I spoke at a Euromoney conference on inflation-linked products last year. My thesis at the time that deflation is the real problem and that inflation isn’t going to be a concern – which has largely proved right – was out of step with most people at the conference. I still believe this is the case. And as I prepare to attend this year’s conference on the same topics, I have begun to think again about the deflation and inflation issues. This post on how the US becomes the next Japan is an outgrowth of that thinking.
Let me lay out my fundamental argument here and try to expand on it below.
- We live in an endogenous money world. That means that demand for and supply of credit – not base money supply – largely determine broad money supply and credit growth aggregates. In our post-crisis world we are seeing this.
- Increases in base money will not spur credit growth. The attempts to spur economic growth via credit growth are at heart based on the money multiplier fallacy that sees credit growth as dependent on base money growth. But in an endogenous money world this hasn’t worked and it won’t work.
- The problem is private debt. You cannot get broader credit and money aggregates to grow in a world of restrained credit demand/supply no matter how much QE you do to add to the monetary base. The system is constrained by high levels of private sector debt and the attendant balance sheet issues at financial institutions servicing that debt.
- So what happens in the next downturn? I have always believed this is the critical question. As I laid out this thesis mentally, I asked myself what happened when you have near-zero rates, extraordinary levels of monetary ease and liquidity, increasing public debt, and high private debt when recession begins? I think you get deflation, spiking non-performing loans, credit writedowns, insolvent financial institutions, massive private and public sector pension problems and renewed crisis. This is Japan.
First, let me say upfront that a key factor in all of this is the nexus of low nominal GDP growth and pension accounting. I saw an article at CNBC yesterday that pointed out that S&P 500 companies were underfunded by a record $451.7 billion despite the surge in profits and share prices. It was that article and my subsequent thinking about it which in combination with my thinking about the Euromoney conference that helped me put all of these pieces together. I want to say that upfront before I forget because it is an important piece of this puzzle.
Below I will unpack the flow of this thesis for Credit Writedowns Pro subscribers.
[Content protected for Gold members only]