up, but not right now.

I maintain that the amount of money lost through housing deflation will far offset the amount of money "printed" for the banks. Hello deflation. At best, we could have a balance between the two and get a really long lost decade.

On Margin: Theoretically, we could "inflate our way out of it" but in practice, I can't see it working without disastrous consequences. Perhaps if the bond markets were not a global thing...If it became clear that we were taking this road, the bond market would not be happy. Higher interest rates mean we need to issue more debt, which means we need more people to buy (unlikely), which means higher interest rates, which means more debt...you see the problem.

Treasuries are the last bubble. Housing was a HUGE bubble. Treasuries are the only asset class that could possibly "hide" the burst of the housing bubble. Besides, inflating anything else will screw over any type of recovery. Could you imagine what $5/gallon gas would do with 10% unemployment?

Daniel in Paris: I don't think "illegitimate" is the right term. More like a pipe dream. I talk to far too many people who don't understand the basic economics of our budget (what else would you expect from a populous with too much debt?) and none seem to understand the gravity of the situation. We have run a massive defect for so long nobody seems to remember what the government was like and I fear so many services will need to be cut that no politician will have the balls to actually do it until it is too late.

What's the saying? You can count on Americans to do the right thing after exhausting all other options? Sounds about right.

June 14, 2009 3:39 AM

 

yoski said...

Nate:

"Theoretically, we could "inflate our way out of it" but in practice, I can't see it working without disastrous consequences.

Perhaps if the bond markets were not a global thing...If it became clear that we were taking this road, the bond market would not be happy. Higher interest rates mean we need to issue more debt, which means we need more people to buy (unlikely), which means higher interest rates, which means more debt...you see the problem"

Right. But obviously this is not sustainable. At some point nobody will loan US any more money regardless of the interest rate. Would you loan a junkie $100 even if he promises you to pay you back $200 the next day? Only a fool would and eventually the world will run out of fools

So at that point some very unpleasant decisions will be forced down our throat. Default or monetizing the debt. Those are the only 2 choices once we reach the end of the road we're currently on.

June 15, 2009 8:33 PM

 

Edwardo said...

Mark my words. The notion that you can't have a hyper-inflation in a reserve currency is going to be proven to be absolute balderdash. The Chinese are quite prepared to take the hit on their U.S. sovereign debt holdings.

To answer the question:

The hyper-inflation would occur against anything that is seen as having real instrinsic value, food, land, gold, silver, (don't laugh) objet d'art.

This is a confidence game my friends. And when, not if, that goes for good, it means that there will be far too few lenders to allow us to escape Weimarization.

June 15, 2009 10:25 PM

Thai said...

... AND, if Obama taxes health insurance AND makes health reforms, all the dreams of the gold bugs will be swept away in one fell swoop (along with much of the earnings they have put into gold).

Betting on the wims of policy people seems the worst of all possible bets as you literally have no idea what they will do in the end.

You are playing a very dangerous bet indeed.

June 15, 2009 10:46 PM

 

fajensen said...

@Thai: ... AND, if Obama taxes health insurance AND makes health reforms,....

Cannot happen: Remember that Democrats always Embrace and Embellish the worst stupidity of the outgoing republican administration ;-)

You see, Obama was too weak to break the bankster-oligarchs; having shown this to the world, he will not have more luck with the medical-insurance cronies!!

Having failed yet again, Obama - to show the world that he is not a complete pussy (and divert attention away from the total lack of performance on USD-paper, including the USD itself) - he will run off and bomb someone like maybe North Korea ...

I would still not buy gold though!

June 16, 2009 5:25 AM

 

Anonymous said...

I tend to agree with On Margin.

I can't see the Obama administration opting for debt destruction, (which they should).

The path of least resistance is to to reduce the real value of debt via inflation. The dollar is set for more devaluation

[Jun 09, 2009] Don't believe the hyperinflation hype - dare to make cuts 

Telegraph

Flush from last year's 234pc rise in their Black Swan Fund, they are betting that quantitative easing and war-time deficits have sown the seeds of inflation reaching "10pc, 15pc, 20pc, or more". They capture the mood of the times, but are they right?

We know that the Fed's balance sheet has exploded (to $2.07 trillion), but that is only half the story. Data from the St Louis Fed shows that the "monetary multiplier" has collapsed from a decade-average of 1.6 to the depths of 0.893. The "velocity" of money has slowed to a crawl.

Professor David Beckworth from Texas State University said the Fed's efforts to boost the money supply are barely keeping pace with the deflation shock. Stimulus is not gaining traction. The credit system is broken.

Where will the inflation impulse come from given that capacity use is at a post-war low of 68pc in the US, and nearer 60pc worldwide? The immediate threat is wage deflation.

• I usually agree with Mr Evans-Pritchard however in this instance he is absolutely incorrect. Inflation does not, I repeat, NOT require a pickup in the economic cycle. There are countless examples of economic contraction matched with gross inflation. Also ignored is the fact that the US requires gross inflation to extricate itself from its own promises. Gross monetary inflation is inevitable despite asset deflation.

  Walkdontrun

  on June 09, 2009

  at 10:31 PM
   

• The numbers you provide us with definitely indicate that economies around the world are contracting, but who cares? The inflation we are concerned with refers to the excessive printing of currency which promises an erosion of purchasing power.

  I wouldn't take seriously any stats coming out of OECD, or so called "independent" bodies commissioned by governments.

  Least of all I would be extremely skeptical of any stats coming out of the US Treasury and Brussels.

  The message we get from financial markets is probably still the best guide we have to what is going on and a number of indicators coming from markets, and not politicians, suggests inflation is more likely than deflation going forward.

  costas

  on June 09, 2009
• "There are reasons, other than rising inflation expectations, to explain why Government bond yields are rising. Firstly, the huge rise in supply. Secondly, the fear that Governments will default."
  
  BINGO
   

FT Alphaville » Blog Archive » It’s not a liquidity crisis, it’s an energy crisis stupid

Posted by Izabella Kaminska on Apr 30 15:34.

While the world’s best brains work furiously to try and alleviate the current financial crisis with all sorts of monetary and fiscal measures, Michael Lardelli posting on Australia’s ‘Online Opinion’ platform presents another explanation for the crisis.

Lardelli’s explanation notably doesn’t blame liquidity, but declining global energy resources.

Bear with us, his reasoning is pretty convincing. First, consider Lardelli’s following point (our emphasis):
No living or manufactured thing exists on this planet without energy. It enables flowers and people to grow. We need energy to mine minerals, extract oil or cut wood and then to process these into finished goods. Without energy the goods would not exist so we can think of each product as containing “embodied energy”. So the most fundamental definition of money is that it is a mechanism to allow the exchange and allocation of different forms of energy. The economy is energy.

Quid pro quo,  if the most important source of energy is hydrocarbon-based,  sharp fluctuations in hydrocarbon supplies will have an effect on the economy.

As Lardelli explains:

Until recently (about 2005) the world economy was growing. The number of people has been increasing which requires increased production of food, clothing and shelter - the basics. On top of this, many of us have been using more energy than previously - to travel farther, eat more food, buy additional clothes and enhance our shelters. Until 2005 we could expand our energy use to meet this demand. This is something we were able to do - with occasional interruptions - for the past 150 years. However, after 2005 we could not expand our energy supply. In other words we could not expand the world economy.

The important point being:

That is not to say that we did not try to expand the world economy after 2005. However, much of the expansion that occurred was an illusion. In many industrialised nations a great deal of “money” was created (by increasing the money supply and other means) but it did not correspond to an increase in energy use. This is illustrated by what happened in the USA, where the rate of money creation increased greatly after 2005:Lardelli supports the view of rampant money creation since 2005 with the following chart depicting M3 money supply — a statistic the Fed actually stopped compiling around 2006.

Others nevertheless  stepped in to duplicate the measure and Lardelli uses their data to complete the time-series.

What it shows is the extent to which money creation tried to compensate for energy supplies in driving global growth, but failed. According to Lardelli, the financial crisis proves the move was simply unsustainable. What’s more, a global shock via GDP contraction was actually needed to rebalance the world in preparation for the growing scarcity of energy supply.

You might ask in that case where is the associated spike in energy prices that comes with such a rebalancing?

Lardelli feels the notion typifies the economic rather than scientific view of how the energy problem will be resolved. Economists, he says, believe scarcity will ultimately raise prices via market intelligence,  encouraging investment in new alternative sources. In that scenario there is no ultimate limit to how much energy humanity can use. That is not the ’scientific’ opinion however. As Lardelli explains:
If we view the economy as a thermodynamic system (since “the economy is energy”) we would say that a high energy price leads to the greater allocation of a society’s current energy production into the production of more energy. But there is a problem - the energy investment required for new energy production from mined sources increases with time.
 

Which means:
No source of energy will be exploited if the energy it yields is less than the energy investment required to exploit it.

Which, consequently, is the situation that is currently materialising in the market — the price of oil is falling below the level most oil majors would need to consider investing in more expensive alternatives. This comes despite voluminous calls from international energy experts that investment is critical to avoid a future crisis. As Lardelli goes on to explain:

The world’s energy production is now declining and the profitability of energy production is declining at the same time. This means that the net energy available to support activities other than energy procurement will decrease much faster than the fall in total energy production. We are approaching a “net energy cliff” that gets very serious when less than five units of energy are produced for each unit of energy invested.
 

He reprises the following chart reflecting ‘energy return on energy invested’, first published on The Oil Drum blog:

So how to stave off the perpetual global contraction that will inevitably come with declining energy supplies?

Well, Lardelli says nothing short of a wartime crash programme will do. Huge proportions of the world’s remaining oil energy simply must be diverted into building alternative sources like nuclear power stations and solar arrays etc.

Unfortunately this is unlikely to happen, he says, especially in democratic nations. As he concludes:
…it would require large, voluntary reductions in living standards in the midst of a serious and worsening economic crisis. The immediate cries for help now (e.g. unemployment benefits, company bailouts) will outweigh any future possibility of improved living standards. Wartime crash programs can work because a nation’s population literally has a gun pointed to its head - the population fears death at the hand of the enemy. Energy decline can be just as deadly as any human enemy but, like climate change, its effects are slower and most people do not understand enough about energy to fear its loss.

