This is a post I just wrote over at Yves Smith’s site Naked Capitalism in response to a reader request. Marshall Auerback has already written a reply as well and I will post this later today.

A reader at Naked Capitalism asked us to respond to a recent article from the Christian Science Monitor asking Does US need a second stimulus to create jobs?

Marshall Auerback has already done some heavy lifting. He says emphatically yes. Now I want to take a crack at this. My short answer is no. But before I go into this, as an aside, I wanted to mention Marshall’s new smiling, happy picture up at the great blog New Deal 2.0 where he now writes.  Earlier, when Credit Writedowns was hosted at Blogger, he used a picture best described as a mug shot in his profile, but he has changed that one too (although he smiles there a little less). He thinks we haven’t noticed this sleight of hand.  Well I have! Once upon a time, Marshall wrote with a man I called all bearish, all the time this summer. Take a look at that post; you don’t see him smiling now do you? We have Lynn Parramore, New Deal 2.0’s editor to thank for making Marshall Auerback into an optimist.

Different policy choices

But all teasing aside, I do want to take the opposite side of this trade.  You see I too was a deficit hawk. And while I may have been backing fiscal stimulus, I have felt conflicted for doing so. Here’s how I see it. 

You have four options:

1. No stimulus. Let the chips fall where they may. Yves Smith calls this the ‘Mellonite liquidationist mode.’ The thinking here is that trying to avoid the inevitable bust only makes it that much larger. And the economic policies during recessions in 1991 and 2001 seem to bear that out. The Harding Recession of 1921 is commonly seen as gold standard response.
2. Monetary stimulus only. Quantitative easing mania. My understanding is this is what Ambrose Evans-Pritchard has been advocating.   The thinking here is that the flood of money and the low rates will eventually jump start the economy. No deficit spending needed.
3. Monetary and fiscal stimulus.  Full tilt Keynesian. This is the Krugman view. The thinking here is that one needs to credibly commit to higher inflation and close the output gap to avoid a deflationary spiral. If that is insufficient, then one needs to go full bore on fiscal stimulus aka deficit spending. And if that doesn’t work, subsidize jobs. The New Deal is commonly seen as the gold standard response.
4. Fiscal stimulus only. Deficit spending. I have been talking up this view. The thinking here is that we need to both close the output gap to prevent a deflationary spiral and revive private sector savings in order to promote deleveraging.

There is no magic bullet here.  We are living through a situation unique in time with few historical precedents. And there are a lot of competing ideas being tossed about. So policy makers are groping around, desperately seeking the holy grail of depression-busting economic policy.  In that regard, I don’t envy them. They are certainly going to make a lot of mistakes. It may seem at times that I don’t realize this given the harshness of my critiques, but I do.

Deficit hawks are misguided

However, there are some policies which could work and others which are flat out wrong.  One policy which is flat out wrong is the concept that we need to reduce deficit spending in order to avoid a double dip recession. This flies in the face of basic economics which says that more spending and less taxes equals greater demand and recovery/boom. More taxes and less spending equals less demand and recession/depression.

Now, it’s not as if we didn’t see this line of argument coming. As far back as November 2008, I heard the chatter (see my post here). So you knew this we-have-to-stop-or-we’ll be-bankrupt nonsense was coming. The problem is it’s just not true.  Here are a few data points:

• Private sector debt (incl. financial firms) was 292% of GDP as of Q2 but public sector debt (incl. state and local municipalities) was 67.2%. Who’s more indebted – the private sector by a factor of 4.
• Adding unfunded liabilities to any public debt number when talking about spiking treasury rates is inaccurate and artificially inflates the number. A lot of people do this to make the public debt scenario look worse. The issue at hand is whether a supply/demand imbalance in Treasury securities spikes interest rates. Unfunded liabilities have absolutely nothing to do with this.
• Cash and bonds are fungible. They are both obligations of the federal government to be repaid in full with a specific sum of fiat money. The Treasury could literally stop issuing government debt altogether and just start crediting accounts electronically to ‘fund’ its purchases. There is no operational constraint to government spending. The U.S. government is not going broke involuntarily. See my post here.

The real issue with deficits causing a double-dip has to do with inflation and overheating. If inflation increases because the economy begins to overheat, interest rates spike and the Fed raises rates to choke off inflation. That’s not going to happen any time soon – although it may be a problem down the line.  The issue at hand now is deflation not inflation. At least Morgan Stanley understands this when they take a deficit hawk position.

And as for the Chinese, they are not going to pull the plug on Treasuries unless they want to tank their export boom. The reason they must buy Treasuries is the dollar peg; they must re-invest in U.S.-based assets in order to prevent their currency from appreciating. This has caused a huge rise in their U.S. dollar reserves. If they changed the peg, their currency would almost certainly rise and this would choke off exports.

No more stimulus, just jobs

I have said my piece about the need for stimulus in the past. So I won’t repeat it here. If you are interested, see my December 2008 posts “Confessions of an Austrian economist,” “What does Mises say about trying to stimulate the economy out of recession,” and “A brief philosophical argument about the role of government.”

But, on the whole, I look at long-term deficits in a dubious light. There are practical constraints to deficit spending – and they lead to inflation, currency depreciation and lower standards of living. This is not national bankruptcy, but it is what Murray Rothbard called default by inflation and it makes you and me less well off.

This, of course, is over the long-run. In the short run, it is the spectre of a deflationary spiral we care about. Stimulus was important to stop this. I said in February that Obama was making a big mistake with his stimulus measures.

My view here is that Obama is forging a middle path that leads to a dead-end. The stimulus is not nearly enough by half to get the job done. The proposed deficit reduction measures for 2013 are outright scary as they risk repeating a mistake from the 1930s. And the banking sector and mortgage plans, both of which I failed to mention, are dubious half-measures as well. One needs to act aggressively and proactively or not at all.

If you are going to deficit spend you need to do it in a big way. You need to stop the deflationary spiral.  That means hitting the reset button by promoting private sector savings and deleveraging and purging all built-up malinvestments. The risk in addressing the situation this way, of course, is replacing the imperfect invisible hand of markets with the imperfect hand of politicians and legislative fiat.

This is a risk I no longer see as worth taking. I have bailout and deficit fatigue just like most Americans. It is abundantly clear that this Administration has absolutely zero intention of purging any malinvestment or promoting any deleveraging. All they want to do is continue business as usual and go back to the asset-based economy that caused this mess. This is why we have seen bailout after bailout coupled with easy money. It makes for record profits on Wall Street but it does nothing for the unemployed.

Moreover, the political process in the U.S. is such that any stimulus money will be diverted to pet projects and used to pay off political constituents. While this may increase aggregate demand, it does so at the risk of serious social unrest as the outrage will certainly spill over into populism.

So I say no to a second (third) stimulus package.  What the President needs to focus on is jobs. The reason Obama’s poll numbers are shrinking is because he now owns this economy.  And people are not benefitting from this fake recovery.  They are angry at the bailouts and distrustful of government – and with good reason.

Cut payroll taxes, subsidize job creation, divert some military spending to direct job creation by ending the foreign wars. But stop the madness.

Related posts:

• Japan does not demonstrate the failure of stimulus
• Don’t underestimate the power of printing money, part 2
• Inflation: The strategy that dare not state its name
• The inflation-deflation debate
• Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”

Steve Horwitz had an interesting read last week on Friedrich von Hayek, the Nobel Prize winning Austrian School economist. Von Hayek is best known for his 1944 Libertarian call to arms “Road to Serfdom” and is generally considered one of the fathers of the free market ideology.

In Horwitz’s piece, he points out that Hayek was not a ‘liquidationist’ and he uses the title quote to demonstrate that Hayek saw deflation as destructive. Was this an evolution in beliefs? it’s hard to say.

Horowitz goes on to say:

Those Austrians who think deflation is always and everywhere a good phenomenon strongly overlap with those Austrians who wonder whether Hayek is really an Austrian (or a even a classical liberal) anyway, so I’m doubtful this will convince them of the claim that a concern with monetary deflation has been, and should be, a core part of Austrian monetary and macro theory.  However, it does, in fact, bolster the case for a monetary equilibrium reading of Hayek.

The question, of course, is if price stability is the ultimate goal of monetary policy, how does one achieve that in a deflationary environment?

Source

Hayek on Deflation and the Great Depression – Steve Horwitz

Related posts:

• The inflation-deflation debate
• Forget Inflation, debt deflation is the real threat
• Credit deflation and the Japanese problem
• Goldman says fund managers expect deflation
• The inflation – deflation debate redux

Morgan Stanley has an interesting piece out this morning called Debtflation. In the past, they have raised alarm bells over what they see as embedded inflation in the loose monetary policy presently being followed by most central banks.  This particular piece focuses not on a general potential for inflation, but the possibility that central banks will explicitly target higher inflation in order to reduce high debt burdens – a policy advocated by Kenneth Rogoff.

The recent downturn has called many of the old certainties into question. In the world of central banking, a prominent victim of the downturn is the – previously orthodox – view that central banks should neglect asset prices when conducting monetary policy. Yet more recently, another major tenet of central bank doctrine is being challenged – the view that monetary policy should not be used to help out governments under debt pressure. We think that the risk of independent central banks creating some amount of (controlled) inflation going forward cannot quite be dismissed out of hand.

We have flagged inflation as a major long-term risk going forward: if the recovery is as tepid as we expect, central banks will be inclined to err on the side of caution when it comes to withdrawing the unprecedented conventional and unconventional monetary stimulus. But we believe that there will be a familiar additional source of inflation risk – the mounting public debt burden.  There is no doubt that, last winter, with the global economy slumping, central bankers welcomed the help they got from hugely expansionary fiscal policy. However, the result has been a massive increase in developed countries’ public indebtedness – the extent of the debt build-up in some countries resembles the consequences of wars. Historically, developed economies have escaped high debt by growing out of it rather than inflating it away or defaulting (with the notable exception of Germany and Japan). Growth after World War II for example was fast, not least because war-ravaged economies were rebuilding their capital stocks.

This time around, however, eroding the debt through faster growth may not be an option. Instead, growth in many developed countries is likely to slow significantly going forward as labour forces shrink due to the demographic transition. Worse, population ageing will impose added pressure on public expenditure through higher pensions and healthcare costs. If outgrowing the debt is unlikely, and if governments lack the resolve to cut spending and/or raise taxes sufficiently, the remaining options are default and inflation. No policymaker in the developed world – and, by now, few in the developing world – would want to countenance default as an option. This leaves inflation. The question is familiar: could central bankers be forced to engineer inflation – ‘monetise the debt’? Almost all developing world central banks are independent from an institutional point of view. Indeed, one of the main reasons for setting up independent monetary authorities is precisely to avoid pressure from governments to inflate away the debt. So, central banks cannot be forced by their governments to generate inflation (unless governments were prepared to change the statutes of their monetary authorities; this would in most cases require going to the legislature).

With governmental coercion being unfeasible, is there a possibility that independent central bankers might generate inflation out of their own volition? If nothing else, they would take a big gamble with their hard-won credibility. And history teaches us that the reason behind most, if not all, episodes of very high inflation has been monetary expansion to finance government expenditure or reduce debt (see "Could Hyperinflation Happen Again?" The Global Monetary Analyst, January 28, 2009).

Morgan Stanley is saying in effect that it fears central banks inflating away private and public debt burdens by printing more money. It is not clear that quantitative easing really is inflationary (at least in the short-term). For this policy to actually produce inflation in an environment that is geared more toward deleveraging, we will need serious asset price inflation to spill over into the real economy – and this would require increases in asset prices that would be extremely destabilizing when the inevitable bust occurs. Most likely an asset bubble bursting would tip the global economy back into deflation. This is the Scylla and Charybdis problem I outlined in June. So, I am not sure central banks could pull this off even if they wanted to.

More from Morgan Stanley at the link below.

Source

Debtflation – Morgan Stanley

Related posts:

• Quote of the day: William White and inflation
• Are central banks independent actors?
• Stephen Roach: Downturn in Asia less severe, but recovery later
• The inflation – deflation debate redux
• Emerging Markets will be tested by inflation

Wolfgang Munchau of the Financial Times wrote a very important comment piece in today’s Financial Times. In it he said that central banks are targeting asset prices to avoid the brunt of cyclical downturns. This policy is inducing asset bubbles and creating a more volatile real economy with unpredictable negative consequences.

I want to expand upon his comments here because his analysis fits well with a number of macro points I have made in the past.  First a quote from the Munchau piece:

We did not need to wait until the Dow Jones Industrial Average hit 10,000. It has been clear for some time that global equity markets are bubbling again. On the surface, this looks like 2003 and 2004 when the previous housing, credit, commodity and equity bubbles started to inflate, helped by low nominal interest rates and a lack of inflation. There is one big difference, though. This bubble will burst sooner…

The single reason for this renewed bubble is the extremely low level of nominal interest rates, which has induced people to move into all kinds of risky assets. Even house prices are rising again. They never fell to the levels consistent with long-term price-to-rent and price-to-income ratios, which are reliable metrics of the property markets’ relative under- or over-valuation…

…there is danger no matter how the central banks react. Successful monetary policy could be like walking along a perilous ridge, on either side of which lies a precipice of instability.

For all we know, there may not be a safe way down.

The argument Munchau is making should be familiar to you as ‘the asset-based economy’ (which I will now retroactively add as a tag to prior posts).  To date, the best outline I have provided for you was in a post earlier this month called,”A brief look at the Asset-Based Economy at economic turns.”

The Asset Based Economy View of America

My pre-conceived thesis is as follows:

1. The U.S. has been living beyond its means for a generation as reflected in the increase of debt to GDP across a wide-spectrum of sectors of the economy.
2. This increase has not been worrying to policymakers because they have only been watching debt service burdens, to the degree they have been tracking debt.
3. Because of “the Great Moderation,” interest rates have fallen, permitting a secular increase in debt to GDP levels without increasing debt service burdens.
4. The Federal Reserve has a dual mandate to support economic growth (through full employment) while maintaining low consumer price inflation (through price stability). Cognizant that debt services burdens were not acute and consumer price inflation was low, the Federal Reserve was able to target asset prices through lowering the Fed Funds Rate as a mechanism for reviving the economy when cyclical downturns occurred.
5. As a result, the Federal Reserve under Sir Alan Greenspan followed an asymmetric monetary policy of only increasing interest rates slowly in the face of large levels of asset price inflation but reducing those rates very quickly to stem asset price declines.
6. The result has been a belief that the Fed would save the economy when it ran into trouble, the so-called Greenspan Put. This has increased the appetite for risk in the financial sector and, most crucially, has meant that debt levels always increased after a brief downturn. The heroic actions of the Bernanke Fed have only increased this belief in the Fed as economic savior, sowing the seeds of the next asset bubble.
7. This Asset-Based Economic Model can last through several business cycles – but will eventually collapse when debt service burdens become too large.

