Thursday, July 1, 2010

Deflation or Inflation

We appear to be at a turning point of sorts, yet again. After much vigorous monetary stimulation, US economy seems to be slipping into a second leg of the recession (or the double dip). All of the efforts aimed at monetary stimulation succeeded in making the banking system solvent, by essentially subsidizing it and moving the leverage onto the government books. However, they did not restart the lending activity and banks are content to be safe, while hoarding their cash. The money supply is contracting yet again and inflation is increasing at a far slower pace. Does this mean that everything we wrote about potential worldwide inflation threat is now less likely? Absolutely not. Contrary to some esteemed critics, who misunderstood our writing, our position was never based on monetary arguments. The initial stage of expansion of money supply was quite inevitable from the perspective of even such differing schools of economics as Neo-Classical and Keynesian (though not Austrian). We also saw no problem with replacing the initially lost money supply through expansion. Our argument for inflation and an eventual dramatic rise in the price of gold and in long term interest rates was based on a very simple precept. United States, with its total liabilities anywhere between 300-500% of GDP is unable to endure deflation without a catastrophe. In fact, in the medium term (3+ years), it is unable to endure anything other than high inflation without a catastrophe. If the inflation is not allowed to happen, the Great Depression will appear to be a golden age in comparison. The same holds true for many countries around the world who are essentially banrkupt. Those that are not bankrupt will not be able to sit idly and watch the indebted ones inflate away debts and inflate currencies, simply because their trade balances will deteriorate rapidly if they do. Therefore, we are heading into an era of global inflation, as we wrote before. Europe's attempts at fiscal austerity surely go against the grain, but I think that they will see the futility of fighting this trend (otherwise they will have to endure a useless bone-crushing recession only to finally succumb to inflation after their exports dry up). The US dollar is going to be the last to fall and is in fact likely to remain strong (relative to other currencies of course, it has been falling with respect to gold quite dramatically) for a while, because it appears as the less dangerous of the crazy bunch. In the short term, we will likely experience deflationary pressures, but these pressures will only serve to ensure the now nearly inevitable inflation by increasing the debt load due to attempts at restarting the failing growth. It is already nearly impossible for the Fed to 'pop the clutch', because doing so will speed up the process of default in the US and could make the US dollar the first one to fall (we still maintain it will likely be the last). Add to this the lifelong mission of Ben Bernanke to avoid the Great Depression deflation and I think we can be sure that deflation will only serve as the gasoline, albeit a slow acting one, on the fire of the eventual inflation.
We are not here passing judgement on the moral propriety of inflation or anything else for that matter. We are merely looking at facts and pointing out the direction.


David Mieczkowski, PhD said...

Based on your post, it seems we agree that deflationary pressures will abound in the immediate term. We also agree that allowing the U.S. to fall into a deflationary spiral would be calamitous. Further, we both take the view that the U.S. government and central banking system will have little choice but continue to pour on economic stimulus.

The point of departure in our gentleman’s disagreement then seems to center over whether the U.S. government and U.S. central banking system actually has the ability, in addition to the desire, to not only stave off the deflationary forces, but to actually engender inflation through a pick-up in the velocity of money due government deficit spending on the one hand, and through a further expansion of the money supply through Fed asset purchases on the other. I do not believe that they have that ability. Repeating the analysis I did, the combined response of the Fed and the U.S. government was not enough to make up for the drop off in household and business borrowing. With austerity measures being implemented in Europe, and the Tea Party movement in the U.S. pushing for the same as the midterm elections approach, the political winds do not favor a scenario where the U.S. government can continue to act as the borrower of last resort with anywhere near the level of aggression needed to stave off the deflationary pressures, much less induce inflationary ones. It would take sustained combined spending at twice the level currently by the Fed and the U.S. government in order to create even 4% inflation. This is just politically unrealistic. The most likely upside scenario is the Japanese one; anemic GDP growth, effectively zero inflation, and very low rates on government bonds, for at least a decade.

I think we both agree that gold is primed to be one of the next bubble assets (if it isn’t already). It may go as high as $5000 per ounce, as Peter Schiff has suggested, before it collapses in the same spectacular manner as every asset bubble when people finally realize that such a price is far above its intrinsic value. Gold may be a durable good, but it has limited actual uses beyond jewelry and in certain electronics, and none of them is likely to support a $5000 per ounce price.

We disagree over interest rates, however. I believe that U.S. Treasury prices will continue to rally. As things continue to deteriorate, the Fed will continue to put pressure on banks to lend by keeping interest rates paid on bank reserves at zero. However, with reduced household demand, and fewer good quality business lending opportunities, the banks will lend to the sole remaining AAA rated source with a level of demand matching the supply of bank money looking to be lent, the U.S. government. With inflation nowhere in sight, the nominal yield on the 10 year will match the real yield on the 10 year TIP, which is currently hovering around 2%. This is exactly what happened in Japan. In this scenario, it doesn’t matter one iota whether China and other foreign sources stop buying treasuries. The U.S. debt will be predominately domestically financed, again just as with Japan.

Extrema Risk said...

"The most likely upside scenario is the Japanese one; anemic GDP growth, effectively zero inflation, and very low rates on government bonds, for at least a decade."
Dear David,
Thank you for your comments, I appreciate the opportunity to renew our intellectually stimulating discussions. I do not think that the US has a choice to go the route of Japan. US is very near the point when the debt will grow exponentially, while Japan was relatively debt free at the beginning of their troubles. It is pointless to argue over political winds, as neither of us is a professional or an insider in that area. Quite apart from the political wisdom of the crowds, I think that US has two choices:
1. High enough inflation to significantly reduce the phenomenal debt burden of private and more importantly public sector.
2. Great Depression (probably something worse).
Japan's way is not an option. I still do not understand why Japan's experience is considered such a tragedy (that is what Paul Krugman called it once, I think that it is the gross misuse of the word). Their so called 'lost decade' was quite propserous and would have been more prosperous if they diverted their resources to something other than building roads to nowhere (for example, in researching new technologies). The idea of building an economy on continuous GPD growth fueled by ever increasing leverage is, in my opinion, a vicious fallacy. A fallacy that now demands its dues in the form of instability that we see before us and more importantly the instability that unfortunately lies ahead of us. All the best and thanks again.