Related links:
Energy is everything - Online Opinion
A commodity anchor, or oil as money - FT Alphaville
M3, where art thou? - FT Alphaville

FT Alphaville » Blog Archive » Compartflation

Why take two price scenarios into the shower, when you can just take one?

Introducing “compartflation” an economic environment in which both inflationary and deflationary forces compete to generate recession or stagnation.

This is not quite stagflation, as not all prices are rising — just a compartmentalised set, namely in this case commodities due to issues of scarcity.

The argument has recently been set forth by Gregor MacDonald. As he writes:

As I was laying out earlier this winter in Recession vs. Collapse, we are experiencing a deflation that appears to trigger both reflationary policy and reflationary responses in the dollar and commodities–which then leads to more deflation.

This is a process that likely began as early as the Summer of 2007. In this deflation-inflation oscillation the metronome ticks first one way, and then the other, causing uproar and loud talk each time among the inflationists, and the deflationists.

As I have been suggesting this year, why the need to choose? We have very likely been in an inflationary recession for nearly two years now, with massive deflation in housing and yet stubbornly higher food, energy and health care costs–the latter well above the price levels of just a few years ago. The risk, in my view, is that both trends now accelerate. And, that we experience next something more akin to an inflationary depression.

The above presumably renders traditional monetary policy focused on measures such as the CPI and RPI somewhat useless as inevitably responses will always be over or under-done.

Price elasticity, meanwhile, also has to be factored in, especially when looking at prices of energy commodities. Gregor looks back at similar peak periods in other commodities like wood and whale oil, noting how increased volatility transpires post the peak; namely before the consumer is able to adjust. As he explains:

When the post-peak phase gets underway the price amplitude increases even further, playing havoc with supply and demand. As demand gets killed, and then finally collapses, it causes confusion about supply. But then, as demand returns, any questions about supply are soon answered as demand once again bumps up against the supply ceiling.

This is exactly what’s happening now with crude prices. And oil’s “dollar-hedge” role ups the volatility even more so.

The issue is that there is no middle ground. In Gregor’s model prices inevitably continue to overshoot and undershoot. The “oil shock” originates not from high prices, but the extreme volatility of prices: too high then too low.  To realise the dangers of this you just have to consider the divergent reactions to oil’s fall last October — joy from consumers yet concerned outcries from producers.

This sort of volatility, meanwhile, also hits business productivity as companies fail to keep up with the shifting price environment.

All manner of industries will be affected too: from energy firms and their energy investments to energy dependent firms (so almost all), especially those with major hedging strategies. Basically, anyone who needs to factor in energy or food prices into their daily business models won’t be able to, or the margin of error will be so wide it will severely impact the reliability of profit projections . In essence profit forecasting could become completely unreliable as prices oscillate in an extreme fashion within the band, which looks a little like this according to Gregor:

While prices may eventually plateau, it will only be at the extreme cost of growth and price stability generally. A falling price environment in other goods and services may also very possibly ensue as consumers try to buffer up for the now expected periods of  higher energy prices, an enforced type of consumption smoothing on the population.

FT Alphaville » Blog Archive » Coming round to compartflation

Dennis Gartman, of the Gartman Letter, is one of the latest market watchers to advance the idea of both an inflationary and deflationary environment in the future.

This follows nicely in the footsteps of Gregor Macdonald’s recent “compartflation” observations.

Market folly provides a nice summary of Gartman’s views:
He explains that due to the weak US dollar complex, commodity prices are going up, indicating inflation in assets. He specifically cites the action in grains, crude oil, and copper. In fact, in the past, Gartman has even said he could see gold being the world’s reserve currency. So, while those assets are signaling inflation, he cites deflation in employment and labor prices. Additionally, he points out that housing prices are in a deflationary spiral and he says that, “homes are not going to go up for a long time.”

Although Market folly adds:
Curiously enough, Gartman thinks that the impact on the consumer will be negligible. We’re not exactly sure how his rationale behind that works out though.

Related links:
 

Compartflation - FT Alphaville
It’s not a liquidity crisis, it’s an energy crisis stupid - FT Alphaville
Niall Ferguson fights back - FT Alphaville
 

The Great Depression II meme

Submitted by Edward Harrison of the site Credit Writedowns.

Last night I wrote an article reminding you that downside risk remains in the global economy. While I have been singing a more bullish tune in regards to the prospect of a technical recovery in 2009, I am concerned about a double dip as a likely outcome.

And for the record, I have said I see a recovery happening probably in Q4 2009 or Q1 2010 (see my post “The Fake Recovery”).

The real question is how robust a recovery are we going to have and this is directly related to why the jobless claims series has been sending a false signal. Now, initial claims has been sending a recovery signal since January. Yet, continuing claims continued to rise more quickly until last week. In the past, one had seen these two series as harbingers of imminent recovery. But, I am talking Q4 here. Why? Deleveraging.

In the end, consumers are going to be forced to reduce debt and save more in this more cautious financial environment. Team Obama does seem intent on re-kindling animal spirits but the personal savings rate has gone up nonetheless. This will be a drag on GDP growth going forward and means that the economy’s rebound will be more tenuous and slower to develop. In my view, this means recovery will be delayed and once it gets going it will be weak. The potential for a double dip is very high.

So, to be clear, first derivatives are starting to turn up and since recession is a first derivative event, we are probably going to see an end to this recession soon enough. But, with structural problems still remaining, the U.S. economy will be weak for a long time to come.

The major reason I see a double dip as more likely than not is the policy response. The Munchau post I highlighted last night certainly should leave you with the impression that policy makers are not taking continued downside risk very seriously. But, I tend to see this as very much a predictable outcome. Back in November I wrote a post called “Beware of deficit hawks” in which I argued that a now-we-can-normalize-policy meme was sure to take hold as soon as the first signs of recovery appeared.

Recently, deficit hawks have been pushing a nefarious line of argument that I need to debunk right here and right now. The line goes as follows: we need to spend government monies now to get the economy back on its feet. In a couple of years, we can signal all clear and then raise taxes on the middle class in order to reduce the deficit again, much as we did in 1993.

While I agree that deficits will need to be eliminated, this line of thinking risks a repeat of 1937-38 in the U.S. and 1997 in Japan and must be refuted.

This line of argument, entirely predictable, does seem to be exactly what is taking place right now. Witness Paul Krugman’s remarks in his most recent post Stay the Course.

The debate over economic policy has taken a predictable yet ominous turn: the crisis seems to be easing, and a chorus of critics is already demanding that the Federal Reserve and the Obama administration abandon their rescue efforts. For those who know their history, it’s déjà vu all over again — literally.

or this is the third time in history that a major economy has found itself in a liquidity trap, a situation in which interest-rate cuts, the conventional way to perk up the economy, have reached their limit. When this happens, unconventional measures are the only way to fight recession…

The first example of policy in a liquidity trap comes from the 1930s. The U.S. economy grew rapidly from 1933 to 1937, helped along by New Deal policies. America, however, remained well short of full employment.

Yet policy makers stopped worrying about depression and started worrying about inflation. The Federal Reserve tightened monetary policy, while F.D.R. tried to balance the federal budget. Sure enough, the economy slumped again, and full recovery had to wait for World War II.

The second example is Japan in the 1990s. After slumping early in the decade, Japan experienced a partial recovery, with the economy growing almost 3 percent in 1996. Policy makers responded by shifting their focus to the budget deficit, raising taxes and cutting spending. Japan proceeded to slide back into recession.

And here we go again.

You will notice that Krugman is making the exact point I made seven months ago – testimony to how inevitable this all is. I suggest you read his post in full because his arguments need to be taken seriously if we are to avoid a repeat of 1937 and 1997. Quite frankly, I am not particularly optimistic that we are going to see policy makers stay the course. After all, the budget deficits in the U.K., the U.S., and Ireland (to name three of the four original bubble economies – Spain is the other) are exploding. Willem Buiter has already warned that the U.K. and the U.S. cannot credibly maintain these deficits (see his U.K. post here and U.S. post here).

Pre-Lehman, I was very much in the deficit hawk camp (see my post “Confessions of an Austrian Economist”). But, those days are over, Lehman’s bankruptcy was the shock that guaranteed a debt deflationary outcome in the U.S. and for the global financial system. If we are to deleverage, credit is going to contract and that will mean recession. The only way to avoid this – and a potentially destabilizing deflationary spiral – is for government to temporarily fill in the gap until we reach a sustainable point of recovery. We are nowhere near that point now. I warned in November that

…the Obama administration is going to be beset by parties using the immediate deficit reduction line of argument: Can we really balloon the deficit to $1 trillion and expect business as usual in 4 to 5 years given the precedents and given the low savings and high debt?

My answer is no. The U.S. economy cannot possibly work itself out of the greatest financial crisis in some 70-odd years in a mere 4 years and then expect to raise taxes on the middle class without a major recessionary relapse.

So, when you hear policy makers talking about reducing the deficit as soon as possible, what you should think is 1938 and continued depression. While all of this is still a number of years off, we need to nip this talk in the bud now before it becomes orthodoxy.

Buiter’s view of the U.S. and the U.K. as Banana Republics demonstrates that there really aren’t very many policy options available here. But, that is the outcome of years of bubbles and unbalanced growth. Think of the United States as Argentina or Latvia writ large. The U.S. does need to demonstrate a longer-term path to fiscal policy normalization to maintain investor confidence. This is something that is not happening. (see David Leohardt’s piece from last week).

Going forward, in all likelihood, we are going to see a move toward fiscal prudence and policy normalization. Stimulus will be seen as irresponsible. This is already the view amongst many politicians in the U.K., the U.S., and Germany (and the Czechs have been making the same noises in Central Europe). So, when the U.S. and global economy relapse into depression because we did not stay the course, you will know why.

34 Comments

Close this window Jump to comment form

 Anon1 said...

First?

Anyway, I just don't understand the idea of "recovery". What will so-called "recovery" be based upon? The service industry? Is everyone in the US who isn't in finance supposed to become hotel maids, waiters/waitresses, butlers, Wal-Mart door greeters, and cashiers? Precisely what is there in the USA to based an economy upon that doesn't merely require that everyone borrow up to their necks (using, once again, their homes as ATMs) to buy stuff they cannot actually afford nor need? What is the recovered economy to be based upon?

Seriously. What is there?

June 15, 2009 9:30 AM

 Edward Harrison said...

Anon1,

Read my post on Economic recovery and the perverse math of GDP reporting. It should give you a fairly good feel for why what I am now permanently referring to as a technical recovery is not something that people will see as recovery.