But, given Munchau’s comments, I want to add a few of my own to flesh out what is happening here. First, this is not just an American phenomenon.  The post I wrote on London house prices earlier today shows that asset prices are being targeted as a vehicle for economic reflation in Britain as well.  The US and the UK are far from alone as nearly every major central bank has been using an extremely accommodative monetary policy to prevent a deflationary bust.

Munchau invokes Hyman Minsky’s model of financial instability to help explain how this sets us up for a volatile future because traditional macroeconomic theory is inadequate for understanding what got us to this point. In essence, the idyllic state of economic and price stability we know as “the Great Moderation” is really just a financialization of the economy. However, a large financial sector leads to excessive dependence on asset prices to fuel growth, which in turn leads to an accumulation of debt.

The financialization leads to both a widening gulf of income in society as the monied class profits (look no further than record financial sector bonuses during a weak recovery for roof). I believe it also leads to regulatory capture and crony capitalism. The debt buildup precipitates asset price deflation during busts — and the potential for a deflationary spiral in the real economy. As a result, central banks flood the economy with money to prevent this outcome. This flooding of the economy with liquidity in bad times, therefore, has the unintended consequence of making monetary policy asymmetrical.

The asymmetry results in extreme volatility in asset price.  All the while, debt keeps accumulating. Clearly, this increases the likelihood of a major bust and depression. Hence Stability (the great Moderation) creates Instability (a pronounced Boom-Bust cycle).

The question is: where does this all lead?  Munchau asks this question at the end of his post and suggests that “there may not be a safe way down.” His discussion about likely policy responses evokes memories of my “Scylla and Charybdis” post. Here is the key part from it:

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.

What you should draw from this is the following:

1. The Great Moderation is revealed as an illusion once we reach the zero bound, where interest rates are near zero.  At this point the asset-price reflation can no longer rely on interest rates alone, but must also use increasingly heavy-handed tactics to get the economy going.  This is where we now are.
2. Terminal Debt is fast approaching. Steve Keen believes we are at a Terminal Debt stage, where no more debt can possibly be accumulated to revive growth.  However, I have presented you with evidence that this is not necessarily the case (see posts here and here). Nevertheless, it is fast approaching.
3. The central bank is damned if it does and damned if it doesn’t. This was the takeaway of the Scylla and Charybdis post: All roads lead to a W-style Japanese depression or a deflationary bust because deflation is secular (Terminal Debt) while inflation is cyclical (asset prices). An inflationary scenario will invite a policy response which kills the recovery.
4. This is good for government bonds but not for risky assets.  Longer-term, this is a good environment for government bonds. They are the risk-free asset in an environment of secular deflation. Shares are not a good investment in this situation despite huge rallies.  Remember, we saw huge bear market rallies after 1929 and again in Japan after 1990.

I believe we are in the reflationary period of a longer-term depression right now. As a result, there is substantial downside risk for the economy going forward. Like Munchau, I don’t have any magic bullet solution to this dilemma – although I do have a number of ideas.  Feel free to chime in with your thoughts on the way forward.

Related posts:

• Quote of the day: William White and inflation
• Liquidity trap of a different sort
• Morgan Stanley warns of a new inflationary period
• ECB rate hike likely as wages in Germany spiral upward
• No Fed cut

Earlier today I wrote a post featuring comments by Marc Faber as I like to do from time to time.  In this particular case Dr. Faber was waxing prosaically about an eventual bankruptcy of the U.S. government.  His money quote was:

“Next station is when the U.S. government goes bust.”

I love this guy. Quite frankly, the man is a quote machine.  He makes a lot of outrageous statements that get him noticed.  Here are a few that I have featured in the past:

• Oct 2009 – “Monetary policy in the United States will stay expansionary”
• Sep 2009 – “The future will be a total disaster, with a collapse of our capitalistic system as we know it today, wars, massive government debt defaults and the impoverishment of large segments of Western society.”
• May 2009 – “I am 100% sure that the U.S. will go into hyperinflation”
• Mar 2009 – “The feds poured the gasoline and lit the match. Now they’ve joined the fire department”
• Nov 2008 – “I advise every American to hold his gold outside of the United States”
• Mar 2009 – “Don’t underestimate the power of printing money.”

The last one is my all-time favorite.  And there are many more available on this site and elsewhere.  Dr. Doom is very entertaining indeed – which is why I quote him so often.  But, is he right?

That’s a good question – one I will take up indirectly by introducing the latest piece by Martin Wolf, another author I have featured here from time to time. You may have seen me tweet this earlier today. I had intended to add it to the links for tomorrow, but Niels Jensen, who I also feature here often, convinced me to write it up as an ‘antidote’ to Faber.

Here’s how Wolf begins his article:

It is the season of dollar panic. These panic-mongers are varied: gold bugs, fiscal hawks and many others agree that the dollar, the dominant currency since the first world war, is on its death bed. Hyperinflationary collapse is in store. Does this make sense? No. All the same, the dollar-based global monetary system is defective. It would be good to start building alternative arrangements.

This is exactly what the Chinese are doing. They are preparing themselves for a non-dollar future. This is why the Chinese are buying gold. This is why the Chinese are settling trade in Yuan. And this also why the Chinese are getting a bunch of other countries onside.  But they are not looking for a dollar crash as I indicated last week.

Then, there is the part about Dollar weakness being a sign of inflation. Here’s what Wolf has to say about this idea:

The dollar’s correction is not just natural; it is helpful. It will lower the risk of deflation in the US and facilitate the correction of the global “imbalances” that helped cause the crisis. I agree with a forthcoming article by Fred Bergsten of the Peterson Institute for International Economics that “huge inflows of foreign capital to the US facilitated the over-leveraging and underpricing of risk”.* Even those who are sceptical of this agree that the US needs export-led growth.

I hope this argument sounds familiar because it is one I made when I asked is the Fed just jawboning? The U.S. wants – it needs a lower dollar to avoid deflation. Quantitative easing is not solving the deflation question. The U.S. government wants a strong dollar? Well, policymakers say one thing and wish for another. The U.S. insistence on focusing on global imbalances at the G-20 should tell you what policy makers really want. This is why the dollar is falling. 

The problem of course is that the dollar’s recent rout is not necessarily helping the U.S. because the dollar is overvalued vis-a-vis a host of pegged currencies. And while those currencies are under pressure to drop the peg, they are resisting because they do not want to move toward a more re-balanced global growth paradigm unless forced to do so.  Unless these countries (read China) do something on the currency front, expect more of this, this and this – protectionism.

Then, the question arises, if everyone hates the dollar, what are they moving to? Wolf says:

Finally, what can replace the dollar? Unless and until China removes exchange controls and develops deep and liquid financial markets – probably a generation away – the euro is the dollar’s only serious competitor. At present, 65 per cent of the world’s reserves are in dollars and 25 per cent in euros. Yes, there could be some shift. But it is likely to be slow. The eurozone also has high fiscal deficits and debts. The dollar will exist 30 years from now; the euro’s fate is less certain.

This view may be too complacent. The danger of a collapse of the dollar is small and of its replacement by another currency still smaller. But a global monetary system that rests on the currency of a single country is problematic, for both issuer and users. The risks are also growing, particularly since the emergence of “Bretton Woods II” – the practice of managing exchange rates against the dollar.

I liken this argument to George Soros’ comments on dollar weakness: "The dollar is a very weak currency except all the others." Right now, there is no alternative to the dollar.  Some people are fleeing U.S. assets if they can. But the alternatives are limited and this limits how far the dollar will fall. And this is unfortunate because the monetary system now in place is in need of change.  Without it, we are likely to see nationalistic policy responses to economic weakness, which will induce conflict.

Wolf says:

I arrive, by a somewhat different route, at the same conclusion as Mr Bergsten: the global role of the dollar is not in the interests of the US. The case for moving to a different system is very strong. This is not because the dollar’s role is now endangered. It is rather because it impairs domestic and global stability. The time for alternatives is now.

Apropos alternative monetary systems, we might start with Paul Davidson’s ideas, which I first highlighted here in November.  So there is no hyperinflation, no U.S. national bankruptcy, and  no dollar crash coming. But, the financial crisis demonstrates we are living on borrowed time and need a new monetary system. The time is now.

Source

The rumours of the dollar’s death are much exaggerated – Martin Wolf

Related posts:

• Marc Faber: “U.S. dollar weakness is a symptom of inflation in the system”
• China to diversify out of U.S. dollars
• Japanese defend dollar’s status while China tears it down
• The latest dollar rout revealed
• Hayek: “I am not only against inflation but I am also against deflation.”

Below are two videos from Marc Faber’s recent interview on Asia Confidential.  In it, he takes questions from user emails in regards to the U.S. dollar, economic decline in the U.S. and gold as an investment.

He sees a need for the U.S. to borrow increasing amounts of money going forward – not less. As a result, what was a crisis in finance in 2008, resulting in the nationalization of Fannie Mae and Freddie Mac will become a national bankruptcy. The U.S. will borrow and print money. The dollar will fall precipitously. Then, “next station is when the U.S. government goes bust.”

Edward here. This might make for good headlines on Bloomberg, but it is patently false.  The United States is not now or ever going bust. A sovereign government which borrows in its own currency in a fiat currency system can never go bust. An entity which borrows and prints its own money does not have the same constraints that, say, California or Ireland have. How prices are affected is another issue altogether.

That’s where gold comes into the picture. Here, there are many questions.

• Is it overvalued?
• Is it a good inflation hedge?
• How does gold perform in deflationary environments?
• How does it perform against equities over the longer run?
• What about silver?

Faber takes on all of these.

On the whole, he is an inflationista and does not believe the U.S. will suffer deflation. When asked how gold might perform in a significant deflationary environment, he responds “first of all, I would like to make a very clear statement. I will believe in deflation once we have a significant period of U.S. dollar strength. U.S. dollar weakness is a symptom of inflation in the system.”

He goes on to say that gold outperforms other asset classes in a deflationary environment and is therefore a good hedge against fiat currency revulsion whether one expects deflation or inflation.

My own view is similar. However, I would differentiate between consumer price inflation, which will remain non-existent while industrial capacity and employment levels are at depressionary levels.  The inflation in the system will manifest itself first in asset prices – with industrial and food commodities or oil being the transmission mechanism into consumer prices.  Secular consumer price inflation will not return until the slack in the system is purged. 

I would add that this is one principal reason that the Great Moderation occurred despite enormous money printing in Japan and extraordinarily loose monetary policy in the U.S.  After China, India and Eastern Europe joined the capitalist system, the enormous increase in labor – both skilled and unskilled – acted as a check on inflation of the consumer price variety.

Alan Greenspan was fooled by this and kept monetary policy too loose. The result was asset bubbles again and again.  Going forward, it would comforting to see central banks target asset prices not just to gain policy traction through reflation but in order to cool the economy through deflation.

Related posts:

• China to diversify out of U.S. dollars
• Quote of the day: William White and inflation
• The inflation – deflation debate redux
• Morgan Stanley warns of a new inflationary period
• Bernanke is responsible for the market meltdown

Last week, I highlighted some of the ideas of Australian economist Steve Keen in my post, “Politics and reform: Say I’m a politician….”  Keen is of the Minsky camp and he believes that an unsustainable debt bubble has build up in the industrialized world which can only be brought to heel through a ‘debt jubilee.’

Below is a video clip of Keen telling Max Keiser a bit more about how he sees things.  Central to his ideas is the concept that demand for credit creates loans which create reserves, which is the opposite causality of what one sees in neoclassical economics.  This would mean that, absent a pickup in demand for credit, inflation is unlikely to reappear – irrespective of what central banks do. I will have more on this subject in later posts.

Related posts:

• Chart of the day: Excess Reserves
• Steve Keen and the spectre of terminal debt
• Steve Keen: Debt and the economy – how do we pay for all of this?
• Is quantitative easing really inflationary?
• Connecting Fed cuts with credit writedowns and quantitative easing

This entry from Gary Shilling comes via John Mauldin’s site InvestorInsight.com where he highlights commentary from some of the best economic thinkers. Shilling, who correctly predicted problems in residential real estate in the US, is in the deflation camp.  He thinks the US will be a slow growing economy prone to recession and high unemployment over the next decade. A major factor in this is the anticipated increase in savings due to withdrawal from the asset-based economy and the beginning of a balance-sheet recession.

As I indicated in my last post, it is this prospect which should keep policy makers up at night because it will mean the US government is going to continue as a major economic actor for years to come.  I should point out that the Great Depression, while much more severe than what we have experienced thus far, had significant periods of high growth, but was largely characterized by short business cycles and a general deleveraging – the D-process, now my short-hand for depression.  Just sayin’.

(excerpted from the August 2009 edition of A. Gary Shilling’s INSIGHT)

Beyond the current recession, the worst since the 1930s, lies years of slow growth, as we’ve discussed in past Insights. The next economic recovery, which will probably start around mid-2010, will likely be so subdued that it may not feel like the recession has ended. And economic growth in the bulk of the next decade will probably be slow — so slow that it will force the federal government to take continuing actions to prevent high and chronically rising unemployment.

Six Causes of Slow Long-Term Growth

As explored in detail in past Insights, six forces will promote slow long-term growth in the U.S. and, indeed, on a global basis — U.S. consumer retrenchment, financial sector deleveraging, weak commodity prices, increased government regulation and involvement in the economy, protectionism and deflation.

Consumer Retrenchment. First and foremost is the dramatic switch by American consumers from a 25-year borrowing and spending binge to a saving spree that should extend a decade or more. As we pointed out last month, in the 1980s and 1990s, U.S. consumers regarded their soaring stock portfolios as continually filling piggybanks that would fund their kids’ education, early retirements and a few round-the-world cruises in between. So they slashed their saving rate and pushed up their borrowing to fund spending growth that consistently exceeded the rise in after-tax income. When stocks nosedived with the collapse in the dot com bubble in 2000-2002, leaping house prices seamlessly took over to finance oversized consumer spending growth.

But now stock and house prices — the vast majority of most Americans’ net worth — are not only depressed but also unlikely to revive to their former glory days for many, many years. Furthermore, our earlier research found no other major consumer assets that could be borrowed against. So consumers are being forced to embark on the saving spree we have been predicting for some years.