Roubini put it best: even 2010 will feel like a recession

Let me know if those posts help.

June 15, 2009 9:47 AM

 Moses Kim said...

Roubini is right, except 2010 will feel more like a Depression.

I must respectfully disagree with your view that the Government should temporarily spend its way out of this crisis. Greenspan's policies directly led to the current crisis, and reckless spending right now will guarantee an even greater crisis in the future. The Austrians had it right: let the failed companies fail, and clean the system once and for all.

June 15, 2009 10:14 AM

 Edward Harrison said...

Moses, I appreciate your respectful tone. I do feel conflicted about the call for stimulus - and so understand your concerns. In due course, we will see policy makers make a definitive choice and the repurcussions will be plain to all. I hope they choose wisely.

June 15, 2009 10:19 AM

 Brick said...

I Suspect real recovery will come from one of three places. Innovation, market consolidation, or emerging market growth. Since there have not been serious steps to bolster innovation and zombie companies have hindered consolidation that leaves emerging markets and I would be looking to India there.

It is perhaps a misunderstanding that those who propose a better balanced fiscal policy are asking for the stimulus plug to be pulled. What is wrong with refocusing current spending as a starting point, apart from upsetting a few politicians pet projects. Just how much of the recent fiscal stimulus could have been better spent in the economy?
The trick is to get the right balance of stimulus to the real economy, and debt load. Neither throwing money at everything but the real economy nor spending until creditors pull the plug seem sensible options.

June 15, 2009 10:41 AM

 Anon1 said...

Moses, I must disagree in part. I do not see stimulus spending as meaning, in any way, bailing out banks and other criminal organizations. I see stimulus spending, done properly, as spending from the bottom up rather than trying to feed trickle down (piss down is more accurate).

Spending must occur on infrastructure (Remember any bridge collapses recently? Want more?): road and bridge REPAIR and maintenance (not new roads and bridges), NEW passenger rail track separate from the crappy freight track it depends upon now, new/more passenger rail in municipalities and across the nation to help get people out of cars, off the highways, and into more eco-friendly and efficient means of travel, investment spending on alternative energy instead of continuing with coal/oil, MORE funding for college education, etc.

Do NOT spend on billionaires, banks, and hedge funds. Screw them.

CUT military spending and quite most of our 750+ overseas military bases. We'd save billions a year AND still be be spending more than any possible opponent even if we cut "defense" spending (yeah, right, defense) by 50% for starters. Cut all corporate subsidies including agribusiness support. Increase taxes back to what they were on the upper income levels BEFORE Bush/Cheney came along. Then slowly ratchet them back up to where they were under Reagan, at least. They'd STILL be rich, fat, dumb, greedy, and "happy" but they would be paying back into society rather than leeching off of it as if they are some entitled aristocracy.

June 15, 2009 10:56 AM

 Moses Kim said...

Anon1,

You are correct, stimulus spending is not the same as bailing out banks and other failed institutions. However, bailouts and other "rescue" programs are crowding out spending that could be used for more productive purposes -- many of which you named. Effectively, taxpayers are getting screwed either way.

June 15, 2009 11:17 AM

 redst8r said...

Edward:
You referred to: "... - and a potentially destabilizing deflationary spiral - ..."

Many have used this as the rationale for the ongoing and massive "stimulus" spending and multi-trillion dollar deficits over the next few years. Yet I have never seen a description of this process.

That is, you indicated the collapse of Lehmann was the trigger for you to swing from a deficit hawk to (what I guess is) a deficit dove.

If the government had not bailed out Goldman, Morgan, Citi, BofA et. al how would our current economic situation be different? Excluding the obvious that more financial industry workers would be out of a job - but not likely that many!

How much worse off would we be? And just why is a deflationary spiral so terrible after so many decades of inflationary spirals that brutally penalized savers and investors?

I'm still trying to find out what the so-called financial domino effect would have been and why it was so important to prevent that instead of having government around afterwards ready to provide assistance to affected individuals.

June 15, 2009 11:24 AM

 Edward Harrison said...

redst8r,

you ask a good question because many people are conflating stimulus with bailout and that is something I would like to avoid. There are three five separate issues:

1. bailouts aka crony capitalism
2. monetary stimulus in the form of low interest rates,
3. monetary stimulus in the form of quantitative easing aka printing money
4. monetary stimulus in the form of qualitative easing
5. fiscal stimulus

I would say that I generally reject the first 4 for various reasons. #1 leads to moral hazard and the last three are inflationary, bubble-inducing mechanisms. That leaves you with #5, fiscal stimulus. Why is this important?

If we had zero stimulus, the reduction in credit availability would induce a contraction in credit which would reduce real economic output which would destroy capital leading to writedowns and a further reduction in credit in a downward spiral. There would be a significant dead-weight loss from such a spiral. This is what we saw in the Great Depression.

So the question is what can be done to arrest this self-reinforcing dynamic. I answer that question in my post "A brief philosophical argument about the role of government, stimulus and recession."

June 15, 2009 11:39 AM

 Edward Harrison said...

Oh and as for bailouts, I think we should have seized bankrupt institutions rather than bailing them out at taxpayer expense.

June 15, 2009 11:40 AM

The problem I see is that the administration is taking a very short-term view of this crisis. There are no plans to spur the growth of new domestic industry, most of the stimulus money is going to existing industries, such as construction and banking, in order to preserve overcapacity developed during the credit boom. So until something is done to revive industrial production, everything else is rearranging the chairs on the Titanic.

June 15, 2009 12:29 PM

 DownSouth said...

 

@Moses Kim and
@Anon 1

If history serves as any guide, neither the Austrians nor the Keynesians offer a credible solution for what ails the U.S.

When Great Britain began its long decline in the 1860s, it was an Austrian/libertarian's wet dream--extremely low taxes (during the 1880s and 1890s public spending between 10 and 11% of national product, and more than 50% of tax revenues derived from consumption taxes so that the tax burden fell disporoportionatly upon the the poor and middle classes), extreme fiscal austerity (doles for both households and businesses were all but nonexistent, and of course there were no "bailouts"), national budgets were balanced with little public debt (for instance in 1887 total government expenditures were 87.4 million pounds and the debt stood at only 26.2 million pounds, and by 1900 the public debt had been reduced to a mere 19.8 million pounds), and the reign of free-trade and laissez-faire was all but absolute.

And yet the economy ground inexorably downward, losing ground relative to the rest of the world.

So the solution the Austrians offer is no panacea, unless one is willing to ignore or rewrite history.

Keynesian spending worked for the U.S. in the 1930s (deficit social spending) and the 1940s (deficit military spending) because the U.S. emerged from WWII the most powerful nation in the world. Deficit spending, however, wasn't so kind to Great Britain. The cost of two world wars with a Depression sandwiched in between left the country heavily indebted, and Britain lost its preeminent position in the world.

Tolstoy in War and Peace observed that:

The human mind cannot grasp the causes of phenomenona in the aggregate. But the need to find these causes is inherent in man's soul. And the human intellect, without investigating the multiplicity and complexity of the conditions of phenomena, any one of which taken separately may seem to be the cause, snatches at the first, the most intelligible approximation to a cause and says: "This is the cause!"
~

I think that people also tend to grasp upon that cause that bolsters or justifies their ideology. As Rienhold Niebuhr observed in "Ideology and the Scientific Method":

Any social theory therefore has some kinship with the procedures of a Rorschach test, which is more revealing about the state of the patient's mind who makes it than about the inkspots which his imagination interprets in terms of various configurations.
~

Is there any policy Great Britain could have followed to arrest its decline? I suspect there was not. My belief is that Britain's rise to world prominence, as well as it's decline (and by comparison also those of the U.S.) were due much more to developments that lay outside the nation's control than within. Aaron L. Friedberg in The Weary Titan gives but one example:

By the second half of the (19th) century, however, the opening of vast areas of the American plains to cultivation and the development of railroads and refrigerator ships to bring goods to market were helping drive high-cost British producers of grain and meat out of business.
~

British exceptionalism did not die an easy death, and I suspect American exceptionalism will not do so either.

June 15, 2009 12:40 PM

 Paul said...

Lehman’s bankruptcy was the shock that guaranteed a debt deflationary outcome in the U.S. and for the global financial system.
***
I keep hearing this again and again, but can someone explain why a poorly run investment bank going BK causes a WW financial system meltdown?

A simple but detailed explanation would be greatly appreciated.

June 15, 2009 12:44 PM

 Edward Harrison said...

Paul,

I wrote this post the day after Lehman went bankrupt. It is not 100% prescient, but it does show that much of the deleveraging was wholly predictable:

http://www.creditwritedowns.com/2008/09/lehmans-bankruptcy-putting-horse-before.html

Lehman should have been seized or a framework to do so should have been worked out in advance to liquidate the firm without systemic risk (you will notice I am not arguing that it should have been bailed out).

The timeframe between Bear and Lehman gave ample opportunity to deal with the fallout from a Lehman failure. But, free market ideology got in the way.

June 15, 2009 12:50 PM

 Steak113 said...

Since we're only going off of two datapoints I would propose the following:

Removing stimulus before structural changes are in place is what causes this double dip. In both instances of Japan & the GD, few of the hard choices had been made.

I posit that countries that take their medicine early can cut their stimulus early and this debate of pulling the rug too soon is absurd. Since we're never going to make structural changes, whenever stimulus is removed (1-5-10 yrs from now) we will have the double dip. I further posit that removal of stimulus in those examples brought on the REAL crash that finally led to structural changes that never would have happened were the economies still on heroin.

June 15, 2009 1:16 PM

 Matthew said...

Isn't it possible that stimulus is appropriate for reserve-currency economies and not for those of weaker ones? Having lived in Central Europe for some time, it would seem to me that countries not using the Euro just aren't able to borrow to fund stimulus at the same rate as the USA or other nations with more stable currencies. Also taking into account the extremely high percentage of export in the GDP of countries like the Czech Republic, Poland, etc. isn't it reasonable to conclude that such countries should restrain from potentially disasterous levels of foreign currency debt? Never mind running up debt in their own currencies, which may not be supportable by the small tax bases which will not get too much bigger over a 5-15 year perspective...

June 15, 2009 1:17 PM

 Hugh said...

I agree with the post. I would say that Keynes worked in the Great Depression and that the lesson of 1937 is that fiscal stimulus needs to continue for as long as needed. I would also say that while initial fiscal stimulus is most easily applied to traditional infrastructure and companies, we should be thinking of a new sustainable industrial policy for the country and using stimulus as a bridge (or at least part of the bridge) to get us there.

June 15, 2009 1:46 PM

 barnaby33 said...

Seems to me you are arguing a circle jerk. Unless we live beyond our means, we will back into recession. That is the very definition of unsustainable. Spending more money than we could reasonably collect in taxes (even including inflation) is what got us in this mess. The ONLY way out is to spend less, period. Eventually enough people will realize this. Unless of course you are in the camp that the govt can go on borrowing, ahem printing, money and shoving it down everyone's throat. This isn't just about near term spending. Its about the massive entitlement mentality that America has spent 3 generations building.

If we have more deflation to undergo (I firmly believe we do) it is because we spent to freely and saved far too little. The sad thing is that not even the concerted efforts of global central banks will be enough to stop this, though they will destroy what is left of the middle class trying.

June 15, 2009 1:49 PM

 Richard said...

Edward, your work in this field is excellent, but allow me to make an ideological objection: you may be making the mistake that an economic recovery is the primary goal of policymakers within the government, and especially the Fed and the Treasury

But there is an alternative, namely that the true goal is consolidation, an oligopolization of financial services, and through that, an even stronger grip upon the rest of the economy by them and the investors associated with them

after all, policymakers have already made several important decisions that benefitted the financial sector, decisions that seemed pretty dubious from an economic standpoint, haven't they?

so, if forced to choose between a possible "double dip" recession, but one that intensifies financial sector control over the economy, or pushing forward sustained economic growth that might threaten the permanent consolidation of their power, which one do they choose?

in that case, then, maybe, a double dip recession isn't so bad

June 15, 2009 1:56 PM

 viking said...

credibility killer

harrison you can't have it both ways

June 15, 2009 2:58 PM

 JR said...

Hi DownSouth,

You brought a lot to the table there, but perhaps we could start with the basic stuff.

Before dismissing the Austro-libertarian perspective as wrong or whatever else, you might be interested to learn what they think, and in particular why they do not consider conditions in 19th century England to have been "Austrian/libertarian's wet dream." In fact, they consider it the opposite.

Hint - expansionary monetary policy is the anti-thesis of the free market.

June 15, 2009 4:28 PM

 Leo Kolivakis said...

Richard wrote:

"But there is an alternative, namely that the true goal is consolidation, an oligopolization of financial services, and through that, an even stronger grip upon the rest of the economy by them and the investors associated with them."

Bingo! You got that right, consolidation and concentration of power. It's exactly the Canadian model. In the U.S., you got way too many banks running amok and in Canada you essentially got an oligopoly of the Big Six. Sure we got tighter regulations but they have a tight grip on all financial services.

cheers,

Leo

June 15, 2009 4:48 PM

 DownSouth said...

JR,

By all means, if Great Britain during the the 19th century did not live up to your idea of an Austrian/libertarian wet dream, please cite specifics as to why not. All the information I cited is from Aaron L. Friedberg's The Weary Titan: Britain and the Experice of Relative Decline.
~
By the way, I failed to mention that Great Britain was on the gold standard at all times during the 19th century:

http://www.knowledgerush.com/kr/encyclopedia/Gold_standard/

There was an error in my earlier comment which I would like to correct. It should have read debt service amounted to only 26.2 million pounds in 1887 and by 1900 had fallen to 19.8 million pounds, the national debt having declined from 736.1 to 635.4 million pounds.

I don't see how you could claim that Britain at any time during the 19th century had "an expansionary monetary policy," but like I said, I'm all ears.

June 15, 2009 6:37 PM

 

 

 Detroit Dan said...

Wow! DownSouth that was a tremendous post! I'll have to investigate Friedberg's book. Thank you.

And thanks to Edward Harrison for getting this excellent discussion rolling...

June 15, 2009 7:13 PM

 cpic said...

I think it is important to understand we are in a D process as most of us do

therefore when we fall from 100 to 92 and then bump up to 93.5 (this fall or spring) it is as much a recovery as it is the possibility it resembles a dead cat hitting a tree on the way down and bouncing

i think (using the number's in the last paragraph) stimulus spending and re-stocking inventory's may cause the cat to bounce to "94-95" but i think the two keys to where we head in mid 2010 and beyond are (not to mention ecnomic strength dependent on more factors then pork spending goosing GDP)

1. A increase of lending into real economy (small businesses)

(CRE exposure will be a large drag on the smaller banks that had been lending)

(we shall see IF Ben and the gang's continued velvet glove treatment of banking cartel expunges bad assets to give banks a incentive to lend)other wise awful employment and corporate earnings enviornment = less risky use of bank capital than lending

2. THE PRODUCTIVITY of the DEBT going foward.......not into zombie banks but into Real pro growth strategy's as outlined by woody brock in "the end game draws nigh" great piece if you haven't read it

You want to know what SADLY the real shape of this D process will likely be (minus some grand technological advancement) (or lobotomy on Politicians and non-elected Elite planners)

picture exactly half a W then hang another half W from that and then flatline ...edit (where the middle of W is half the peak of the beginning lol it shows up different when posted)

where likely to be double dippin and the second dip will take us "significantly" below the trough of the first and then unless enough zombied out citizens raise a fist we may then truly welcome ourselves to the new normal....complete with a sobering two tier caste system

I hope we get credit into the real economy and decide to pursue more aggressive stategy's that maximize the productivity of debt!

what ya think edward

June 15, 2009 7:23 PM

 Peripheral Visionary said...

I think Voislav has the best comment thus far. There has been much talk about an eventual recovery, with precious little attention paid to just what that recovery might look like; at this point, it is a hope and nothing more. Hardly a basis for policy.

Also agreed that stimulus has focused on maintaining inefficiencies rather than supporting new growth. This is a fine but very important distinction, and one politicians are not likely to get correct.

Krugman et al.'s fear of a "double dip" recession may come to pass, but much sooner than expected, and without the expected trigger (sudden tightening). Rather, the economy may simply move down as it is recognized that the U.S. is no longer economically competitive and will continue to decline until deep structural changes are made, and that U.S. competitiveness is outside of the reach of government spending (which if anything worsens it by raising interest rates and taxes.) At that point, the expansionists will be out of options, and we will be facing the truly difficult choices: devaluing the currency, lowering wages, reducing regulation, cutting taxes, etc.

June 15, 2009 7:40 PM

 Dan Duncan said...

These historical comparisons are tedious.

Looking back to the 1930s...or 19th Century Great Britain for that matter provides no useful template.

OK, so G.B. was "exceptional" then and the US is "exceptional" now. In the 1930s, the gov't did X; it was unpleasant, therefore we should do Y.

They were different cultures without speed of light communication...they didn't rely on oil like we do now...they didn't have nukes, nor did they have to contend with them...and on and on....

I know these things seem irrelevant, but believe it or not---they actually do have an impact on politics and economics of the day.

The moving parts are all different. Just because a particular course of action worked back then, it does not mean it will work now. And vice-versa.

The historical economists are trying to extrapolate way too much information from a single similarity.

As a result, the historical comparisons yield no useful information.

History is instructive in teaching us about who we are...not what economic policy decisions we should make.

June 15, 2009 7:47 PM

 juan said...

Edward,

I very much agree with the distinction between a technical or accounting based recovery and an actual recovery of the real, nonfinancial, economy.

The latter might be:
1. a rising rate of nonfinancial profit [ideally calculated as total profit relative to total capital rather than as percent or share of GDP].
1a. that such rise incorporate but not be driven by the expectation of durability.
1b. that this rate be, and be expected to remain, higher than that of the financial sector.

Associated with/driven by the just mentioned -

- rising investment in production of means of production and, related to this, transportation.
- definitive turn from rising un and underemployment as well as the transcyclic decline of real wages.
- etc.

In still shorter form, the death of rentier capitalism, the money from money economy that through, among other things, its restructuring of effective demand [and greater inequalities] stands against society's reproduction of itself other than on a declining basis.

From a long waves in rate of profit perspective, the present crisis is 'merely' the most severe marker along a nearly forty year path that's seen the rise [and possible demise] of 'permanent crisis management'.

Too 'doom and gloom' or a rising potential to make history?

June 15, 2009 8:33 PM

 cpic said...

Richard and Leo

You really think the Fed may not have the greater good of the broader economy at the top of it's priorities?

... But rather that of the Bigger Financial Center leverage and power.....would you venture to say the treasury secretary for the last few terms think the same way ...

that's just not politically acceptable to Question and be taken seriously ....but maybe it should be

oh wait that would be unpleasant re-direct me to the fed's talking points ......otherwise i would possibly conclude the economy (after 30 some years of finanicial sector growing influence and big industry pulling more politician and regulator strings) that this corrupt poltical snowball rolling down hill....seems destined to end badly .....and comparisons with the last several decades are futile

who would guess that the simple cumulative effect of those with big industry interests posing as public sector guards could eventually bring the standard of living down more than most imagine in our "worst case scenario's"

instead most collapse scenario's seem increasingly associated w/ some evil conspiracy as cause for collapse.. which is much easier for most to disregard and then with it .....the chance we will collapse (not to mention psychologically speaking we want to disregard this unpleasent idea)....kind of like ....even respectable people who mention such scenario's are labeled some "dismissive catch phrase" like doom and gloomer....

June 15, 2009 9:19 PM

 Edwardo said...

There is an air of comical unreality about this discussion that, unfortunately, emanates from the original post. I mean no disrespect to the author, but I will be frank in saying that I don't care for the argument. Nor do I care for the invocation of the arch Keynesian, Paul Krugman, who lately utters statements both for and against the presence of "green shoots." I assume the purpose of this tactic is to insure that he can always tell us that he told us so. Unfortunately, as a card carrying Keynesian, Mr. Krugman can not, or will not, reckon with the fact that since 2003 the marginal productive capacity of debt is at zero as that leaves his approach to the problem in the junk pile.

Andrew Mellon was reviled in his day for his advice to, and here I paraphrase, liquidate, shares, farms, real estate and labor, etc. etc. It was indeed a rather heartless and not altogether defensible nostrum mostly because, at the time, deficit spending by the government, which was not itself in hock beyond all reckoning, was at least a plausible response to economic collapse. It didn't really work so much as it held the line to some degree. Now, however, that our government is massively indebted, as well as the private sector, more deficit spending is a recipe for even more enhanced catastrophe.