For the next decade, we’re forecasting an average one percentage point rise in the saving rate annually, raising it to 10% in 10 years. That still would not return the saving rate to the early 1980s level of 12% even though the demographics for saving have gone from the worst to the best in the interim. And even a decade of vigorous saving will probably not return household net worth even close to its former peaks or eliminate completely the three decades of ever-increasing household financial leverage.

Financial Deleveraging. Financial deleveraging will also reduce long-term economic growth. As we’ve discussed in many past Insights, the recession really started in early 2007 in the financial arena with the collapse of subprime residential mortgages. Then it spread to Wall Street in mid-2007 with the complete mistrust among financial institutions and their assets, too many of which were linked to troubled mortgages. A huge gap opened up back then between the 3-month LIBOR and Treasury bill yields, and that panicked Washington into opening the money floodgates. The Fed started its interest rate-cutting campaign that ultimately drove its federal funds rate target to the zero-to-0.25% range (Chart 1 ).

But the central bank soon found the banks were too scared to lend and creditworthy borrowers didn’t want to borrow when Bear Stearns and Lehman collapsed and other large banks and Wall Street houses were on the brink. So the Fed embarked on quantitative easing that exploded its balance sheet. And Congress and the Administration joined in with the $700 billion TARP, the $787 billion fiscal bailout and many other programs, as witnessed by the exploding federal deficit.

The Bank for International Settlements recently said only limited progress has been made in clearing up the global financial system, and any economic recovery will be short-lived and followed by a long period of stagnation unless bank balance sheets are corrected.

Except for hotels, commercial real estate woes aren’t so much the result of overbuilding, as is the case with residential. Rather, the problems are due to aggressive refinancing and pricing in earlier years as well as current slumping demand. As retailers close stores or fold completely, mall space becomes vacant. Warehouses are empty as consumer retrenchment curtails goods imported from Asia and elsewhere. Excess space and weak business and leisure travel is axing hotel room rates and occupancy. Layoffs result in sublease office space competing with landlords for tenants.

Furthermore, a great deal of real estate debt must be refinanced soon amidst falling occupancy, rents and sales prices as well as tight credit markets. Estimates are that $155 billion in securitizations are coming due by 2012 and two-thirds won’t qualify for refinancing as prices drop 35% to 45% from their 2007 peaks. Meanwhile, $525 billion of commercial mortgages held by banks and thrifts will come due by 2012. About 50% won’t qualify for refinancing since they exceed 90% of the underlying property value. Lenders prefer loans of no more than 65%.

Deleveraging of the financial sector will obviously have negative ramifications for the real economy it finances. We’ve already seen plenty of effects. Many small businesses that depend on outside financing are starving as banks tighten lending standards. In a sense, many derivatives were financial cobwebs spun among bank and other speculators, but they did finance much of the housing boom.

Commodity Crisis. The earlier collapse of the commodity bubble (Chart 2) will also subdue global economic growth in future years. Sure, commodity consumers benefit from lower prices by the same amount that producers lose. But the share of total spending on commodity imports by consumers, especially in developed lands, is tiny while they account for the bulk of exports for producers, many of them developing countries such as Middle East oil producers.

Furthermore, security losses last year devastated sovereign wealth funds, many of them in oil-rich countries as well as Asian exporters. A year ago, they were estimated to hold $3 trillion in assets on their way to $10 trillion. Now the estimate is $1.8 trillion and optimistically forecast to rise to only $5 to $6 trillion by 2012. Lower oil prices have a lot to do with the downward revisions. Singapore’s huge Temasek Holdings fell more than $28 billion, or 22%, at the end of March from a year earlier.

More Government Regulation. So, U.S. consumer retrenchment, global financial deleveraging and weak commodity prices will keep worldwide economic growth subdued for many years. So, too, will vastly increased regulation here and abroad, the normal reaction to financial and economic crises, as noted in our earlier reports. When a lot of people lose a lot of money, there is a cosmic need for scapegoats and increased regulation. Sure, many embarrassed financial wizards have sworn off their wayward ways and will be cautious for years, probably the balance of their careers. But that won’t stop witch hunts.

The Administration has proposed a substantial overhaul of financial regulation. It doesn’t plan to combine regulators to eliminate overlaps and gaps, as originally discussed. Still, it would empower the Fed to monitor financial risks to avoid systemwide instability; create a Consumer Financial Protection Agency with control of mortgages, credit cards, savings accounts and annuities; push public companies to give shareholders say on pay; bring hedge funds under federal regulation; require firms to hold some of mortgage securitizations they create and sell; force derivatives to be traded on exchanges; beef up oversight of insurance; force industrial loan companies to obtain bank holding company charters; urge the SEC to stem runs on money market funds and to strengthen regulation of credit rating firms; create a mechanism for government to takeover large, failing financial institutions; and amends the Fed’s lending powers to require the Treasury Secretary’s approval.

The first Obama federal budget also points clearly to more government regulation and involvement in the economy, in health, education and the environment. Beyond the financial sector, the bailout of U.S. auto producers led to considerable government control of that industry, almost day-to-day management by Washington.

Rising Protectionism. Without question, protectionism will slow or even eliminate global economic growth as international trade slumps. As noted in earlier Insights, recessions spawn economic nationalism and protectionism, and the deeper the slump, the stronger are those tendencies. It’s ever so easy to blame foreigners for domestic woes and take actions to protect the home turf while repelling the offshore invaders. The beneficial effects of free trade are considerable but diffuse while the loss of one’s job to imports is very specific. And politicians find protectionism to be a convenient vote-getter since foreigners don’t vote in domestic elections.

As noted earlier, initially this recession was in the financial arena — the collapse in the residential mortgage market led by the Subprime Slime that started in early 2007, and the follow-on Wall Street woes that commenced in the middle of that year when two big Bear Stearns hedge funds imploded. So it’s not surprising that protectionism began in the financial arena and took the form of competing to safeguard a country’s financial institutions. But at least that competition was positive for financial systems and economies, even if expensive for taxpayers.

Now, however, protection has spread to its more classical import-export arena with the advent late last year of massive U.S. consumer retrenchment and globalization of the downturn. Both forces are severely depressing the goods and services sectors as U.S. consumer spending falls the most since the 1930s and unemployment here and abroad leaps.

Since the early 1980s, world trade has functioned in a smooth but unsustainable fashion. The rest of the world produced and America consumed. In many foreign lands, households were weak consumers and big savers, so production exceeded domestic consumption. Their production surpluses were exported, directly or indirectly, to the U.S. where consumers were saving less and less and spending more and more. With their growing trade surpluses, foreign nations had growing piles of dollars that they recycled into Treasurys and other American investments, helping to hold down interest rates and making it cheaper for spendthrift American consumers to borrow easily and cheaply to fund their leaping debts.

Now, with American consumers embarking on a saving spree, the U.S. will no longer be the buyer of first and last resort for the globe’s excess goods and services. Furthermore, with slower global growth for years ahead, virtually every country will be promoting exports to spur domestic activity. When every country wants to export and none want to import, the pressure for protectionism leaps.

Deflation. Chronic deflation is the sixth reason we forecast slow economic growth in the next decade or so. Chronic deflation spawns self-fulfilling deflationary expectations. Today, who would have the guts to tell a friend he paid the full sticker price for a vehicle? Years of rebates have trained car buyers to expect continuing and even bigger rebates. So they wait to buy. That leads to excess inventories that require even larger price concessions. Buyer suspicions are confirmed so they wait longer, promoting more inventory buildup, more price cuts, etc. in a self-feeding cycle. A key effect, of course, is to retard spending and slow economic growth.

Long-time Insight readers know that we have been forecasting chronic deflation to start with the next major global recession. Well, that recession is here. We earlier forecast chronic good deflation of excess supply because of today’s convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output and depress prices. As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. Big output growth also results from the globalization of production and the other deflationary forces we discussed in and since we wrote our two Deflation books a decade ago. With U.S. consumer retrenchment and a shrinking pool of global imports, export-dependent lands will be competing even more fiercely for the remaining markets.

In contrast to good deflation, bad deflation reigned in the 1930s as the Great Depression pushed demand well below supply. Japan also suffered bad deflation over the last two decades after the collapse of her 1980s housing and stock market bubbles. But in Japan, the lack of demand wasn’t caused by a dearth of employment and income as in the U.S. in the 1930s, but because the government delayed cleaning up her financial institutions while consumers refused to spend their incomes.

We’ve consistently predicted the good deflation of excess supply, but we’ve also said clearly that the bad deflation of deficient demand could occur — due to severe and widespread financial crises or due to global protectionism. Both are obvious threats, as explained earlier.

Few agree with our forecast of chronic deflation. They’ve never seen anything but inflation in their business careers or lifetimes, so they think that’s the way God made the world. Few can remember much about the 1930s, the last time deflation reigned. Excessive monetary and fiscal stimuli are also key reasons why most observers forecast chronic and severe inflation in future years. They may concede that deflation is more likely in the balance of the recession (Chart 3) for the reasons we’ve cited in past Insights. Past weakness in commodity prices is still working its way through the production and distribution system. Surplus inventories (Chart 4) — the result of producers, wholesalers and retailers being caught unaware when consumers suddenly retrenched last fall — are still being worked off and depressing prices in the process.

Wage cuts and mandatory furloughs for the first time since the 1930s, as well as layoffs are obviously deflationary as they depress purchasing power. In addition, the excess of supply over demand has clear implications for deflation.

Nevertheless, the vast majority still maintain that inflation is inevitable in the long run. All the money being pumped out by the Fed and the Treasury deficits is sure to stimulate too much demand in relation to supply, they believe. But before money can promote excess demand, it’s got to get into circulation, and scared lenders and creditworthy borrowers are unlikely to convert massive bank reserves into money until rapid economic growth resumes. And that, we believe, is unlikely for many years. Furthermore, if economic growth and loans mushroom, contrary to our forecast, major central bankers, with their congenital fear of inflation, will no doubt withdraw much of that liquidity.

Slow And Weak Recovery

We continue to forecast that the recession will extend into early 2010. Only by then is enough fiscal stimulus likely to be pumped out to stabilize consumer retrenchment. By then, most of the global financial woes should be at least stabilized. And by then, enough excess house inventories may be absorbed to end the downward pressure on prices.

Excess house inventories were built up in the 1996-2005 boom and still number about 1.5 million new and existing houses above normal working levels despite the collapse in housing starts and recent stabilization in sales. Excess inventories are the mortal enemy of prices in any goods-producing industry, especially housing. We continue to believe it will take at least until the end of next year before excess house inventories are reduced to levels that no longer depress prices. Meanwhile, prices — already down 32% from their second quarter 2006 peak — are likely to fall to reach a total 37% decline we’ve forecast for the last two years.

The decline in house prices is evaporating home equity. In the early 1980s, those with mortgages had almost 50% equity in their houses on average, after subtracting all mortgage borrowing from the market price of their homes (Chart 5). Due to increasing mortgage leverage and, more recently, collapsing house prices, that equity was only 20% in the first quarter and continuing to fall.

If house prices drop about 37% from their peak to their final bottom, that equity will be down to about the 15% range. At that point, over 25 million homeowners, or half those with mortgages, will be under water, compared to about 25% today.

After the recession ends as the economy stops falling, a weak recovery is likely to follow, one so tepid and with such high unemployment that you may not know it has arrived. The two normal forces that generate economic recoveries are missing this time. As usual, the Fed eased monetary policy once it saw that the economy was headed for recession.

But unlike the past, Fed action is not reviving housing (Chart 5), given the overhang of excess house inventories. And the normal pop in production when the liquidation of overall inventories ends (Chart 6 ) will be muted and overshadowed by the unusually large slashing of consumer spending. It’s hard for businesses to cut inventories fast enough to keep up with dropping consumer demand.

2.0% GDP Growth

A chronic 1 percentage point annual rise in the consumer saving rate for the next decade or so will knock around 1 percentage point off real GDP growth after its effects work their way through the economy. That’s a big contrast with 0.5 annual percentage point declines in the saving rate over the previous quarter century that added around 0.5 percentage points to growth. That total swing of 1.5 percentage points will reduce real GDP growth from 3.6% per year in the 1982-2000 salad days (Chart 7 ) to 2.1%.

So with the five other inhibitors to growth in coming years — financial deleveraging, weak commodity prices that will retard spending by producing countries, more government regulation and involvement in the economy, rising protectionism and deflation — our forecast of 2.0% real GDP growth is probably even optimistic.

With 2% to 3% deflation, nominal GDP might not gain at all. And with slower growth in the years ahead, economic expansions are likely to be shorter and less robust while recessions will probably be deeper and more frequent.

Consumer Spending Growth

We’re also forecasting real consumer spending growth of 1.4% per year in the next decade. That, too, may be optimistic as consumers retrench and slash real debt which far outran real housing wealth even before it collapsed, outran real annual growth in real stock wealth before it nosedived, and bested real disposable income growth. Much of the explosion in debt was residential mortgage-related borrowing in the mid-1990s – mid-2000s housing bubble, fueled by low borrowing costs, weak lending standards, exotic mortgages and securitization, which distributed toxic mortgage loans to unsuspecting investors.

The deleveraging of consumers that we expect to continue for years is a reversal of the same long run phenomenon of past decades that was measured in different ways — the decline in the saving rate, the rise in debt and debt service rates and the rise in consumption’s share of GDP, reflecting what consumers did with the money they didn’t save and did borrow.

Consumption vs. GDP

With real consumer spending forecast to grow 1.4% annually over the next decade and real GDP 2.0%, real consumption’s share of GDP falls from 71.0% last year to 66.5% in 2018 (Chart 7). That would bring it back to the level of the early 1980s when the consumer spending binge began (Chart 8 ). It may seem inconsistent that we’re forecasting a rise in the household saving rate of 10 percentage points but a decline in real consumption’s share of real GDP of only 4.5 percentage points from 71% to 66.5%. But note that the reverse occurred in the last 25 years — the saving rate fell from 12% to zero, or 12 percentage points while consumption’s share of real GDP rose from 67.5% to 71%.

These differences are in part because household saving is being measured as a percentage of disposable (after-tax) income, which is less than GDP, so the effects of the change in the saving rate on GDP are muted. In the earlier 1980s, real disposable income was about 78% of GDP. Furthermore, the rise in consumption’s share of real GDP in the 1982-2000 boom years (Chart 8) was actually held back by the drop in the real DPI/real GDP ratio. That in turn was largely the result of employee compensation’s share of national income falling while corporate profits’ share leaped during those years.