There will be no recovery worthy of the name-please let's not engage in terms like technical recovery-until the debt is allowed to clear the system. To engage in end runs around the present and intractable mathematical realities is to simply guarantee the manifestation of ever more grotesque and painful distortions.

Frankly, at this point, I doubt even allowing the debt to clear will allow Humpty Dumpty better than 2 to 1 odds of being put back together again, But at least we should acknowlege that allowing the debt to clear the system is a necessary but not necessarily sufficient condition for establishing a firm economic foundation going forward.

June 15, 2009 9:44 PM

 Ryan said...

So you tell us we shouldn't make the mistake of 1937 and 1997 by balancing our budget, but also that the U.S. cannot credibly maintain our current deficit, while then saying that the U.S. should "temporarily" (temporary so far has been 18 months) fill the gap until there's a sustainable point of recovery? You're having your cake and eating it too. Define what sustainable is for example.

And don't mention Krugman. I had a post of mine removed from his blog once because I rightly pointed out one day he hadn't offered a solution to anything, he was only saying why everyone else was wrong. I think it was when he was saying that the Obama stimulus was not enough money and it would fail and he drew back on Keynesian theory. I asked "fine then, how much do you want? And if the amount you want fails, does this disprove your personal economic theory?" It's easy for a person to throw stones at others when he himself doesn't stand for anything or is willing to put his neck on the line to risk being wrong.

June 15, 2009 10:22 PM

 DownSouth said...

Dan Duncan said: "Just because a particular course of action worked back then, it does not mean it will work now. And vice-versa."

Do you really believe the leading lights of the Austrian school would have agreed with that statement? If we take a look at the history of the thought of Dicey, Mises, Hayek, and Simons, it is very much based upon England's experiences.

In Capitalism and Freedom Milton Friedman wrote:

In the early nineteenth century, Bentham and the Philosophical Radicals were inclined to regard political freedom as a means to economic freedom. They believed that the masses were being hampered by the restrictions that were being imposed upon them, and that if political reforms gave the bulk of the people the vote, they would do what was good for them, which was to vote for laissez faire... The triumph of Benthamite liberalism in nineteenth-century England was followed by a reaction toward increasing intervention by government in economic affairs. This tendency to collectivism was greatly accelerated, both in England and elsewhere, by the two World Wars. Welfare rather than freedom became the dominant note in democratic countries. Recognizing the implicit threat to individualism, the intellectual descendants of the Philosophical Radicals--Dicey, Mises, Hayek, and Simons, to mention only a few--feared that a continued movement toward centralized control of economic activity would prove "The Road to Serfdom," as Hayek entitled his penetrating analysis of the process.

Friedberg fleshes out what Friedman was talking about. Civil expenditure (includes civil and social services, postal services, and spending on revenue collection) in Britain was extremely low, about 30 million pounds, for many years. Then in 1890 it began to increase, reaching 52.9 million pounds by 1907. But it still remained a tiny sliver of national income, as the conservatives remained in power and kept a lid on spending. As Friedberg writes:

The existing tax system was no longer capable of funding steadily expanding peacetime expenditures. Those few, like Joseph Chamberlain, who continued to defend further increases in spending were now decisively outnumbered. In the wake of the (Boer) war a new consensus had emerged in favor of the proposition that the limits of Britain's financial resources had been reached and that the government could therefore no longer continue to do business as usual.

In theory, at least, a recognition that change was necessary could have had two kinds of consequences. On the one hand the Conservatives could conceivably have undertaken a major effort at tax reform, breaking out of the confines of the old system in order to sustain continued increases in expenditure. This is exactly what the Liberal party would do only a few years later (in 1913) when it imposed a new "super tax" on incomes and used the revenues to pay for expanded social programs and eventually, a larger navy. Such a course was unacceptable to the Conservatives, both because it violated othodox principles and because it ran counter to their immediate political interests.

So let me repeat. Nineteenth century Britain was an Austrian/libertarian wet dream. What Friedman fails to mention in his narative, and this is why Friedman is one of the greatest public liars of the 20th century, is that beginning in the 1860s, and for 50 years thereafter, Britain was in a prolonged, inexorable economic decline. This was a time when Austrian/libertarian thought ruled supreme, and yet it, nor the policies it inspired, saved Britain from decline.

 

[Jun 11, 2009]  Deflation v. Inflation

The debate rages on in the financial blogosphere: will the current crisis ultimately be resolved through a period of cataclysmic deflation or in a hyper-inflationary auto da fe, Weimar-style? (Typical of human reactions when emotions run high, very few talk about middle-of-the-road alternatives.)

What do I think? First, some background to set the stage.

In the past few decades we experienced rapid asset inflation, combined with relatively mild consumer price inflation. Many perceived this to be a good development - and up to a point it was. After all, who doesn't want to see their wealth increase while paying low prices for goods?

Trouble is, you can't have it both ways for too long because asset prices must reflect a reasonable multiple of the income they produce ("rents"). Income derived from assets must be high enough to provide a competitive current return and to offset the risk of holding them. That is to say, dividends from shares, interest from bonds and rents from real estate must have reasonable yield ratios.

How do we know when assets reach unreasonable levels, i.e. how do we define a bubble? Greenspan claimed that it was impossible to do so and that we could only identify bubbles after they burst. Obviously, I disagree.

Apart from observing crowd psychology (i.e. maniacal behaviour), I believe the best fundamental indicator of a bubble is the relationship between earned income and debt. Don't forget that asset prices and debt levels are opposite sides of the same card: it takes lots of "money" (debt) to inflate asset prices. Debt, on the other hand, must be comfortably serviced out of earned income: wages, salaries, etc. When the two are considerably out of balance then the debt-asset bubble must and will pop.

Furthermore, things get really ugly when debt and asset prices rise very fast, as happened after 2000 (i.e. Sudden Debt). Earned income then has no chance to catch up to debt in an orderly fashion and the result is debt default and destruction, with a commensurate plunge in asset prices. That's exactly what is going on right now, of course.

Let's look at this relationship more closely. Below is a chart indexing home prices (Case-Shiller National Home Index), share prices (S&P 500), average hourly wages and household debt per working person. Obviously, assets and debt got way out of balance against income, particularly about 10 years ago.

 

High Debt + Low Wages = Asset Deflation, Eventually (Data: FRB St. Louis, S&P, BLS)
 

Notice how asset prices have now corrected to a significant degree, but household debt still remains high. That's because the Fed and Treasury are furiously pumping in public debt into banks' balance sheets to avert (and mask) household debt defaults. But this is a fool's errand: in the end all debts, private and public, must be serviced out of earned income. And since income is extremely unlikely to rise suddenly, debt must also come down, sooner or later.

A few months ago this blog's masthead used to proclaim: "We hold this truth to be self-evident: We cannot solve a debt crisis by issuing more debt". By definition, therefore, the only way to resolve this crisis is to allow debt to be destroyed in as orderly a fashion as possible, taking as long as possible in order to avert social consequences.

My view, thus, is that we are in for a long period of persistent asset/debt deflation that will eventually bring debts and asset prices into closer balance with incomes. At least that should be the aim of our policy makers. But, truth be told, I am not sure at all that they see things this way...

Time will tell.

Selected comments

Thursday, June 11, 2009

12 comments:

Tiago said...

The issue is: how do the several existing powers perceive this crisis and how will they interact among themselves?

I think there is a massive attempt to maintain the status quo. But the the status quo is unmaintainable (at least for those who believe that growth is unsustainable).

One of the reasons for maintaining the status quo is that it is of the interest of people who have a tight grip on power (e.g., banksters). Call it class-warfare if you want.

But another (coming from well intended people, who care for the public good) is just wrong analysis: I was shocked with todays Bob Reich post. People are still completely hooked to the permagrowth way of thought. Bob should know better.

Good intentions might prove disastrous if based on wrong analysis.

 

But What do I Know? said...

Great analysis, Hell. The problem is that things haven't gotten bad enough to change; i.e., there are plenty of decision-makers who believe that we can go back to the "good old days" of five to ten years ago if we just do some tinkering around the edges and get people to believe again.

 

Their efforts are being undermined by those that know the end is inevitable and are looking for ways to shelter themselves from the storm -- I suppose there are those who are doing the former in public and the latter in private.

The shame of it all is that nothing really bad has happened yet -- if we would take some pain now it would soften the blow down the road.

June 11, 2009 8:47 AM  

On Margin said...

Hell - Is there an "easier" way out of all this? Create inflation which creates wage growth - while the nominal cost of fixed rate debt stays the same? If as a whole the American consumer is over levered the politically palatable solution seems like inflation (money printing). I am obviously appalled by this, but I don't really have a vote. As a country, we like easy solutions - seems like inflation rather than debt reduction from restructuring is the easier of the two.

June 11, 2009 8:52 AM  

Anonymous said...

What happens under inflation when a lot of the debt's rates are subject to reset?
sc

June 11, 2009 8:55 AM  

Thai said...

@Hell re: "the only way to resolve this crisis is to allow debt to be destroyed in as orderly a fashion as possible, taking as long as possible in order to avert social consequences"

 

Not to defend the people in power one bit, but isn't the key word in your posting today orderly?

 

At least key if you want to look at this from our leaders point of view?

 

Our brains' do have flawed heuristics when it comes to investment behavior. Our brains are irrational at times.

 

Work in prospect theory has shown people feel more than twice as much pain from a $100 loss (or the potential of a $100 loss), than pleasure from a $100 gain (or the potential gain).

All this debt is going to be destroyed one way or another but a massive debt destruction via deflationary credit crunch might not be nearly as orderly as the very same process via inflationary credit crunch.

Order is our leaders primary job.

I understand that if you are the skin of an organism that is in shock with hypotension, you are not going to be all that happy that the brain told the circulatory system to shunt blood away from you to other core organs. But the point is to keep the organism whole in the end.

June 11, 2009 9:54 AM  

Daniel in Paris said...

I certainly do not buy into the hyperinflation. The 1970s scenario is enough for me.

Except for a few bad memories and nurturing the neocon ideology, Volcker did it.