In the years ahead, however, it’s unlikely that DPI will decline as a share of GDP. As we discussed in earlier years when profits’ share was at its zenith, a big decline in corporate earnings’ piece if the pie was probably in the cards. In a democracy, we noted, neither capital nor labor can continually increase its share indefinitely while the other one’s share chronically shrinks. We also suggested that the recession and financial mess we were forecasting, the worst since the Great Depression, would depress profits. We also opined that Obama Administration and Democratic-controlled Congress would be adverse to shareholders while smiling on their labor constituents.

Where’s The Growth?

If consumer spending grows slower than GDP in the next decade, other GDP components must grow faster. Which ones? As shown in our forecast table (Chart 7), it’s unlikely to be residential construction, which we see growing 1.0% per year in real terms compared with 5.2% in the 1982-2000 years. Housing should remain weak even after the huge excess inventory is worked off. Earlier, homeowners were convinced that house prices never declined — and they hadn’t on a nationwide basis since the 1930s.

But the recent collapse in house prices and the prospect that they will move with overall prices in the future — which means chronic declines with chronic deflation — are shattering the scales that blinded homeowners. So they’re beginning to separate places to live from investments. That means they’ll want smaller quarters, and the new houses that are built will be smaller and less expensive.

Capital Spending

Real spending on nonresidential structures grew only 0.6% per year in the 1982-2000 era as overexpansion in the earlier years curtailed spending later on. With slow economic growth in the years ahead, demand for warehouse, factory, office and hotel space is likely to be subdued. Ongoing consumer retrenchment will keep retail vacancies high and new building low. On balance, we project about the same growth rate for real nonresidential construction, 0.5% per year, in the next decade.

Equipment and software real spending advanced briskly in the 1982-2000 years, 8.2% annually as new technologies such as computers, semiconductors, the Internet, biotech and telecom absorbed tremendous amounts of spending. Furthermore, inflation and interest rates were declining (Chart 9 ) to the benefit of the corporate sector, and operating rates were generally high while profits growth was robust. Those new technologies will continue to attract heavy spending in the next decade, but their initial huge bursts of spending are probably over. Furthermore, although the interest costs to finance capital investment will probably remain low, especially with deflation, profits will probably remain under pressure in an era of slow revenue growth and deflation. And most important, capacity utilization rates are likely to remain low.

A statistical model that we’ve run many times over the years and just updated shows that year-over-year changes in corporate profits, interest costs and capacity utilization in the post-World War II era are all statistically significant in explaining year-over-year growth in both the equipment and software component of GDP and equipment and software plus nonresidential construction. But in either case, capacity utilization is much more important with coefficients almost three times as large as those for interest costs and even bigger relative to those for profits in both models (Charts 10 and 11).

We forecast annual real growth in equipment and software investment of 3.0% per year in the next decade, faster than the 2.0% we foresee for real GDP but much less than the 8.2% in the 1982-2000 golden years.

Imports and Exports

With weak consumer spending growth and overall muted economic advance, real imports are likely to rise only 2.8% annually in the next decade, much less than the 9.0% growth in 1982-2000 when U.S. consumer spending was booming and free trade ruled the world. This forecast is even lower than suggested by our 1.4% annual growth in real consumption. Historically, a 1% rise in consumer spending results in a 2.8% rise in imports, but rising protectionism is likely to dampen that relationship.

This weakness in U.S. imports will leave profound effects on the many foreign economies that have depended for growth on American consumers buying the excess goods and services for which they have no other ready markets. The net effect of subdued growth in U.S. imports will be sluggish economic growth abroad, perhaps even slower in other developed lands than in the U.S. That should limit the growth in U.S. exports to 3.0% per year compared with 7.4% in the 1982-2000 years (Chart 7). Still, government policies in Asia and elsewhere that promote consumer spending are likely to result in U.S. exports growing slightly faster than American imports, the reverse of earlier years. Severe protectionism, however, may stymie even these low growth forecasts for foreign trade.

State and Local Government Spending

Real state and local government spending, as recorded in the GDP accounts, rose slower than real GDP in the 1982-2000 years, 3.2% vs. 3.6%, and no doubt would in the years ahead — except for federal government stimuli that’s spent by municipalities, as discussed later. State governments are in terrible financial shape and likely to continue so in the years ahead. In the first four months of this year, state income taxes plunged 26%. In the economic climate we foresee, corporate, sales and individual income taxes will all remain depressed.

At the local level, collapsed real estate prices will hold down property tax collections in the years ahead while reductions in aid and revenue-sharing from state governments will persist. In a recent survey, 18 states reported cuts in local aid. California Gov. Schwarzenegger proposed that low-level crimes like auto theft and drug possession be considered only misdemeanors so those convicted would do time in county jails. That would reduce state prison expenses and save the state $1.1 billion in the next three years, but raise local government costs. Furthermore, California’s latest budget stopgap will take, temporarily, $4 billion from local government funds.

We’re forecasting 5.0% annual growth in state and local government spending in the next decade, but the majority of it will probably come from Washington, which will be forced to spend heavily to prevent high and chronically rising unemployment.

Rescued By Slow Productivity

Some suggest that slower economic growth will bring slower growth in production. That would reduce the upward pressure on unemployment since more people would be needed for work than with faster productivity growth. But there’s no evidence that productivity growth necessarily slows with a chronically weak economy. In the depressed 1930s, productivity grew 2.39% annually, among the highest decades since 1900. In that decade, much of the new technologies of the 1920s — electrification of homes and factories and mass-produced automobiles — was being implemented, despite the Great Depression and its slow growth aftermath.

Similarly, the new tech burst of the last decade or so in computers, the Internet, biotech, telecom and semiconductors will no doubt promote rapid productivity growth in coming years.

Finally, the mindset of American business will probably promote robust productivity growth in future years. Throughout this decade, the emphasis has been on producing more with fewer people. Note (Chart 12) that even at the top of the expansion in 2007, job openings were fewer than in 2000 at the peak of the previous expansion, despite the growth in the economy in the meanwhile. And since 2007, job openings have collapsed.

Unemployment will also remain high since many of the people who have lost jobs were in construction and finance, two areas that will probably do little net hiring for many years. Normally, a 2 percentage point drop in real GDP causes a 1 percentage point rise in the unemployment rate. But June’s 9.5% rate is 1.5 percentage points higher than this rule of thumb would predict, given the drop so far in real GDP.

Big Federal Spending

If we’re right, then, on our forecast of slow economic growth in the next decade, unemployment will be high and chronically rising — absent huge federal intervention. And that intervention is assured since no government — left, right or center — can withstand high and rising joblessness for long. And don’t forget current as well as future increased federal immersion in the economy builds constituencies that fight fiercely to preserve their government goodies.

Some of this federal intervention will probably take the form of more federal employees and direct purchases of goods and services, which show up in the GDP breakdown (Chart 7). But most of it won’t be recorded as the federal spending GDP component since it will be transferred to individuals as federal unemployment benefits, extra Social Security checks, etc. and to state and local governments to fund leaf-raking and other make-work projects.

Notice that in 2018, we project real federal spending to account for only 7.2% of real GDP, up from 5.9% in 2008. Of course, nobody but economists look at these measures of federal spending, but instead concentrate on the ratio of total federal budget spending to GDP. This ratio mixed apples and oranges since budget spending includes transfers that GDP does not, but it does measure federal involvement in the economy.

In 2008, federal spending equaled 21% of GDP, outdistancing the 17.7% from revenues. This gap is likely to widen even after the current extraordinary spending to combat the recession and financial mess is over. Anti-unemployment spending will jump to higher levels while federal revenues languish. How will the resulting large deficit be financed?

Savers To The Rescue

In the past, federal deficits were financed by foreigners as they recycled back to the U.S. the dollars gained from their trade surpluses, as noted earlier. The growing U.S. current account deficit measures the increasing gap between domestic saving and investment, or, in effect, and the need for foreigners to not only finance government deficits but also make up for declining U.S. consumer saving.

But now, the current account and trade deficits are shrinking as American consumers retrench and slash imports. Further declines will accrue in future years if exports grow faster than imports (Chart 7), so foreigners will have smaller American current account deficits to finance. At the same time, much more of federal deficits will probably be financed by rising U.S. consumer saving.

Household saving is basically what’s left from wages, salaries, rent, interest, dividends and transfers like pension benefits after subtracting spending on durables like autos and appliances, non-durables such as food and clothing and services like recreation and medical services. That amount, divided by the after-tax income in the period in question, is saving rate. Saving can be used to either reduce debt or increase assets.

Debt Reduction

Although the stock bulls may salivate over the prospect that increased saving will mean more equity purchases, we believe that most of the money will go to debt repayment — the flip side of a saving spree. The 6.9% saving rate in May, mentioned earlier, was a result of consumers saving their tax cuts and extra Social Security payments, and is unsustainable. Still, since after-tax income was about $11 trillion at annual rates in May, this saving rate produced annual rate saving of $769 billion. That money was basically used for debt reduction and since money is fungible, it ended up financing a major part of the mushrooming federal deficit. As consumer saving grows in future years, it will increasingly finance the federal deficit, indirectly.

Repaying debt will be attractive to many Americans in future years as they shun many investments after their huge losses in stocks throughout this decade and their shocking setbacks in real estate. A number will want to be less leveraged as slower economic growth makes employment less stable and unemployment more likely. Chastened lenders, pressed by regulators, will be pushing individuals to lower their leverage by repaying debt.

So will the deflation we foresee. Incomes may grow on average in real or inflation-adjusted terms, but shrink in current dollars. Still, debts are denominated in current dollars and therefore will grow in relation to current dollar incomes and the ability to service them. This will be the reverse of inflation, which reduced the value of debts in real terms and makes it easier to service them as incomes rise with inflation.

Future Insights

In future Insights, we’ll update our 2006 study that showed that over 50% of Americans depend in a meaningful way on government spending. The number will probably be much higher in the coming decade of likely slow growth and greater government involvement in the economy. We also plan to discuss our investment themes for an era of slow growth and deflation.

Meanwhile, don’t expect the burst of federal government spending and immersion in the economy to disappear with economic recovery. It’s likely to persist, not only because it spawns self-perpetuating constituencies, but also because the slow economic growth in the years ahead and threats of high and chronically rising unemployment will force continuing high levels of government involvement.

Source

Slow Long-Term Growth, And Government’s Response – Gary Shilling

Related posts:

• Chart of the day: Real GDP growth
• Chart of the day: consumer credit growth
• Switzerland gets deflation too
• Recession: How Long and How Deep?
• U.S. CPI: Lowest since 1954 – deflation here we come

The list of countries with deflation is growing by the month.  We have Spain, Switzerland, Britain, Ireland.  Now add Germany.

German consumer prices fell for the first time in 22 years in July, official figures have shown.

Prices fell 0.6% in July from a year earlier – the first fall since March 1987, when they declined by 0.3%.

The decline was largely due to falls in energy prices, which peaked in summer 2008, and analysts said Germany was unlikely to see a deflationary spiral.

Prices can fall for a short time without hurting the economy, but prolonged declines can be damaging.

Dirk Schumacher, an analyst at Goldman Sachs, said that the falling prices could help the economy in the short term.

"Falling prices are aiding consumer confidence and purchasing power. That’s aiding consumption," he said.

"This is not deflation. We’re still far away from that. It’s no cause for alarm," he added.

Right.  Keep telling yourself that.

Prices are falling.  This is deflation and it should underline for anyone with half a brain that deflationary forces of demand growth declines, deleveraging and overcapacity are still at work.

Source

Consumer prices fall in Germany – BBC News

Related posts:

• Switzerland gets deflation too
• U.S. CPI: Lowest since 1954 – deflation here we come
• Ireland gets deflation
• Britain gets deflation
• US consumer prices down 1%, core prices also down

In talking to the FT’s Gillian Tett, Hugh Hendry of The Eclectica Fund makes the hilarious metaphor of China as Santa Claus bringing gifts to a world constrained by excessive Western government debt issuance.  But, Hendry thinks the Asian surplus countries are the most exposed and most vulnerable because they are excessively dependent on foreign demand for economic growth.  Basically, Hendry sees China as a “deep out-of-the-money call option on America.” In Hendry’s view, Santa is not coming to town. And, if he is, he’s bringing lumps of coal.

Below is the video and two others of Hendry talking China, the Fed, Bonds, and Equities.  By the way, Hendry is bearish on equities, bullish on bonds.

• Bond bull, equity bear
• The Fed hasn’t done enough
• Bearish on China and gold

Read his June newsletter and comments about deflation here at Zero Hedge.  His view puts him in the deflation camp with David Rosenberg, but Rosenberg is more bullish on Asia.

Related posts:

• Hugh Hendry: China – The Emperor has no clothes
• China issues bonds to “promote the RMB in neighbouring countries”
• China to diversify out of U.S. dollars
• Will China enter deflation?
• China sovereign wealth fund diversifies into a massive loss

In the clearest signal yet that we are still in a potentially devastating global deflationary spiral, The Riksbank, Sweden’s central bank and the world’s oldest central bank, has effectively cut interest rates to minus 0.25% and has started a program of quantitative easing a.k.a printing money. These are the most dramatic moves yet by a major central bank and will be watched the world over for signs of success or failure.  Let me explain what the Swedes are doing and why.

On the 2 July 2009, the Riksbank unexpectedly lowered rates across the board.  Economists had expected the Riksbank to keep the repo rate at the low 0.5% level. The repo rate is the official bank rate at which banks can borrow from the central bank against government bond collateral. It is the floor rate, the lowest rate in the banking system.  But, the Swedes lowered the rate to 0.25%, a record low.

The interesting bits were buried deep in the accompanying press release, namely that the Riksbank was to engage in quantitative easing and to penalize banks for holding reserve deposits. The full press release is below with the important parts highlighted in bold.  I will translate this econ-o-speak into plain English after the Riksbank statement.

The weak development of the economy requires a somewhat more expansionary monetary policy. The Executive Board of the Riksbank has therefore decided to cut the repo rate by 0.25 of a percentage point to 0.25 per cent. The repo rate is expected to remain at this low level over the coming year. At the same time there are several signs that economic activity will improve.

Deep economic downturn

Economic activity abroad is very weak and this hits Sweden hard. Exports have fallen substantially and the situation on the labour market is continuing to deteriorate rapidly. The information received in recent months points to the economic downturn in 2009 being somewhat deeper than the Riksbank forecast in April.

Low repo rate over a long period of time

A lower repo rate and repo rate path are needed to counteract the fall in production and employment and to attain the inflation target of 2 per cent. The Executive Board of the Riksbank has therefore decided to cut the repo rate to 0.25 per cent. The repo rate is expected to remain at this low level until autumn 2010. The Riksbank’s assessment is that cutting the rate to 0.25 per cent will not threaten the functioning of the financial markets.

The Riksbank’s assessment is that after cutting the repo rate to 0.25 per cent it will have reached its lower limit in practice, and that the situation on the financial markets is still not completely normal. Supplementary measures are necessary to ensure that monetary policy has the intended effect. The Executive Board of the Riksbank has therefore decided to offer loans totalling SEK 100 billion to the banks at a fixed interest rate and with a maturity of 12 months. This should contribute to lower interest rates on loans to companies and households.

Stable underlying inflation

Despite the expansionary monetary policy, production and employment will be lower than normal over the next few years. Inflation will be kept up by weak productivity and a weak krona. However, there will be large fluctuations in CPI inflation during the coming period. This is primarily due to the fact that changes in the repo rate affect mortgage rates, which are included in the CPI. The CPIF underlying inflation rate (the CPI with a fixed mortgage rate) will on the other hand remain stable close to 2 per cent during the forecast period.

Signs of a turnaround

In recent months there have been several signs that economic activity will improve. At the same time, the financial markets in Sweden and abroad have begun to function more effectively, which creates the potential for an acceleration in international and domestic demand. The low repo rate and current fiscal policy will also contribute to the recovery. GDP growth is expected to be positive in 2010, but the labour market will lag behind and employment will not begin to rise until 2011.

Considerable uncertainty

The economic outlook is still uncertain. When the turnaround comes, the upturn may be stronger than in the main scenario. However, it could also be the case that the recovery will take longer than expected. The future direction for monetary policy will therefore depend on how new information on economic developments abroad and in Sweden will affect the prospects for inflation and economic activity in Sweden.

Forecast for inflation and GDP Annual percentage change

	2008	2009	2010	2011
CPI	3.4	-0.2 (-0.3)	1.4 (1.3)	3.2 (3.2)
CPIF	2.7	1.9 (1.9)	1.9 (1.8)	2.0 (2.0)
GDP	-0.2	-5.4 (-4.5)	1.4 (1.3)	3.1 (3.1)

Inflation forecast, 12-month figures Annual percentage change

	Sept. 09	Sept. 10	Sept. 11	Sept. 12
CPI	-1.2 (-1.4)	1.5 (1.4)	3.7 (3.7)	3.7
CPIF	1.5 (1.4)	1.7 (1.6)	2.0 (2.1)	2.2

Note. The assessment in the April 2009 Monetary Policy Update is shown in brackets. Sources: Statistics Sweden and the Riksbank

Forecast for the repo rate Per cent, quarterly averages

	Q2 2009	Q3 2009	Q4 2009	Q3 2010	Q3 2011	Q3 2012
Repo rate	0.6	0.3 (0.5)	0.3 (0.5)	0.3 (0.5)	1.8 (1.8)	4.0

Note. The assessment in the April 2009 Monetary Policy Update is shown in brackets. Source: The Riksbank

Deputy Governor Lars E.O. Svensson entered a reservation against the decision and advocated cutting the repo rate to 0 per cent and a repo rate path in line with the scenario for a lower repo rate in the Monetary Policy Report, so that the repo rate would be kept at this level for one year. He considered that such a repo rate path entails a better balanced monetary policy, with lower unemployment and higher resource utilisation without inflation deviating too far from the target.
Deputy Governor Barbro Wickman-Parak supported the decision to cut the repo rate to 0.25 percentage points, but entered a reservation against the growth forecasts, and thereby the repo rate path these entailed, in the Monetary Policy Report. Ms Wickman-Parak said her stance was due to a more positive view of economic activity both abroad and in Sweden further ahead, which would mean that the repo rate would need to be raised earlier than is forecast in the main scenario of the Monetary Policy Report.

The minutes from the Executive Board’s monetary policy discussion will be published on 16 July. The decision on the repo rate will apply with effect from Wednesday, 8 July. The deposit rate is at the same time cut to -0.25 per cent and the lending rate to 0.75 per cent. A press conference with Deputy Governor Barbro Wickman-Parak and Anders Vredin, Head of the Monetary Policy Department, will be held today at 11 a.m. in the Riksbank. Entry via the bank’s main entrance, Brunkebergstorg 11. Press cards must be shown. The press conference will be broadcast live on the Riksbank’s website, www.riksbank.se/.

So, here’s what the Swedes are saying:

1. Economic activity abroad is very weak and this hits Sweden hard. That means the Swedes can’t export their way to prosperity because no one is buying.  Everyone is in a synchronized global downturn.  One subtext I should mention is that Sweden is greatly affected by the collapse in the Baltics because there was a huge trade flow and banking relationship between Sweden and the Baltics.  Therefore, the economic depression there is not good for the Swedes or their banking system.
2. A lower repo rate and repo rate path are needed to counteract the fall in production and employment and to attain the inflation target of 2 per cent. Output and employment in Sweden is so weak now that it is creating deflation.  We have to lower interest rates in an effort to stimulate borrowing, which we hope increases credit and ultimately production and employment.
3. The Riksbank’s assessment is that after cutting the repo rate to 0.25 per cent it will have reached its lower limit in practice, and that the situation on the financial markets is still not completely normal. Look, we are cutting rates as low as they can go, effectively zero.  And financial markets are still not normal. Banks just are not lending enough to create the credit in the system necessary to increase production and employment.
4. The Executive Board of the Riksbank has therefore decided to offer loans totalling SEK 100 billion to the banks at a fixed interest rate and with a maturity of 12 months. Because cutting rates, the policy tool we prefer, is not getting the job done, we are going to effectively print money out of thin air. We will start making loans to banks with fictitious money that we create solely to increase the amount of money in circulation in a desperate attempt to increase consumer and business credit, consumer price inflation, and output.
5. The deposit rate is at the same time cut to -0.25 per cent. And as an extra measure, we will start penalizing banks for not lending by charging them 0.25% for holding deposits at the Riksbank.  Now, they will have every incentive to start lending…we hope.

Pretty aggressive plan, if you ask me. Will it work, though?

Well, first of all, most every major central bank in the world, certainly the biggest: the Americans, the Eurozone, the British, the Swiss, and the Japanese, have rates near zero and are printing money.  The world is awash in money and the incentive to borrow is huge.  So, is the Swedish announcement qualitatively different?  On some level, it is not.  Nevertheless, it is the most aggressive policy and the fact that they are charging negative interest rates for deposits is unprecedented.  This does make events in Sweden something to watch.

Moreover, the situation in Sweden is bleak.  GDP is expected to contract 5.4% this year and inflation is expected to be negative. Clearly, the Swedes are in a deflationary spiral.  It doesn’t help that its banks lent recklessly to the Baltics and that those countries are imploding.  The Swedish banking system is at present severely undercapitalized – this is why lending is not taking place.  The chart to the right of key figures from the Riksbank website sums it up.

So, the Swedes are lending and printing money. What’s more is they are taking economists up on their suggestions regarding negative interest rates. Back in April and May, Greg Mankiw and Willem Buiter suggested that negative interest rates were the way to go in order to deal with these problems.  Basically, you are giving people money to borrow.  There cannot be much more incentive than that.

The thing is you can lead a borrower to the bank, but you can’t make him borrow.  Do you even want him to borrow?  The last time I checked, it was savings and investment which created long-term growth.  In my view, people are terrified of over-borrowing now and no amount of easy money is going to change that overnight.

Here’s the problem.  I take a fairly Austrian School tack here.  Punishing savers by lowering interest rates to zero and printing money is not going to solve the problem.  The problem was low interest rate and easy money to begin with (and a lack of regulatory oversight never hurts too). This created a binge of reckless lending.  We are now seeing the result of that lending worldwide, Sweden included.

What Sweden needs is more capital in its banking system. Remember the whole song and dance about the Swedish solution? Supposedly, the Swedes were brave enough in the early 1990s to bite the bullet and nationalize insolvent banks in order to re-capitalise the banking system and get lending going again.  Everyone and his sister was saying this is what America needed to do (including me).  I still say this is what needs to be done: punish reckless lenders by liquidating zombie undercapitalized banks but provide enough liquidity at normal interest rates to keep the system intact.  And, I am sure taxpayers would be a lot more willing to pony up under these circumstances than under the present policy of giving the reckless lenders free handouts. If you want to prevent systemic collapse, it is the banking system, not the banks, which is important.

But, apparently, everyone just wants easy money and no one wants the Swedish solution – not the Americans and certainly not the Swedes.

Update 1300ET: Note – so as not to play too fast and lose with my terminology, I should clarify that the Riksbank is charging banks for holding deposits at the Riksbank.  They are not lending at negative interest rates as the statement “Basically, you are giving people money to borrow” suggests.  Also, regarding the lending by the Riksbank, they are not technically engaging in quantitative easing (buying government paper with new money). However, the net effect of the lending is to increase credit flow.

Related posts:

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• Connecting Fed cuts with credit writedowns and quantitative easing

This post is from Niels Jensen of Absolute Return Partners.  I have featured his monthly newsletter a number of times on Credit Writedowns (here’s the link to the last one, hilarious title).  Jensen is very good.

Visit www.arpllp.com to learn more about Absolute Return Partners and to sign up to receive their free monthly newsletter by e-mail.  You can reach them by email at info@arpllp.com.

In this particular article, he makes a well-argued case for deflation over inflation as the likely long-term outcome.  I express some of the finer points differently, but come to similar conclusions. The scenario I see is a low-growth muddle through (see the section labelled “Scylla and Charybdis” in my post, “Central banks will face a Scylla and Charybdis flation challenge for years”).  Also, note that he is not talking about a sustained recovery at all, while I expect a fake recovery in 3-9 months.

The central question here is: “But what actually happens when credit is destroyed at a faster rate than our central banks can print money?”

Here is the post.  Enjoy.

The Absolute Return Letter, July 2009

“You can’t beat deflation in a credit-based system.”-Robert Prechter

The great debate

As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won’t have to get more than a handful of key decisions correct – everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.

Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those ‘make or break’ decisions which will effectively determine returns over the next many years. The question is a very simple one:

Are we facing a deflationary spiral[1] or will the monetary and fiscal stimulus ultimately create (hyper) inflation?

Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or ‘quantitative easing’ as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?

A Story within the Story

Following the collapse of the biggest credit bubble in history, there has been no shortage of finger pointing and the hedge fund industry, which has always had an uncanny ability to be at the wrong place at the wrong time, has yet again been at the centre of attention. And politicians, keen to divert attention away from themselves as the true culprits of the crisis through years of regulatory neglect, have been quick at picking up the baton. Admittedly, the hedge fund industry is guilty of many stupid things over the years, but blaming it for the credit crisis is beyond pathetic and the suggestion that increased regulation of the hedge fund industry is going to prevent future crises is outrageously naïve.

If you prohibit private investors from investing in hedge funds which on average use 1.5-2 times leverage but permit the same investors to invest in banks which use 25 times leverage and which are for all intents and purposes bankrupt, then you either don’t understand the world of finance or you don’t want to understand. Shame on those who fall for cheap tactics.

Let’s begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that ‘less bad’ doesn’t necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn’t suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.

The return of the boom & bust

Going forward, not only will economic growth disappoint, but the economic cycles will become more volatile again (see chart 1) with several boom/bust cycles packed into the next couple of decades. This is a natural consequence of the Anglo-Saxon consumer-driven growth model having been bankrupted. Growing consumer spending over the past 30 years led to rapidly expanding service and financial sectors both of which will now contract for years to come as overcapacity forces players to downsize.

Chart 1: US GDP Growth Volatility

Source: Reserve Bank of Dallas

This will again lead to higher corporate earnings volatility which will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. At the bottom of every major bear market in the last 200 years, P/E ratios have been below 10. As you can see from chart 2 overleaf, few countries are there yet. The next decade is therefore not likely to be a ‘buy and hold’ market for equity investors. The combination of low economic growth and pressure on valuations will create severe headwinds. The most likely way to make money in equities will be through more active trading.

Japan all over again?

So now, two years into this crisis, where do we stand and where do we go from here? History offers limited guidance, as we have never experienced the bursting of a bubble of this magnitude before. The closest thing is the collapse of the Japanese credit bubble around 1990. As the Japanese have since learned, recovering from a deflated credit bubble is a long and very painful affair.

Governments and central banks on both sides of the Atlantic are pursuing a strategy of buying time, hoping that a recovery in economic conditions will allow our banking industry to re-build its capital base. The Japanese pursued a similar strategy back in the early 1990s. It failed miserably and set the country back many years in its recovery effort. Ironically, the Japanese approach was almost universally condemned as hopelessly inadequate. It is funny how you always know better how to fix other people’s problems than your own. A little bit like raising children, I suppose.

Chart 2: P/E Ratios in Various Countries

Another lesson learned from Japan is that once you get caught up in a deflationary spiral, it is exceedingly hard to escape from its grip. The Japanese authorities have used every trick in the book to reflate the economy over the past two decades. The results have been poor to say the least: Interest rates near zero (failed), quantitative easing (failed), public spending (failed), numerous attempts to drive down the value of the yen (failed); the list is long and makes for painful reading.

The liquidity trap

We are effectively caught in a liquidity trap. The Bank of England, the European Central Bank and the Federal Reserve have all flooded their banking system with enormous amounts of liquidity in recent months but what has happened? Instead of providing liquidity to private and corporate borrowers as the central banks would like to see, banks have taken the opportunity to repair their balance sheets. For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.

This is illustrated in chart 3 which measures the growth in the US monetary base less the growth in M2. As you can see, the broader measure of money supply (M2) cannot keep up with the growth in the liquidity provided by the Fed. In Europe the situation is broadly similar.

There is another way of assessing the inflationary risk. If one compares the total amount of credit destruction so far (about $14 trillion in the US alone) to the amount spent by the Treasury and the Fed on monetization and fiscal stimulus ($2 trillion), it is obvious that there is still a sizeable gap between the capital lost and the new capital provided[2].