However may I ask why the current government that is unable to tighten budget or monetary policy, at least one of the two items, would be able to do it within 10 years. Doe Obama really want to wait for all baby-boomers to have quit work to start the painful payback efforts! That cast some doubts on the payment.

What prevents the administration to tighten now? Are they really expecting some kind of miraculous better times to do so? What better times ? The end of current wars is an acceptable answer. But who has anything like a decent agenda on this.

I recently re-read Rueff, a French economist than most of us here ignore in spite of his brilliant successes. Not as academic but via effective policy-making.

Rueff is adamant on the fact that fiscal policies are the key to balanced external accounts. In view of the aggregate level of debts, balanced public accounts, at all levels, should become a top priority. Not a simple temporary outcome of the current deflationary burst.

I have the feeling that the "fiscal expectations" are currently extremely low in the US. I am under the impression as well that there is a perception that balanced public budgets are deemed illegitimate. Am I wrong?

Combined with massive spending, this is certainly enough to trigger something that could approach hyperinflation. The countries that went this way were decent ones. Even the Weimar was a decent regime held by very decent gentlemen. But the payments for reparations for France and Belgium were deemed illegitimate. No way that the German people would accept to pay anything like reparations. No way to get it to accept anything like a tax-based pay-back.

On the one hand, would could believe inflation could reach Weimar level? But on the other one, in view of the current political climate, I find no possible positive outcome to the current situation. What am I missing?

June 11, 2009 9:58 AM  

Arnould said...

This post has been removed by the author.

June 11, 2009 10:49 AM  

Arnould said...

...also from Paris.

Jacques Rueff was a genious, not only because he was a great economist, but also because he wrote about small events that had big effects to deepen the depression of the 1930's (you know, the butterfly effect).

However my post is not about Rueff but about raising wages. It is about the Grenelle agreements negotiated in Paris at end of May 1968.

These agreements show that apparently all it needs to raise wages is a little bit of political will. Do our leaders have some of it?

Granted these 10% immediate increases of real wages were negotiated after 4 weeks of strikes and riots, and the only alternative for General de Gaulle who had disappeared during 3 days in Germany would have been to launch tanks into Paris. Fortunately he was a democrat and he never gave that order.

Now guess what: France is still here today, even after these "cataclysmic" wage increases. Strange isn't it?

Even stranger, this episode seems to be forgotten by everyone even here, as I never heard of this through the press or politicians, but thanks to wikipedia!

And an anecdote about these events. The strikes and the riots suddenly ended at beginning of June 1968 after the army filled in the gasoline pump stations tanks which were empty for weeks at that date. This was told to me by my father. I also guess that the weather was fine, but I do not remember the details because I was aged only 5...
.

June 11, 2009 11:25 AM  

Greenie said...

"Hell - Is there an "easier" way out of all this? Create inflation which creates wage growth - while the nominal cost of fixed rate debt stays the same?"

That's what the Fed is trying - 'lift all prices little bit so that debt feels less burdensome', isn't it?

Here is the problem. When an economy goes out of balance, inflation will push the sectors in the same out of balance manner. For example, last year we had huge oil bubble (oil=140) that finally broke the back of the consumer. See what happened since Dec. Government's attempts to inflate made oil price rise the fastest, and home prices not move at all. There is no way for the government to increase wages, but they can cut taxes. All tax cuts by Obama, however, got nullified by rising cost of oil. Also, Ben's attempt to bring down mortgage rates through purchase of MBS made treasury rates go up - resulting frozen mortgage market.

The market is a bitch for manipulators.

June 11, 2009 11:52 AM  

marcus said...

The government wants inflation, the financial "Wizards" want a new asset class to inflate and wrap "innovative products" around. Two powerful entities that will cooperate to get what they want. Stagflation anyone?

What is there left to inflate? Commodities? Maybe investment in Chinese and Indian domestic consumption and growth to complete the cycle. Scary thought huh kids?

June 11, 2009 12:07 PM  

Thai said...

Greenie is right. But it is also a case of steering our economy vs. foreign competitors.

A carbon tax is politically difficult because of ideology but somehow playing with monetary policy is not as difficult.

So if the Fed inflates commodities prices more than income, it will crimp our economy. But it will also cause commodity consumption relative to income to drop and the 900 lb commodity gorilla is oil and most of our oil comes from abroad.

If our oil consumption drops then our balance of payments drop as well AND the there is a strong boost to mostly domestic energy conservation industries (say LED lighting, smart grids, etc...).

I am sure there are a thousand other loops I am missing but my point is these things will work themselves out either way.

The issue for the politicians is really just an issue of confidence and order, e.g. getting people to believe it is not the end of the world while they do work themselves out.

June 11, 2009 12:45 PM  

mich said...

Somehow debt doesn't disappear without repaying or defaulting. I don't see the former happening much so it's going to be mostly the latter.

 

Looks like the people who took the gamble are trying to spread the losses around as much as possible in as many forms as possible instead of taking responsibility and eating it themselves. Savers (I'm talking global here; pension funds, price inflation, meh, you all know) and (future)taxpayers are of course easy targets. They do get unhappy and angry though.
What a waste.

Merkel's inflationary fretting may wake the bears from hibernation - Telegraph

The fall in industrial output has been roughly equal to the 1929-1930 stage for Germany and the Anglo-Saxons, but worse for Japan, France, Italy, and Eastern Europe. The collapse in world trade has been swifter: the global equity crash has been twice as bad. "It's a depression alright. The good news is that the policy response is very different. The question now is whether that response will work," they said.

The elastic was bound to snap back, just as it did in the bear rally of early 1931. Whether the underlying economy has begun to heal is another matter. World Bank chief economist Justin Yifu Lin said capacity utilization is running at an historic low of 50pc-60pc. Companies will have to fire a lot of workers. This is where the danger lies, and why he fears that deflation is creeping up on us.

Trade data from Asia are flashing warning signals again. Korea's exports were down 28.3pc in May, reversing the April rebound. Malaysia has slipped to -26pc, and India has touched a new low of -33pc.

US freight data is getting worse, not better. The Association of American Railroads said traffic was down 22pc in the third week of May from a year earlier. Canadian freight was down 34pc.

The American Trucking Association (ATA) said it saw fresh drops of 4.5pc in March and a further 2.2pc in April. Tonnage is down 13pc over 12 months. Bob Costello, the ATA's chief economist, said companies have not cut inventories fast enough to keep pace with declining sales. The contraction in truck volume has "accelerated".

Yes, the Baltic Dry Index for bulk shipping of resources has quadrupled since January, but this reflects China's bid to stockpile metals while prices are low.

Stephen Roach, Morgan Stanley's Far East chief, fears an "Asian Relapse", saying the region is prisoner to its fatal dependency on exports to the West. The export share of GDP has risen from 36pc to 47pc across developing Asia over the last decade.

"China's incipient rebound relies on a time-worn stimulus formula: upping the ante on infrastructure spending in anticipation of an eventual rebound of global demand," he said. The strategy cannot work this time because Americans have exhausted their credit, and their desire to borrow. Consumption will fall from its peak of 72pc of GDP to the "pre-bubble norm" of 67pc, if not more.

David Rosenberg from Gluskins Sheff expects Americans to retrench ferociously as 78m baby boomers face the looming threat of penury in old age. "The big story is that the personal savings rate hit a 15-year high of 5.7pc in April. I believe it could test the post-War peak of 15pc. Too many pundits are still living in the old paradigm of Americans shopping till they drop," he said.

If he is right, this will shatter the surplus economies of China, Japan, and Germany, unless they adjust fast to the new world order. Germany does not even seem to understand the problem it faces. Chancellor Angela Merkel lashed out last week at quantitative easing by the Fed, the Bank of England, and the European Central Bank, repeating the silly mantra that this will set off an inflationary storm.

How can it do so when the velocity of circulation has collapsed, and unemployment is rising everywhere? The Fed's "monetary multiplier" ended last week at 0.867, half its average of 1.7 over the last decade. The credit mechanism is still broken. This is what happened in Japan in its Lost Decade.

The ECB says the eurozone economy will contract until mid-2010, at best. Germany's trade association (Wirtschaftsverbände) warned Mrs Merkel last week that the credit drought threatens to become "life-threatening by the summer at the latest".

The list of countries in deflation is growing every month: Ireland (-3.5), Thailand (-3.3), China (-1.5), Switzerland (-1), Spain (-0.8), the US (-0.7), Singapore (-0.7), Taiwan (-0.5), Belgium (-0.4), Japan (-0.1), Sweden (-0.1), Germany (0).

Yet markets seem to think otherwise, and this has its own awful consequences. Inflation fears have driven 10-year US Treasury yields to 3.86pc, a full point above levels in March when the Fed intervened to force rates down. US mortgage rates have jumped to 5.29pc. Gilts have reached 3.92pc, and French 10-year bonds are at 4.05pc.

This bond revolt is enough to bring any global recovery to a shuddering halt. The irony is that those fretting loudest about inflation may themselves tip us into outright deflation, with all the perils of a debt compound trap. It is Angela Merkel who plays with fire.

[June 6, 2009] FT.com Willem Buiter's Maverecon After the Crisis Macro Imbalance, Credibility and Reserve-Currency

The US will most likely face a long period of stagnation... In the horizon of the coming years no domestic fiscal policy will be capable of revitalizing the central economies... Inflation and the devaluation of the dollar, presently, are not a concrete threat in a world on the verge of deflation.

... ... ...

There is symmetry between inflationary and deflationary conditions. The inflationary condition to be contrasted with deflation is not the one of small inflations, always present in a healthy economy. It is not even the inflation that, given circumstantial pressures, might reach two digit annual rates. The inflationary condition that should be compared to deflation is the one of great chronic inflations, as those encountered in the Brazilian economy, from the seventies until the Real Plan in the nineties.  While chronic inflation is essentially a question of excessive debt of the public sector, deflation is essentially a question of excessive debt of the private sector.

[Jun 3, 2009] Guest post: Central banks will face a Scylla and Charybdis flation challenge for years

naked capitalism

Submitted by Edward Harrison of the site Credit Writedowns.