The output gap

If we instead move our attention to the real economy, a similar picture emerges. One of the best leading indicators of inflation is the so-called output gap, which measures how much actual GDP is running below potential GDP (assuming full capacity utilisation). It is highly unlikely for inflation to accelerate during a period where the output gap is as high as it currently is (see chart 4). Theoretically, if you believe in a V-shaped recession, the output gap can be reduced significantly over a relatively short period of time, but that is not our central forecast for the next few years.

Chart 4: Output Gap & Capacity Utilization

The deflationary spiral

I can already hear some of you asking the perfectly valid question: How can you possibly suggest that deflation will prevail when commodity prices are likely to rise further as a result of seemingly endless demand from emerging economies? Won’t rising energy prices ensure a healthy dose of inflation, effectively protecting us from the evils of the deflationary spiral (see chart 6)?

Good question – counterintuitive answer:

Contrary to common belief, rising commodity prices can in fact be deflationary so long as demand for such commodities is relatively inelastic, which is usually the case for basic necessities such as heating oil, petrol, food, etc. The logic is the following: As commodity prices rise, money earmarked for other items goes towards meeting the higher commodity price and consumers are essentially forced to re-allocate their spending budget. This causes falling demand for discretionary items and can in extreme cases lead to deflation. We only have to go back to 2008 for the latest example of a commodity price induced deflationary cycle.

A price increase on a price inelastic commodity is effectively a tax hike. The only difference is that, in the case of the 2008 spike in energy prices, the money didn’t go towards plugging holes in the public finances but was instead spent on English football clubs (well, not all of it, but I am sure you get the point) which have become the latest ‘must have’ amongst the super-rich in the Middle East.

For all those reasons, I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now. The Japanese have pursued an aggressive monetary and fiscal policy for almost 20 years now, and they are still nowhere.

Interest rates on the rise

So why are interest rates creeping up at the long end? Part of it is due to the sheer supply of government debt scheduled for the next few years which spooks many investors (including us). And the fact that the rising supply is accompanied by deteriorating credit quality is a factor as well. But countries such as Australia and Canada, which only suffer modest fiscal deficits, have experienced rising rates as well, so it cannot be the only explanation.

Maybe the answer is to be found in the safe haven argument. When much of the world was staring into the abyss back in Q4 last year, government bonds were considered one of the few safe assets around and that drove down yields. Now, with the appetite for risk on the increase again, money is flowing out of government bonds and into riskier assets.

Perhaps there are more inflationists out there than I thought. Several high profile investors have been quite vocal recently about the inevitability of inflation. Such statements made in public by some of the industry’s leading lights remind me of one of the oldest tricks in the book which I was introduced to many moons ago when I was still young and wet behind the ears. ‘Get long and get loud’ it is called; it is widely practised and only marginally immoral. Nevertheless, when famous investors make such statements, it affects markets.

Make sure you get it right

The point I really want to make is that the inflation v. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come. If I am wrong and inflation spikes, you want to load your portfolio with index linked government bonds (also known as TIPS for our American readers), gold and other commodities, commodity related stocks as well as property.

If deflation prevails, all you have to do is to look towards Japan and see what has done well over the past 20 years. Not much! You cannot even assume that bonds will do well. Recessions are bullish for long dated government bonds but a collapse of the entire credit system is not. The reason is simple – with the bursting of the credit bubble comes drastic monetary and fiscal action. Central banks print money and governments spend money as if there is no tomorrow, and all bets are off. Equities will do relatively poorly as will property prices. But equities will not go down in a straight line. The market will offer plenty of trading opportunities which must be taken advantage of, if you want to secure a decent return.

All in all, deflation is ugly and not conducive to attractive investment returns. It is also not what governments want and need right now. With a mountain of debt hitting the streets of Europe and America over the next few years, as the cost of fixing the credit and banking crisis is financed, one can make a strong case for rising inflation actually being the favoured outcome if you look at it from the government’s point of view. The problem, as the Japanese can attest to, is that deflation is excruciatingly difficult to get rid of, once it has become entrenched. I am in no doubt which of the two evils I would prefer, but we may not have the luxury of choosing our own destiny.

Focus on volatility trades

So where does all that leave us? Our good friend and business partner, John Mauldin, has just put the finishing touches to a new accredited letter which will be published in the next day or two. In his letter, John makes the point that markets are likely to remain volatile for quite a while yet. On a personal note I will add that if my worst fears are proven correct and we have to fight a bout of deflation, the authorities will have no choice but to try and provoke price increases through aggressive policy measures. Otherwise entire countries could be bankrupted as they suffocate in their own debt. Whether it will work is a different story.

Such a struggle for supremacy between deflationary and inflationary forces will only add to the volatility predicted by John and give rise to an investment environment which is very unlike the one we have seen during the past 20-30 years. You need strategies in your portfolio which thrive on volatility, and they are certainly not the same strategies as those held by most investors today.

We are currently preparing the launch of a new single manager fund which is designed to thrive on volatility. It is also operating in markets as far detached from the world of equities as you can imagine, so the correlation to equities will almost certainly be low. If you are based in Europe, Africa or Asia and want to learn more about this new product or if you wish to receive John’s letter[3] when it is published, just drop us a note and you will hear from us. In the meantime, join me and wish for a bit if inflation. It is clearly the lesser of two evils.

Niels C. Jensen

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[1] See chart 5 for a definition.

[2] http://seekingalpha.com/article/145904-hyperinflation-trade-looking-crowded

[3] If you have already signed up as an Accredited Investor on John Mauldin’s website, you will receive his new letter automatically.

Related posts:

• Roubini: How to avoid the horrors of ‘stag-deflation’
• Inflation or deflation?
• Liquidity trap of a different sort
• Germany gets deflation
• Kasriel: ‘greater risk for the global economy…is inflation’

Of late, there have been a lot of worries about he potential for inflation in the U.S.  Marc Faber is the most noted pundit in this regard. Over-the-top comments he made back in May about hyperinflation in the U.S. may have been a catalyst for all of the inflation talk. See my post Marc Faber: “I am 100% sure that the U.S. will go into hyperinflation” for more on Faber’s comments.

But Janet Yellen, the Chairman of the San Francisco Fed and a potential successor to Ben Bernanke, is having none of this.  She gave a speech yesterday at the Commonwealth Club, which was widely followed – in part due to talk about her succeeding Bernanke. There, she was very dovish on inflation, at least over the near term. In her view, the deflationary risks associated with this downturn will keep the Fed’s bias toward policy accommodation.

Here is the crucial passage in her speech (emphasis added):

Let me now turn to an issue that has lately garnered a great deal of attention—inflation.  Just a short time ago, most economists were casting a wary eye on the risk of deflation—that is that prices might drop, perhaps falling into a downward spiral that would squeeze the life out of the economy. Now, though, all I hear about is the danger of an outbreak of high inflation.

I’ll put my cards on the table right away. I think the predominant risk is that inflation will be too low, not too high, over the next several years. I take 2 percent as a reasonable benchmark for the rate of inflation that is most compatible with the Fed’s dual mandate of price stability and maximum employment. This is also the figure that a majority of FOMC members cited as their long-run forecast for inflation, according to the minutes of the committee’s April meeting.
First of all, this very weak economy is, if anything, putting downward pressure on wages and prices. We have already seen a noticeable slowdown in wage growth and reports of wage cuts have become increasingly prevalent—a sign of the sacrifices that some workers are making to keep their employers afloat and preserve their jobs.  Businesses are also cutting prices and profit margins to boost sales. Core inflation—a measure that excludes volatile food and energy prices—has drifted down below 2 percent.  With unemployment already substantial and likely to rise further, the downward pressure on wages and prices should continue and could intensify.  For these reasons, I expect core inflation will dip to about 1 percent over the next year and remain below 2 percent for several years.

If the economy fails to recover soon, it is conceivable that this very low inflation could turn into outright deflation. Worse still, if deflation were to intensify, we could find ourselves in a devastating spiral in which prices fall at an ever-faster pace and economic activity sinks more and more.  But I don’t view this as likely. The vigorous policy actions of the Fed and other central banks, combined with sizable fiscal stimulus here and abroad, have sent a clear message that deflation won’t be tolerated.

On the whole, I would agree with this point of view. And Reuters does a good job of summing up the main takeaways from her speech (article linked at the bottom). But, I would make a few caveats.  First, just because deflation is the primary risk at present, does not mean that we shouldn’t be worried about eventual inflation.  The Fed should be devising exit strategies away from policy accommodation because it is unclear that they have one.  That said, the fact that the Fed can now pay interest on reserves is a often overlooked new tool in the Federal Reserve’s arsenal.  I could see the Fed using this as a means to keep all of the excess reserves now in the system from being lent out as it sells off assets to soak up liquidity.

Bu, it is clear that Yellen thinks the Fed should err on the side of accommodation. The mantra: ‘Don’t fire monetary policy bullets until you see the whites of inflation’s eyes.’  To me, this means that eventual inflation risk is real despite Yellen’s present fears of deflation.  In early June, I said in my post “Central banks will face a Scylla and Charybdis flation challenge for years”:

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.

While yields have eased of late, this dynamic is still at work. Yes, deflation should be the Fed’s primary concern right now because the economy is still very sick.  However, when the economy does rebound, inflation is going to be a real challenge.

Sources
President’s Speech: Presentation to the Commonwealth Club of California, San Francisco, CA (pdf version here) – San Francisco Fed website
Yellen says Fed should not rush to reverse policy – Reuters

Related posts:

• U.S. CPI: Lowest since 1954 – deflation here we come
• Pimco sees inflation in America’s future
• The Fed is on the easy money trip
• One on One with David Rosenberg, Chief North American Economist at Merrill Lynch
• Roubini: How to avoid the horrors of ‘stag-deflation’

The real worry right now should be deflation, as we have not yet beaten back all of the ill deflationary effects of the financial crisis.  Nevertheless, a growing number of market participants see inflation as a longer term worry.  With unemployment high, a cost-wage push will not be part of that equation.  Nevertheless, increases in food, oil and commodity prices could create problems down the line as this Bloomberg News video on milk prices attests – they are talking about a doubling in milk prices in 2010.

And, remember, before 2007, $70 was an unheard of, recession-inducing price for a barrel of oil.  Yet, in the midst of a deep, deep global recession, we have $70 oil.  What does that tell you about likely prices in a recovery?  Is it too early to worry about inflation?

Sources
Dairy-Cow Kill to Double Milk Price on Biggest Slump Since 1980 – Bloomberg

Related posts:

• George Soros warns UK on economy, oil and inflation
• Oil to sink to $100
• Oil breaks out above 2009 high
• Quote of the day: William White and inflation
• Oil down below $138

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

Related posts:

• Is quantitative easing really inflationary?
• The next crisis is already under way
• Debtflation
• Morgan Stanley warns of a new inflationary period
• Plosser: The Fed must stop qualitative easing

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

Related posts:

• Deflation has already arrived
• The inflation-deflation debate
• Pimco sees inflation in America’s future
• Inflation or deflation?
• Central banks will face a Scylla and Charybdis flation challenge for years

For the time being, I am more worried abut the potential inflationary effects of quantitative easing than about the deflationary impact of deleveraging.  But, the latest news from Ireland shows us that deflation is alive and well. This comes via the Irish Independent:

Consumer prices recorded a second annual drop in April as the cost of energy, clothes and food declined amid a deepening recession.

Prices based on a European Union measure dropped 0.7 percent from a year earlier after falling at the same rate in March, the Cork-based Central Statistics Office said today. The decline in March was the first annual drop since the data were first collected in 1996. Prices rose 0.1 percent in April from the previous month.

Crude oil has dropped around 60 percent since reaching a record $150 a barrel in July. At the same time, waning consumer demand as unemployment rises has prompted stores to cut prices.Tesco this month said it will reduce prices at some Irish stores by as much as 22 percent.

Rising unemployment and tax increases have “heightened consumers’ reluctance to spend,” Lynsey Clemenger, an economist at Ulster Bank in Dublin, said in an e-mailed note today. “Prices have further to fall, as the consumer strike continues.”

The EU measure excludes mortgage interest payments. Based on an Irish gauge, prices fell 3.5 percent in April from a year earlier, the biggest decline since 1933.

In my opinion, the ECB’s recent announcement that it was getting into the covered bond market has a lot more to do with Spain and Ireland than it does with Germany.  Spain and Ireland suffer from their joining the Euro to escape the impossible trinity of free exchange rates, independent monetary policy and free capital movement.  Having sacrificed monetary policy for a fixed exchange rate, the Spanish and Irish are seeing some horrific debt deflation dynamics.  The ECB seems to have awoken to this and is now engaged in quantitative easing via the covered bond market (although Trichet denies this). See Edward Hugh’s take on this from a Spanish perspective.

So, Ireland has joined the deflation camp along with Spain, the U.K., Switzerland and China, to name a few.  If you think this deleveraging cycle is too powerful for the money printers to override, you’ll see the increasing number of countries with deflationary numbers as a bad harbinger.  However, if like me, you are equally concerned about the upturn in commodity prices and the steepness of the yield curve, you will also see inflation as a looming threat.

To be continued.

Related posts:

• Germany gets deflation
• Irish unemployment gaps up by most in 40 years
• Spain gets deflation
• Switzerland gets deflation too
• U.S. CPI: Lowest since 1954 – deflation here we come

An increasing number of countries are recording negative year-on-year inflation numbers. I reported first on Spain, then on Switzerland.  Add the U.K. to the list as well.

Deflation returned to Britain for the first time in nearly five decades last month as prices measured by the retail price index (RPI) were lower than the same time a year ago.

The Office for National Statistics said the RPI was 0.4% lower in March than it had been in March 2008. That was the first negative reading since March 1960, when Harold Macmillan was prime minister and John F Kennedy was running for the US presidency.

On the government’s preferred consumer price index measure, which excludes housing and mortgage costs, inflation was still comfortably in positive territory, at 2.9%. CPI is much higher here than the 0.6% figure for the eurozone and economists say the falling pound has pushed up some import prices, delaying the drop in the CPI.

A short period of falling prices should help consumers because it will make their increasingly squeezed income go further. However, if prices continue falling for a long period and deflation becomes entrenched, that can have an adverse effect on the economy as consumers continually hold off making purchases in the expectation of lower prices. This in turn forces firms to cut wages and sets off a damaging spiral.

Source
Deflation returns to Britain for first time since 1960 – Guardian

Related posts:

• Switzerland gets deflation too
• Germany gets deflation
• U.S. CPI: Lowest since 1954 – deflation here we come
• Inflation or deflation?
• Recession ‘95% likely’ in Britain

This is a re-post that I hope serves as a reminder that although we are NOT talking about a liquidity crisis in the financial sector, but rather a solvency crisis, liquidity remains very much a concern. This post, despite being 6 months old, should highlight this issue in terms that are equally true today.

The original post follows.

The Credit Crisis has clearly entered a new phase. This is the most critical phase of the crisis to date because it hinges, not on solvency, but on liquidity. How well policy makers lead us through this period will decide whether the United States enters a deflationary spiral akin to the Great Depression.

The crux of the matter is that our financial system has been so shredded by the leverage that was allowed to be created and the bad debts that resulted that lending has slowed to a halt. We are experiencing credit deflation. And it is no longer a case of companies’ fear of lending to other companies. It is now a case of fear for one’s own solvency. Credit liquidity must return.

Early last month I wrote a post warning that credit crises are dangerous because of the debt weight loss that results from a lack of credit.

One problem with financial crises is that perfectly healthy companies, perfectly healthy financial institutions can go bankrupt just because they temporarily lack the funds to pay their creditors. This is what the lack of liquidity in our financial system can do. The real problem of crisis is that healthy institutions are often dragged down with unhealthy ones, leading to a dead weight loss and a negative feedback loop in the real economy.

That’s clearly where we are now. And I am not just talking about financial institutions here. I am talking about every company and every person that relies on credit to fund operations. Anyone could potentially be dragged down into bankruptcy because of the lack of credit availability. And this is a vicious cycle because companies realize that credit is unavailable. They do not want to get caught out. Therefore, they refuse to part with their own cash, making less cash available to lend.

This is called deflation. This is exactly what happened in the Great Depression, this is why Greenspan lowered interest rates to 1%, and this is what Ben Bernanke is desperately trying to avoid. Unless Bernanke can do something creative to stop this train wreck, companies are going to fall victim to this. Lehman Brothers chairman claims this is what happened to his firm. Northern Rock claims this is what happened to them. While those claims are debatable, it is clear that Fed Chairman Ben Bernanke understands this threat. This is one reason the Federal Reserve has intervened in the Commercial Paper market.

The Federal Reserve announced a radical new plan on Tuesday to jump-start the engine of the financial system. 

The Fed said in a statement that it would begin to buy large amounts of short-term debt in an effort to stimulate the credit markets, which have all but dried up.

Under the program, the Fed said that it would buy the unsecured short-term debt that companies rely on to finance their day-to-day activities. “This facility should encourage investors to once again engage in term lending in the commercial paper market,” the Fed said Tuesday in a statement. “An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.”

While the move will put more taxpayer dollars at risk, it underscores the growing sense of urgency felt by policy makers in a climate where lending has stalled. The Commercial Paper Funding Facility, “will complement the Federal Reserve’s existing credit facilities to help provide liquidity to term funding markets,” the Fed statement said.

The Fed said it was creating a new entity to buy three-month unsecured and asset-backed commercial paper directly from eligible companies. It hopes to have the program running soon.
-NY Times

Bernanke can’t get this thing running soon enough. The thing we want to avoid is solid, well-run businesses being force into bankruptcy because no one will lend to them or because they can not roll over their debt. Certainly, one might feel well-run companies should not get into a position where they are beholden to their lenders for survival. Fair point, but it is still clear that there are companies which would be able to operate normally under normal credit conditions, which are suffering in these credit conditions. That is a dead-weight loss to the economy and is what ultimately leads to the vicious spiral of deflation.

I hope as much as anyone else that we can avoid deflation. However, I have to be realistic – it’s not looking very promising at this point. But, maybe Bernanke can pull a rabbit out of his hat.

Related posts
Solvency

Source
Fed Announces Plan to Buy Short-Term Debt – NY Times

Originally posted 7 Oct 2008 at 1252ET

Related posts:

• Solvency
• Fed is buying money market fund assets
• The Fed is on the easy money trip
• Lehman fallout: HBOS and RBS are getting slaughtered
• Paulson and Bernanke got it wrong on Lehman

First Spain, now Switzerland:

Consumer prices in March were down 0.4% from a year ago, the Federal Statistics Office said, a 50-year low.

The country has been close to deflation all year, with inflation having fallen from a peak of 3.1% in July 2008. The rate was 0.2% in February.

The Swiss National Bank predicts that inflation will average -0.5% this year and remain close to zero throughout 2010 and 2011.

The deflation was blamed on energy, rent and transport costs all falling as a result of lower oil prices.

The year-on-year price fall for March was the biggest since December 1959, when consumer prices fell 0.6%.

Full story at link below.

Source
Switzerland experiences deflation – BBC News

Related posts:

• Britain gets deflation
• U.S. CPI: Lowest since 1954 – deflation here we come
• Germany gets deflation
• Ireland gets deflation
• Quote of the day: William White and inflation

Spain is one of the original four bubble economies to implode.  This group includes the U.S., the U.K. and Ireland.  Unfortunately for the Spanish, in the wake of their property crash, things in Spain are looking particularly bleak with unemployment rising, GDP plummeting, and banks like Caja Castilla-La Mancha and property developers like Martinsa Fadesa and Drac hitting the skids.  Add deflation to this list of concerns.

The harmonized inflation rate in Spain – measured in the same way in all countries of the euro-zone – fell 0.1 percent in March, representing the first interannual decline in prices in the history of this indicator since it began to be developed in 1997.

Throughout the history of this indicator, which began in January 1997, this has never come to pass. It is also the eighth consecutive decline experienced by the annual HICP, which has tailed off since July 2008.

The annual rate of HICP usually tracks — and it varies little, usually by tenths of a percent —  the overall CPI, for which March figures are to be published next April 15.

Look at the graph below to see how precipitously inflation has dropped in Spain.

Clearly, Spain is in depression — and things are likely to get worse before they get better. The U.K., the U.S. and Ireland will have to do some heroic things to avoid an equally dismal outcome.  While the U.S. and the U.K. can try to print their way out of depression, Ireland, along with Spain doesn’t have that option.

Source
La inflación cae el 0,1% en marzo, su primer descenso de la historia – Finanzas.com

Related posts:

• Ireland gets deflation
• Spain begs to be at upcoming G-20, Brazil says no
• Spain and Ireland ‘thrown to the wolves’ after ECB move
• Switzerland gets deflation too
• Germany gets deflation

This post is a contribution from Rob Parteneau of MacroStrategy Edge about fiscal expansion, printing money, avoiding debt deflation, and U.S. treasuries.  He has some great insights on deflationary spirals, the paradox of thrift and the desire of foreign investors to dump dollars.  He also argues that the “Blame Asia Meme” is misguided as the ultimate source of credit growth in the United States is domestic.   The crux of his statements is that the only way to avoid a deflationary spiral when household savings is increasing is through fiscal expansion, which is one reason I support fiscal stimulus.  But, there are consequences.

Rob is a CFA, research associate at the Levy Economics Institute and the sole proprietor of MacroStrategy Edge, where he uses macroeconomic insights to inform U.S. equity and global balanced-portfolio strategy. He also serves as editor of the monthly Richebächer Letter, which was started by the lovely Kurt Richebächer,a well-known Austrian economist. For more information about Rob, visit: www.levy.org/vauth.aspx?auth=363.

Here’s what he had to say in an e-mail:

Remember with a flexible exchange rate, capital inflows have to equal the the current account deficit. Dollars flow out through the trade deficit (which is a large part of the current account deficit) as the US spends more on imports than it earns on exports. Those dollars are net saved by our trading partners and they are reinvested in dollar denominated assets. If portfolio preferences of foreign net savers shift away from holding US dollar denominated assets, asset prices have to adjust until they are willing holders of the dollars they earn in trade (that is, interest rates must rise, equity prices must fall, until expected returns are attractive enough for foreigners to maintain their US dollar holdings). Also, if foreign net savers of dollars favor particular assets, like US Treasury bonds, for a variety of institutional reasons, then relative US asset prices can also be influenced.

The money that flows out through the current account deficit flows back in through the capital account. For a nation with a flexible exchange rate, there is no change in the money supply from trade activity. This is just the opposite of a fixed exchange rate system, of which gold based systems are one type, and that is why James Grant advocates leaving flexible exchange rate systems in the dustbin of history. In a fixed exchange rate system, money balances of trade deficit nations are drained off to the trade surplus nation, and the trade deficit can only be run until the existing money balances of the trade deficit are exhausted.

Neither foreign private or public entities can create US dollar reserves out of thin air. That is the charge of the US central bank and commercial banks. Foreigners have to earn dollars from sales of goods or assets to US dollar holders.

That means the ultimate source of the credit to support US trade deficit spending could not have come from abroad. Rather, credit was created in the US as households engaged in mortgage equity withdrawal during the housing boom, and spent more than the earned. Neither foreign savings nor foreign capital inflows were required to create this credit. All that was required was a household willing to borrow with identifiable equity in their home, and a bank willing to expand its balance sheet, with new home equity loans creating new deposits out of thin air. The loan is made, which shows up on the banks asset side of the balance sheet, and the homeowner has a credit line it can draw down, which shows up on the liability side of the bank balance sheet. Nobody here or abroad needed to save beforehand for this money deposit and credit loan to be created.

So what happens when the housing bubble bursts? Equity in homes shrinks, mortgage equity withdrawal shrinks, bank balance sheet growth reverses, household deficit spending reverses as they begin to net save, the trade deficit begins to turn, foreign net saving is reduced, and foreign capital inflows to the US are also reduced. The trade deficit is the twin of the household deficit spending, and the household deficit spending was made possible by credit expansion by US financial institutions on the back of the housing bubble.

In other words, foreign saving and capital inflows are at the tail of the dog, not the head. The only way the tail wags the dog is if foreign portfolio preference shift suddenly or persistently against US dollar denominated assets or specific US asset classes, in which case asset prices must adjust to keep foreign investors willing holders of US dollar denominated assets. We must always be careful to distinguish between shifts in preferences with regards to existing holdings, and shifts in saving out of income flows. The two are not the same, but they often get conflated.

That is not to say the threat of foreign investors dumping US assets isn’t a danger, but it may not be the central risk. The central risk is that the US private sector is shifting to a net saving position in a dramatic way for the obvious reasons – loss of wealth, precautionary saving given recession, etc. Arguably, this needs to happen if households are going to pay down debt and reduce debt burdens, and if they are realizing capital gains are not guaranteed.

The risk of this necessary adjustment arises because if the private sector moves to a net saving position – spending less than it earns – the income level in the US will fall unless the trade deficit turns quickly enough, and unless the fiscal deficit expands commensurately. For every net saver, there must be a net deficit spender, or else the net saving cannot be accomplished without an adjustment of incomes. This is where the so called paradox of thrift comes from. If incomes fall, debt defaults and delinquencies will increase more dramatically, and there is a good chance of heading into a debt deflation spiral, a la Irving Fisher.

In Q4 2008, US nominal GDP fell. Incomes have started to fall. That indicates the private sector is trying to net save more than is feasible given the shrinkage of the trade deficit and the expansion of the fiscal deficit, largely through so called automatic stabilizers, to date.

From a US only perspective, ideally all of the increase in the private sector net saving position would come from a reversal of the trade deficit. But in a world where global trade is collapsing, in part because export dependent economies have just had the rug pulled out from underneath them as US consumers (and others) try to save, it is a fantasy to think the adjustment process can be done entirely through trade. The only way to avoid a debt deflation outcome, as long as the private sector is trying to increase its net saving, is through an expanding fiscal deficit. As the government spends more than it earns in tax revenue, private sector incomes are boosted, and the private sector can earn more than it spends. They are two sides of the same coin. In that sense, if you agree private sector deleveraging is necessary part of the adjustment process, or at least important, it comes at the price of public sector releveraging, barring a heroic reversal in the US trade deficit (which would throw our trading partners into an even more severe recession unless they also pursued domestic demand led polices, a la China).

To illustrate this, the current account deficit has already gone from about 6% of GDP to 4% of GDP. Let’s say further consumer and inventory contraction gets us to 2% of GDP by year end. The CBO suggests the federal fiscal deficit will be out to 12% of GDP. That means the private sector can net save 10% of GDP without nominal incomes falling in the economy. At the depths of the 1973-5 recession, private sector net saving hit a post WWII high of nearly 9% of GDP. Maybe it needs to go higher this time because of the larger shock to household balance sheets with home and equity price deflation. But at least we can say the fiscal deficit is now programmed to scale up fast enough to reduce or contain the risks of US income deflation, and hence a runaway debt deflation process.

So can the foreign trade and US household spending imbalances be adjusted? Yes, they can. Does that adjustment process create further challenges? Yes it can, to the extent massive fiscal deficit spending is required to allow the private sector to accomplish its net saving objective without cratering private incomes and setting off a debt deflation spiral.

Then the question really boils down to, can the massive Treasury bond issuance be placed, especially if a smaller US trade deficit means foreign investors have fewer dollars to reinvest in US assets?

Treasury bonds were once 40% of commercial bank balance sheets. They were below 1% last I checked. Default free securities might look attractive to banks these days, especially with a positively sloped yield curve. The Fed used to hold 70-80% of its assets in Treasuries, now down to 20%. The Fed will want to have plenty of Treasuries to sell into the market once the eventual recovery comes and private investor liquidity preferences fall… Remember, the Fed has no budget constraint.

Does this imply an increase in liquid assets in the economy? Yes it can, but we are also undergoing a large financial sector deleveraging, and we have begun a household sector deleveraging as well for the first time in the post WWII period. As loans are paid backed, deposits are cancelled out, shrinking conventional measures of the money supply. Much of the credit in the shadow banking system has been obliterated, and will not be coming back soon.

Is there nevertheless a risk of a flight from the dollar to the extent the US is willing to be the first mover, and an aggressive one at that, down these paths of quantitative easing? Yes there is. Is there a risk investors seeing the more central banks pursing the quantitative easing path will take flight into precious metals and other real assets as prospective inflation hedges, even if product price deflation is showing up in more countries? Yes there is. Could that complicate the policy exit strategy to the extent some of these commodities, like oil, are inputs to production, and so higher commodity prices could lead to an adverse shift in supply curves (to the left in price/quantity space, as in stagflationary periods)? Yes it could.

My reaction to all this concerns our monetary system, dubbed by many “Bretton Woods II.” It is a volatile and unstable system which has been an enabler of bubbles and crashes since it was begun in the early 1970’s.  Now, we are at  critical juncture.