Nearly a month ago, back on May 5th, I highlighted some testimony by Federal Reserve Chairman Ben Bernanke before congress in a post labelled, “Bernanke expects recovery later this year".  In his testimony, Bernanke used the phrase ‘Scylla and Charybdis’ to describe the Federal Reserve’s policy challenge regarding deflationary and inflationary forces.  I would like to highlight this characterization because I believe it goes to the core of the debate as to how the global economy and asset markets will fare over the next 5-10 years.  In my view (and apparently in Bernanke’s), both inflationary forces and deflationary forces will be at work for some time to come. This will present policy makers with a problem as the reflation trade comes good, and the resulting policy responses will have serious implications on the medium term outlook for the economy and asset markets.

Deflationary forces

The problem is this: we have just witnessed one of the most serious asset bubbles in history. In fact, I would call the great housing bubble an ‘echo bubble’ that was merely a continuation of the bubble forces that created the technology bubble of the late 1990s.  So, the world saw asset price inflation of the most severe kind for over a decade – from the mid 1990s when Alan Greenspan first voiced concern about ‘irrational exuberance"’ to 2007 when the housing bubble imploded.  What results from the implosion of such a significant bubble is deflation.

Actually, more crisply put, what results is ‘the D-process,’ an outcome highlighted by Ray Dalio of Bridgewater Associates (see my post "A conversation with Bridgewater Associates’ Ray Dalio" for more detail).  This process involves the three D’s of deleveraging, deflation and depression (outlined in my post “We are in depression").

Richard Koo goes further in his book “The Holy Grail of Macro Economics.”  Here, he argues that the unwind of great bubbles suffers from what he labels a ‘balance sheet recession.’  In essence, companies go from maximizing profits, as they had done in normal times, to a post-bubble concern of reducing debt. Regardless of how much priming of the pump monetary authorities do, the psychology of debt reduction will limit the effectiveness of monetary policy as a policy tool.

In my view, the catalyst for this change of psychology is the ‘debt revulsion’ that ushers in the panic phase of an asset bubble collapse.  (Charles Kindleberger highlights the various stages of a bubble and its implosion in his seminal book “Manias, Panics and Crashes”). In this particular bubble, debt revulsion began post-Lehman Brothers.  What we have seen, therefore, is a reduction in leverage and debt as the most leveraged players have gone to the wall.  But, more than that, the household sector has gotten religion about debt reduction as the savings rate has increased dramatically since Lehman. In fact, I would argue that companies learned their lesson about debt from the aftermath of the tech bubble.  It is the household sector in the U.S. (and the U.K.) which is heavily indebted. Therefore, if the psychology of a balance sheet recession does take form, it will be the household sector leading the charge.

In sum, the psychology after a major bubble is very different than the psychology before its collapse.  The post-bubble emphasis becomes debt reduction and savings, making monetary policy ineffective, not because financial institutions are unwilling lenders but because companies and individuals are unwilling borrowers. These are forces to be reckoned with for some to come.

Inflationary forces

Meanwhile, inflation is going to be a problem too.  Why?  Two principle reasons come to mind: commodity prices and money supply. Now, just yesterday in my most recent post “Kasriel: ‘greater risk for the global economy…is inflation’,” I highlighted Paul Kasriel’s view that there are several inflationary forces, both secular and cyclical which will impinge upon the economy. I want to bear down on just the two forces of commodity prices and money supply.

First, let’s look at money supply.  The Federal Reserve and other central banks have been pumping a lot of money into the financial system in an attempt to add reserves to the system and to take on the intermediation role the wider banking system normally serves.  Nevertheless, this money is not being lent out and excess reserves are piling up at the Federal Reserve.  Last April, there were only $1.8 billion in excess reserves i.e. reserves against which loans were not being made. According to figures just released by the Fed on May 28th, this April that figure has soared to $824.4 billion, a surge of 447 times in one year. If you want to know what is wrong with the American economy, you should start here.

But, what happens when the economy returns to an environment in which those excess reserves start to be lent out?  Inflation.  And this is an inflation that will not be so easy to control because the Federal Reserve has embarked on a policy of ‘qualitative easing’ by buying up non-treasury assets, transforming its balance sheet from one dominated by treasury assets to one in which Treasury assets are in the minority.  So, as the Fed has intervened and bloated its balance sheet, an increasing amount of the assets it has with which to withdraw the excess liquidity in the system is hard to sell.

So, you have a huge amount of excess reserves, hard to sell assets on the Fed’s balance sheet.  Add in the fact that the Federal Reserve is going to be loathe to choke off an incipient recovery and you have the makings of inflation when recovery takes hold.

Moreover, there is a rise in commodity prices which is adding inflation to the pipeline.  Much of the recent decrease in headline inflation numbers is due to the collapse in commodity prices.  But, Copper is near a seven-month high. Oil is near a seven-month high.  And all of the agricultural and industrial commodities are taking off again.  As China ramps up its economic stimulus, the recent increases in the ISM manufacturing data in the U.S. and elsewhere point to an increasing demand for industrial commodities, and this is inflationary.

In sum, any pickup in the economy is going to be met by a host of inflationary forces.  This is one reason that bond yields have been increasing and the spread between the two-year and 10-year U.S. government bond is near a record.

Scylla and Charybdis

So, how do I see this push and pull of deflationary and inflationary forces playing out?  There are two outcomes I am looking for.

Outcome Number One

• No policy traction. This is a sluggish muddle-through Japanese scenario where the Richard Koo thesis of the balance sheet recession comes into play. You would see an output gap and below-trend growth for an extended period. Most pundits would say it is the lack of lending that is creating the problem.  However, what if it is the lack of borrowing which is at fault?  Then, we are going to see no traction from monetary policy.

Outcome Number Two

• Start-Stop economy. I believe Bernanke would prefer this outcome. This is one in which the Federal Reserve allows the economy to recover by keeping interest rates low.  The result is a rise in inflation. We could see inflation rising to 3 percent inflation and then to 5 to 7 and 10 percent. An example would be animal spirits coming back in 2010. And leading to 3 percent inflation followed by 7 percent including $100 oil and then interest rate hikes and another recession at which point the deleveraging begins again in earnest. Followed by more easing and on it goes. But, of course, the problem with outcome two is it is unstable and that it invites an aggressive policy response which risks situation one as an ultimate outcome.

Neither of these scenarios is one in which asset markets are likely to benefit, one reason I see the latest uptick in share prices as nothing more than a bear market rally.

Sources
H.3 Aggregate Reserves of Depository Institutions and the Monetary Base, current release – U.S. Federal Reserve website
H.4.1 Factors Affecting Reserve Balances, current release – U.S. Federal Reserve website
Copper Falls From 7-Month High on Speculation Gains Too Rapid – Bloomberg.com
Soybeans Advances to 8-Month High, Corn Gains to 7-Month Peak – Bloomberg.com
Oil Falls From Seven-Month High on Signs OPEC Output Climbing – Bloomberg.com

Selected Comments

DownSouth said...

I take issue with your analysis on two points.

► First, there is no indication of any deleveraging, at least of any significant degree, going on. We can see this in a graph from a Brad Setser post from yesterday's NC links:

http://blogs.cfr.org/setser/2009/05/31/more-government-borrowing-doesnt-necessarily-mean-more-total-borrowing/

Business and household borrowing have approached zero, but they have not gone negative. Meanwhile, federal government borrowing has exploded. The combined result is a very slight decrease in overall borrowing. Outstanding debt has decreased only ever so slightly. There has been almost no deleveraging:
(see Fed spreadsheed d3)
C:\Documents and Settings\Owner\Local Settings\Temporary Internet Files\Content.IE5\7DJKP3NO\z1r-2[1].zip

► Second, what if the uptick in commodities is not due to underlying supply and demand fundamentals as you seem to indicate in this statement: "As China ramps up its economic stimulus, the recent increases in the ISM manufacturing data in the U.S. and elsewhere point to an increasing demand for industrial commodities, and this is inflationary." What if, as I think poster Hugh keeps hammering away at, the recent increase in commodity prices is due to speculation?

I'm not so sure the "change of psychology--the "debt revulsion"--that you speak of has really taken hold. I believe there's a rather good possibility that the nation is still in speculation mode. Therefore I'm not sure that the bubble has even began to collapse.

June 2, 2009 11:35 AM

 Edward Harrison said...

DownSouth, fair points. Let me see if I have your interpretation of events right: "animal spirits never died - they are now being re-channeled into commodities again. And deleveraging has not occurred in any meaningful way yet."

This would support outcome number two, which I see as the likely outcome. Again, outcomenumber two is inherently unstable because it risks hyper-inflation, the Faber thesis. I suspect an aggressive policy response i.e. interest rate hikes will be the likely result. This response would risk a double-dip in which both deleveraging would begin and animal spirits would dissipate.

June 2, 2009 11:50 AM

 Mr. S said...

Where do wages fit in this discussion? I see little to no possibility for wage-inflation kicking into gear.

It seems to me that this is a significant factor in the deflation/inflation debate and the possibility that there could be both. Inflation in commodities but deflation in other consumer space as the wage income simply isn't there to support the debt needed to make the purchase.

Can you address this in a post?

June 2, 2009 12:56 PM
 

 DownSouth said...

Edward,

On the psychological spectrum, with "debt revulsion" on one end and "speculative infection" (this is what you call "animal spirits," no?) on the other, I'm not sure where we are right now.

Frederick Lewis Allen in Only Yesterday recounts that in the 1920s, in spite of the popping of a nationwide real estate bubble, a "marked recession" and in February, 1928, unemployment "more serious than at any time since immediately after the war," this did nothing to dampen the speculative fever and the Big Bull Market. (see my comment on todays Links for more detail)

Aaron L. Friedberg in The Weary Titan: Britain and the Experience of Relative Decline 1895-1905 points out a similar phenomenon. Great Britain, "from the 1860s at least," experienced a negative trade balance and began "living off its capital." Between 1872 and 1896 was the "Great Depression." Friedberg concludes that "the beliefs of national leaders are slow to change." Lord Bolingbroke wrote: "They who are in the sinking scale...do not easily come off from the habitual prejudices of superior wealth, or power, or skill, or courage, nor from the confidence that these prejudices inspire."

Friedberg cites the work of Kenneth Boulding who speculated that the citizens of a country as a whole may come to share a historical "national image" that extends "backward into a supposedly recorded or perhaps mythological past and forward into an imagined future." Boulding argues that adjustments to this national image occur "rarely, if at all," while John Stoessinger asserts that change "is possible only as the consequence of some monumental disaster." The process of change is "driven by gradual developments in the thinking of 'change agents,' middle- and upper-level officials whose views begin to deviate from the norm and who are able to receive a wider hearing only at moments of intense crisis."