WIth the G-20 coming up next week, it bears remembering that a large part of what these conferences could accomplish is stabilizing our global financial and monetary system. Recent comments by leading figures in China and the United States have reinforcd the sense that the status quo is not stable. Along those lines, I published excerpts from a paper by Paul Davidson, a leading scholar in this area (”Paul Davidson: Reforming the world’s international money“).  Judging from recent comments from Barack Obama, the United States is open to Davidson’s ideas.

As for Rob, there is a good Levy Institute paper he wrote in November 2006 that early on outlined the results of the housing bust on the ability of households to deficit spend and on the prospects for the US economy.

http://www.levy.org/vdoc.aspx?docid=866

There is also audio of his presentations at the past two Minsky conferences held at the Levy Institute. The 2007 Session 1 audio, in which Rob presents in the second half, may be particularly useful as it laid out the roadmap for the current global crisis in advance. In the 2008 conference audio, he appears midway in session 2 and update the outlook.

He will be speaking at the Levy Institute’s Minsky conference in NYC in two weeks if anyone wishes to catch the live update!

http://www.levy.org/vdoc.aspx?docid=930

Related posts:

• The Cult of Zero Imbalances
• Is quantitative easing really inflationary?
• The choice is between increasing or decreasing aggregate demand
• The inflation-deflation debate
• It’s the debt, stupid

James Montier has a very good piece out via John Mauldin (JohnMauldin@InvestorsInsight.com) on the need for real economy stimulus over financial sector stimulus.

The quote I find most memorable goes to the heart of our debate about the financial system:

Investors seem to be rather excited about banks posting profits at the moment. Frankly, if a bank didn’t post a profit in this environment it should be shot out of kindness. The environment for profitability from banks has rarely been better, but that doesn’t make them solvent.

I thought the piece important enough to post parts here with a few comments. The original is on John’s site at the link at the bottom of this post.

As Albert and I regularly point out during meetings, we have never been more unsure on the inflation/deflation outlook. I have previously said I was torn between the deflationary impact of the bursting credit bubble, and the inflationary pressures of the policy response. When we read something by the deflationists we sit there nodding our heads in agreement, then we pick up something by the proponents of a return of inflation and we find ourselves agreeing with that as well. The respective sides seem deeply entrenched in their positions.

In contrast, we are trying to keep an open mind on the subject. Albert is biased towards a Japanese style outcome, and I am biased towards an inflationary outcome, but neither of us has any strong conviction.

Fisher and the debt-deflation theory of depressions

In the face of this uncertainty I decided to return to history and see what it has to say about the way out of a depression. My first point of call was Irving Fisher’s “The debt-deflation theory of Great Depressions” published in 1933¹. Fisher is probably most infamous to those in finance for his pronouncements of a new era of permanently high stock prices in 1929. But in the wake of his disastrous calls he turned to trying to understand the experience of the depression. Incidentally, he also invented the Rolodex.

In his debt-deflation theory, he posits “two dominant factors” in driving depressions “Namely over-indebtedness to start with and deflation following soon after… In short, the big bad actors are debt disturbances and price-level disturbances”. He continues “Deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debt cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed.” That is to say, debt-deflation spirals can easily become self-reinforcing.

The good news is that Fisher is also very clear on how to end a debt-deflation spiral: “It is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors… I would emphasize… that great depressions are curable and preventable through reflation and stabilization”. The irony of Fisher’s route out of deflation is that, probably only the Fed – after helping lead us into this mess² – can now get us out of it.

I am very much in the same situation as Edwards and Montier — struggling with the arguments for and against deflation versus inflation. At this juncture, it is far from clear where things are headed going forward. While I leaned toward deflation up until recently, the balance is tipping in the other direction for me right now.

You should note that the concept that easy money is a viable way out of a deflationary spiral is considered heresy in Libertarians circles. However, this is essentially what Irving Fisher has suggested. More to the point, he also says that one needs to fix the real economy first. People don’t buy things when they don’t have jobs. This one reason that increasing wages should be central to economic policy right now.

Montier uses an analysis by Christina Romer, the head of Barack Obama’s Council of Economic Advisors, to make his points. In discussing this with Marshall Auerback, he took issue with her underselling of fiscal stimulus. To his mind, fiscal stimulus is more important than monetary. Nevertheless, I think much of what she has to say is spot on. Below I have highlighted the bits I find most important.  In a nutshell, they are:

• The Great Depression’s fiscal expansion was small
• Printing money can break the deflationary spiral (this is essentially Paul Krugman’s philosophy.  I am instictively negative about the concept of easy money being used as a mechanism to stop a deflationary spiral, but this is the path we are on.  Call it an ideological bias on my part.
• If you stimulate, you cannot undo it overnight.  This was the mistake in 1937 and in Japan in 1997 (see my post, “Beware of deficit hawks“)
• The most important point as I see it is the need to get the real economy going.  In my view, this means increasing wages.
• Competitive currency devaluations ca actually be beneficial by creating inflationary expectations.  I am skeptical here.

Romer’s lessons from the Great Depression

After reading Fisher’s analysis of the 1930s, I came across a recent speech given by Christina Romer, who is now the head of the Council of Economic Advisers, and who made her name in academic circles studying the events which ended the Great Depression. In the speech, Romer offers six lessons from the Great depression for the current juncture.

Lesson 1 – Small fiscal expansion has only small effects

Romer wrote a paper in 1992³ arguing that fiscal policy was not the key driver in the recovery from the Great Depression. Not because fiscal expansion is ineffectual per se, but rather because the fiscal stimulus that was conducted wasn’t large. As Romer notes “When Roosevelt took office in 1933, real GDP was more than 30% below its normal trend level… The deficit rose by about one and a half percent of GDP in 1934″.

Lesson 2 – Monetary expansion can help heal an economy even when interest rates are near zero

Romer notes that actually it was the Treasury rather than the Federal Reserve that drove the monetary expansion (a peculiarity of the system under the Gold Standard). In April 1933, Roosevelt suspended convertibility to gold on a temporary basis, and the dollar depreciated. When the US returned to gold at the new higher price, gold flowed into the US, allowing the Treasury to issue gold certificates which were interchangeable with Federal Reserve notes. As Romer notes “The result was that the money supply, defined narrowly as currency and reserves, grew by nearly 17% per year between 1933 and 1936″. Romer argues that this “Devaluation followed by rapid monetary expansion broke the deflationary spiral” – empirical evidence to support Fisher’s hypothesis outlined above.

Lesson 3 – Beware of cutting back on stimulus too soon

The monetary expansion seems to have produced remarkable results in terms of real growth: the US economy grew by 11% in 1934, 9% in 1935 and 13% in 1936 in real terms. This lulled the authorities into thinking that all was well with the system again. Hence, in 1937, the deficit was reduced by approximately two and half percent of GDP. Monetary policy was also tightened, as Romer notes “The Federal Reserve doubled the reserve requirement in three steps in 1936 and 1937″. She concludes “taking the wrong turn in 1937 effectively added two years to the Depression”.

Lesson 4 – Financial recovery and real recovery go hand in hand

Romer points out the inseparable nature of the real and financial recoveries. This meshes with our analysis that the banks aren’t really the problem in a debt-deflation environment, rather they are a symptom of the problem. The current policy in the US seems to be aimed at “fixing the financial system”, witness Bernanke’s recent comments “Recovery is not going to happen until the financial markets and the banks are stabilized”. This appears to be a misperception, as, Romer notes “Strengthening the real economy improved the health of the financial system. Bank profits moved from large and negative in 1933 to large and positive in 1935, and remained high through the end of the Depression”.

Investors seem to be rather excited about banks posting profits at the moment. Frankly, if a bank didn’t post a profit in this environment it should be shot out of kindness. The environment for profitability from banks has rarely been better, but that doesn’t make them solvent. If you were starting a business today, then setting up a bank would be a very attractive option. However, history – as represented by the balance sheet – cannot simply be ignored when it is inconvenient. As John Hussman noted “The excitement of investors last week about Citigroup posting an operating profit in the first two months of the year simply indicates that investors may not fully understand the term “operating profit.” Citigroup could burst into flames while Vikram Pandit sells lemonade in the parking lot, and Citi would still post an operating profit. Operating profits exclude what happens on the balance sheet.”

Lesson 5 – Worldwide expansionary policy shares the burdens

Given the worldwide nature of the current slump, Romer makes an interesting point on the effectiveness of competitive devaluations, “Going off the gold standard and increasing the domestic money supply was a key factor in generating recovery… across a wide range of countries in the 1930s… These actions worked to lower world [real] interest rates… rather than just to shift expansion from one country to another“.

This is something that Albert and I have been discussing of late. We have been pondering the possibility of competitive devaluation (obviously ultimately a zero sum game in terms of exchange rates) having enough of an impact on local monetary creation to increase inflationary expectations, thus helping countries reflate. It appears as if Romer has sympathy with this view.

Lesson 6 – The Great Depression did eventually end

The final lesson that Romer offers may be of use to investors at the current juncture. She makes the point that the Great Depression did finally end. As Romer puts it “Despite the devastating loss of wealth, chaos in our financial markets, and a loss of confidence so great that it nearly destroyed American’s fundamental faith in capitalism, the economy came back. Indeed, the growth between 1933 and 1937 was the highest we have ever experienced outside of wartime. Had the U.S. not had the terrible policy-induced setback in 1937, we, like most other countries… would probably have been fully recovered before the outbreak of World War II” This is a reminder that the current obsession with no scenario being too pessimistic is probably ill advised.

I am going to stop here. But, Montier’s post has much more to it, so if you want to read it, click the link below.

Source
Roadmap To Inflation And Sources Of Cheap Insurance – James Montier via John Mauldin

Related posts:

• The Japanese Problem is now ours
• Hayek: “I am not only against inflation but I am also against deflation.”
• Nouriel Roubini: Will massive stimulus ward off stag-deflation?
• Some tidbits about stimulus, recovery, and the Great Depression
• Pushing on a string and similar notions on monetary policy ineffectiveness

According to this Bloomberg video, China will enter deflation when data is released later today. Deflation may stay with China for all of 2009 because of lower commodity prices:

Related posts:

• Britain gets deflation
• Switzerland gets deflation too
• Germany gets deflation
• U.S. CPI: Lowest since 1954 – deflation here we come
• Oil price cliff diving and a whiff of deflation is in the air

Yesterday was a regular Depression-o-rama here because many of the articles I wrote were very much centered around the Depression theme. I would like to move away from this subject. But before I do, I feel compelled to relay a news piece that came out at the weekend (Hat tip Scott).

Bridgewater Associates founder Ray Dalio gave an interview to U.S. investment publications Barron’s in which he said that we are in a deleveraging deflationary depression. He labeled this the ‘D-Process.’ Now, you may remember Bridgewater Associates is the company which correctly predicted enormous writedowns in this downturn back in July. While many were incredulous, their predictions have turned out to actually understate the likely eventual losses.

Fast forward 7 months and we get a sense of what this influential financial firm is thinking via the Barron’s interview with Ray Dalio. I have highlighted the most noteworthy points.

Barron’s: I can’t think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.

Dalio: Let’s call it a “D-process,” which is different than a recession, and the only reason that people really don’t understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn’t live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.

Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?

Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.

You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.

You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what’s essential to combat deflation and a depression?
The D-process is a disease of sorts that is going to run its course.

When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?

The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the ’90s, that occurred in Latin America in the ’80s, and that occurred in the Great Depression in the ’30s.

Basically what happens is that after a period of time, economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.

As goes GM, so goes the nation?

The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.

This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes — the cash flows that are being produced to service them — or we are going to have to raise incomes by printing a lot of money.
It isn’t complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.

Isn’t the process of restructuring under way in households and at corporations?
They are cutting costs to service the debt. But they haven’t yet done much restructuring. Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.
What are you suggesting?

An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.

So where do things stand in the process of restructuring?

What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven’t said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.

The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.

However, the reason it hasn’t actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece — banks and investment banks and whatever is left of the financial sector — that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.

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Dalio is essentially saying that we will not see renewed lending until the bad debt is cleared away – until we see the credit writedowns taken for all of the existing debts. Basically, debtors cannot take on any more loans. The corollary of what he is saying is that the approach taken to date by Paulson and Bernanke and likely to be followed by Geithner will be a failure.

What is interesting about Dalio’s analysis is that he focuses on the debtors. He sees debtors as incapable of taking on more debt given the decline in asset prices and income. All of this was possible as asset prices rose.  But no longer. I have come to similar conclusions by focusing on the lenders i.e. that no increase in lending will get done until the lenders get a handle on their bad debt and feel they can write everything down without going bankrupt.

You should also notice that he is inferring that the United States is a banana republic (i.e. a country that is overly indebted to foreigners) when he makes the comparison to Latin America, much as Willem Buiter has done regarding the U.S. and the U.K. One must use the term ‘banana republic’ because there is a pride, an arrogance if you will, that the United States is better than the countries in Latin America like Argentina and Mexico which have had similar problems in the past. It is not, and to deal with this problem, Americans need to get rid of that notion.

A few other points:

• He also takes a view on Treasuries that I share:  the Fed will eventually have to come in and start buying Treasuries.  He says: “The Federal Reserve is going to have to print money. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression. We are in a position where that will eventually create a problem for currencies and drive assets to gold.”
• So Dalio sees quantitative easing i.e. printing money as an attractive solution for a country which is indebted in its own currency.  In Latin America, the problem was that the debt was in foreign currency.  Here, the U.S. has a relief valve — it’s called devaluation.  That makes gold attractive.
• Nationalization is inevitable.  The U.S. banking system is effectively bankrupt.  That means that the bad debts are greater than the capital in the system.  Many institutions are solvent. However, today, so many large ones are not that nationalization must happen.  Eventually.  In my view, the sooner, the better.  But, we know that politicians will only do this as a last resort.
• To the question of whether we need to get more credit to good businesses because they ae credit starved, he says: “Those examples exist, but they aren’t, by and large, the big picture. There are too many nonviable entities. Big pieces of the economy have to become somehow more viable. This isn’t primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The ’30s were very similar to this.”

Dalio has a lot more to say about China, the Chinese currency, inflation and more. It is a very good piece and I believe it is accessible to those without a subscription. See the link below.

Source
Recession? No, It’s a D-process, and It Will Be Long – Barron’s

Related posts:

• It’s the writedowns, stupid
• We are in depression
• Central banks will face a Scylla and Charybdis flation challenge for years
• A brief philosophical argument about the role of government, stimulus and recession
• Some tidbits about stimulus, recovery, and the Great Depression