In Great Britain, the "change agents," the most prominent and strident being colonial secretary Joseph Chamberlain, were not successful in the period 1895-1905 in altering the "national image" of the country. "The consensus (free-trade and laissez-faire dogmatism) that had grown up over the course of the preceding sixty years would not be easily shattered," Friedberg writes. "Most people probably...believed their country was still the world's industrial leader and that, under a policy of free trade, it would be able to continue in that role." Chamberlain's calls for reform therefore went unheeded.

To give an idea of the spirit of the debate here's a quote from the reform-minded Chamberlain:
 

Granted that you are the clearing-house of the world, but are you entirely beyond anxiety as to the permanence of your great position?...Banking is not the creator of our prosperity, but is the creation of it. It is not the cause of our wealth, but it is the consequence of our wealth, and if the industrial energy and development which has been going on for so many years in this country were to be hindered or relaxed, then finance, and all that finance means, will follow to the countries which are more successful than ourselves.~

Charles Ritchie, president of the Board of Trade and later chancellor of the Exchequer, an adamant defender of the status quo and Chamberlain's principle obstacle to reform, issued this statement:
 

The solution of the question of how best to develop and increase our competing power is one to which the State can only give limited assistance... What the Government can do is to facilitate the supply of accurate and carefully collected information and in the dischage of this duty...we are somewhat behand-hand.

June 2, 2009 2:33 PM

 Jamie said...

Edward,

Deleveraging is in progress and attempts to demonstrate that this is not the case ignore the collapse of the shadow banking system (e.g., Downsouth's reference to Setser).

There is no sign or prospect of wage inflation.

Impact of commodity prices on medium term core inflation is not significant because supply/demand forces for commodities act in the shorter term.

Recent increase in equities could well be due to speculation - or simply normalisation - but either way the movement is a short term one of no great significance to the macroeconomic reality.

The inflation risk from the excess reserves is negligible whilst deleverage continues - and that process has a long way to run.

So I expect your outcome 1 will endure for many months and potentially several years to come.

Which bit of this don't you agree with?

June 2, 2009 3:48 PM

 Edward Harrison said...

Mr S and Jamie,

I don't see wage inflation as a huge threat at this point. What I do see as the inflationary threat are the two things I identified: excess reserves being lent and commodity prices going through the roof/the dollar getting killed.

I just wrote a follow-up to this post in which I have pinpointed a statistic that I call the Consumption-to-Income Gap which should help gauge which outcome is likely to prevail.

June 2, 2009 5:05 PM

 Hugh said...

I too am unsure about deleveraging. Banks still have found no definitive way to dump their crap assets on to the government, though they are trying. Sitting on large cash reserves is consistent with deflation since money increases in value relative to everything else. On the other hand, large reserves to some extent balance off the inability of banks to dump their toxic waste. Meanwhile where they can as in commodities, there is a return to speculation and leveraging. So overall a mixed picture. Nothing has been solved but government money is for the moment keeping the whole enterprise afloat or possibly sinking more slowly.

June 2, 2009 5:32 PM

 Larry said...

@Ed - "the household sector has gotten religion about debt reduction as the savings rate has increased dramatically since Lehman. In fact, I would argue that companies learned their lesson about debt from the aftermath of the tech bubble"

Well, there's one more institution that has to get religion about debt. It's the one that's leveraging up right now - government. In fact, aren't we in the middle of the "final" bubble - the government bubble - with t-bills as the inflated asset?

About #2 - if the Fed even hints that it might inflate, won't the Chinese pull the trigger on their SDR idea and/or require the US to write RMB paper instead of USD paper? And if that happens...

@Hugh - The banks' big mistake was to not unionize!

June 2, 2009 8:52 PM

 myself said...

All of you have written very well. I would like to add two points. From some points of view, the US is moving towards a "global mean" wage. I don't see manufacturing returning until we're competitive. I just don't see any kind of upwards wage pressure.

The second point is that I don't believe that it is applicable to group oil in with the rest of commodities. Our second biggest supplier, Mexico is rapidly running out of oil. They expect to import in a few years.

Even Dick Chaney said that demand is more than supply. I believe that oil should be considered separately.
Dan

June 2, 2009 10:12 PM

 ScottB said...

Agreed, great discussion. I'm trying to make sense of the huge growth of reserves at the Fed. Those are U.S. bank holdings? Is any of it toxic assets that the banks have "loaned" to the Fed? How much of that is a needed hedge against future losses?

June 2, 2009 11:59 PM

 kackermann said...

So jobs and house prices are not much of a factor in either scenario?

I can't help but come back to fundamentals, and the fundamentals say we go back to a credit-fueled consumptive economy again any time soon.

I realize that is what the banks want, but unless they unveil a program to train everyone as a banker, and create an economy where everyone creates synthetic CDO's comprised of everyone else's synthetic CDO's, and declare us all systemmically important and elegible to borrow free money and receive bailouts, then I see nothing but trouble.

I see a financial system that put the theory to test, and won. The banks called all the shots for themselves in this. They created a risk tranch called public compulsory, and now the only thing to do is fine tune it.

There are people running around still talking about how stupid AIG was, and point to their being on the wrong side of all those bets.

They honestly don't see it for the nuclear option that is was. Why go out with a whimper, when you can strap up and threaten to take a bunch with you when you go?

I'm keeping one neighbor partly employed right now, and other than despair and feelings of worthlessness, he's doing fine.

It's my other unemployed neighbor that worries me. He lost his job of 21 years, and if he looses his house, he will snap.

I want someone to explain to me why the economy seems to tank when taxes are at their lowest, and why the outrageously high tax rates in the decades following WWII were coincident with an extremely stable economy and massive wealth creation.

I'm at the point where globalization can go to hell. I can't afford $8.00 workboots from China if I don't have a job. Slap a tarriff on imports, and open up a boot factory here. I know the banks don't want to hear that, but they have had their fill.

We are not buying anything these days anyway.

Eventually you all will come around to my thinking ;-)

June 3, 2009 2:43 AM

 skippy said...

@kackermann...bravo and well said!

 

[Jun 1, 2009] Guest post- Dollar weakness continues

ndk said...

Back in the dark days of the credit implosion, a lot of people feared that there would be a capital flight from the U.S. I stated bluntly that I thought it quite unlikely, but that the signs to watch for would be a simultaneous rise in yields and drop in the dollar.

How times have changed. We might just be witnessing re-risking -- corporates are faring much better than Treasuries, for example -- but on any measure, compared to the USD, it's looking a little like very mild capital flight.

I still am very curious to see what China does. Yves once volunteered that depegging the yuan or ceasing the purchase of Treasuries was their nuclear option; I thought "diversifying" into commodities while maintaining their peg was. They've certainly done the latter to date.

While I would immediately concede the likelihood that the U.S. consumer is out to lunch for good -- the gain in incomes today was all transfer payments, and the oil standard's about to punch them again -- there are other good reasons for China to peg their currency still. One is limiting the ability of the U.S. to compete with China as exporter to the world. The weight of the U.S. will drag the yuan down, making exports to the rest of the world more appealing as well.

Will that be sufficient incentive to incur further capital losses on USD investments? My hunch is yes, but really, I have no idea.

I really am surprised re-risking has gotten off the ground this quickly, and capital flight has occurred so fast. I didn't see it coming.

June 1, 2009 3:05 PM

 Andrew Bissell said...

GBP has *already* reached the mid $1.60's today. Near-term anti-dollar sentiment readings are near records, Bloomberg headlines are littered with news of the coming dollar apocalypse, and the announcement of Taleb's Hyperinflation Fund seems as good a headline as any to mark at least a near-term top in this stupid "reflation trade."

The days of "Don't Fight the Fed" are over. It is remarkable to me that a mere two month rally in various asset classes is enough to convince everyone to start getting short the dollar again. It is a sign of just how little anyone ever believed in the deflation thesis, and, therefore, of how much further that trade has to run.

June 1, 2009 3:21 PM

 ndk said...

Andrew, my money is still with you in the deflationary trade. The most painful part of being wrong on it is not just suffering capital losses on longer-dated debt, but also that the positions themselves are in a currency of diminished value.

I don't see any lasting successful reflation, because I believe the real equilibrium interest rate is negative -- we've been flirting with deflation for nigh on 10 years now, and China's been in and out of it -- but I've got a couple of those hedges Edward mentioned on just in case.

June 1, 2009 3:34 PM

 tradelite said...

do realize that there are two levels at play here. The instinctive, animal level, where we want to punish those who have done us wrong, while those who have done us wrong have done it following their animal desires. There is also the rational level, of which to I am referring to above.Realistically, I know the beast in us will take over and this will end like it did in France in the 1790's. I will, however, not be the one holding the sword.

Econ &
Finance Articles Updated Daily

June 1, 2009 6:18 PM

 Andrew Bissell said...

I don't see any lasting successful reflation, because I believe the real equilibrium interest rate is negative -- we've been flirting with deflation for nigh on 10 years now, and China's been in and out of it -- but I've got a couple of those hedges Edward mentioned on just in case.


I'm definitely with you on this, ndk. However, I don't believe paper assets like options on commodity futures or even gold ETFs are the right way to purchase "insurance" against a hyperinflationary holocaust, because there's too much risk your counterparties wouldn't be able to pay off on the bet. I don't hold any real estate (which actually works brilliantly as a hyperinflation hedge) but I do always keep a reasonable share of my net worth in physical precious metals.

June 1, 2009 8:10 PM

 Hugh said...

I don't really follow the currency markets, but the current run up in oil is about speculation in a market that lends itself to leveraging.

 

This is the same kind of speculative spike we saw last year.

Continued

Recommended Links

FT.com Willem Buiter's Maverecon After the Crisis Macro Imbalance, Credibility and Reserve-Currency -- The US will most likely face a long period of stagnation... In the horizon of the coming years no domestic fiscal policy will be capable of revitalizing the central economies... Inflation and the devaluation of the dollar, presently, are not a concrete threat in a world on the verge of deflation.

The truth about inflation This primer on inflation, written by Implode-O-Meter founder Aaron Krowne and published at BullionVault

Investing In Bonds

• Corporate Market At-A-Glance

Investing in Bonds, MM-0005-01

Investing basics, Ch. 3- Investing in bonds

Investing in Junk Bonds- Inside the High Yield ...