Saturday, 26 January 2008

Deflation or inflation

In my most recent post which was on the possibility of major US investment bank failing, a reader - trader boy - left the following comment:

"do you read Mish?

if not, you should. it's becoming clear that DEFLATION is on the way. even the markets are telling you that, TIPS have not really done a lot for years, and long treasuries just hit all-time lows. that's not an inflationary sign."

On the first point, I will admit to reading Mish, but perhaps not as much as I should. I will, in future, rectify that failing.

However, trader boy has a second, more serious comment to make; whether the US, or the UK for that matter, will drift into a prolonged period of deflation rather than inflation.

His comments taps into a very difficult question, and I will admit to holding both opinions on different occasions. Nevertheless, I thought it might be useful to outline what I understand to be the two arguments, and why I think inflation, ongoing financial sector difficulties, and ultimately a recession are the most likely outcomes.


Why would anyone think that after decades of inflation that prices might actually start to fall?

If inflation is due to an increase in the money supply, then deflation must be due to a decline. So why might Trader Boy and others think that the money supply might suddenly contract?

It is one of the great ironies of the modern world, but the vast majority of people do not have a clue how money is created. Of course, people understand that there are such things as central banks, and somewhere, the banks have printing presses that produce the notes they carry in their purses.

It is the role of commercial banks where the ignorance arises. It is the high street banks that generate the greater part of the money supply. The banks do this by creating loans while keeping only a small fraction of their assets in reserves as cash.

Central banks only determine short term interest rates, and in reality, have little control over commercial banks lending activities. In recent years, commercial banks made the most of their independence. They have created staggering amounts of money, largely through financing the real estate boom.

The commercial bank's money creating capacities are at the core of the deflationary argument, which in fact comes in two sizes; regular and supersize.

The regular deflation argument suggests that the banks, after years of feeding the housing frenzy are now chastened. Lending standards are tightening, and credit growth will be reduced. Without the performance enhancing flow of credit, the economy will slide into a recession, aggregate demand will fall, and inflation will abate. Banks may even become so cautious that credit growth grinds to a halt and with it, the money supply. This lack of monetary growth will eventually lead to prices falling.

The supersize version looks for a more dramatic and absolute decline in credit growth. Bank balance sheets, both in the UK and in the US, are fundamentally rotten. Those housing loans are about to go bad; defaults will rise, and when they do, banks will fail. The subsequent banking crisis will create a catastrophic collapse of balance sheets, credit will contract, and the money supply will fall. The consequences will be deflation and a depression very much along the lines of what happened in the United States in the 1930s.


Given the events of the last six months, it is not hard to see why some people might think that deflation could be a possibility. The idea of a systemic banking crisis does not seem so far fetched; Northern Rock, sub prime, failing bond insurers, rising spreads and sporadic liquidity difficulties all attest to the growing weakness of the financial sector in both the UK and the US.

The problem, however, is that it is not just the US where we see a recent period of lax monetary policy. The world is full of money. From the tip of Africa to the top of Siberia, countries are loaded with unprecedented levels of foreign reserves, while their central banks have allowed very rapid monetary growth.

The cause of this worldwide explosion in monetary growth lies in an unspoken agreement between the US and emerging market economies. They agreed to supply cheap goods, and in return they accepted US dollars in exchange. Rather than spend these dollars on American goods, these dollars have been reinvested back into the US assets. This has kept US interest rates down, and allowed Americans to build up huge debts and keep on spending.

The deal has been good for emerging market economies, who have run up current account surpluses, and built up huge holdings of US assets, especially US treasury bills. Over the last ten years, these economies have enjoyed unprecedented growth and rising living standards.

These surpluses, if left to their own devices, should have prompted emerging market currencies to appreciate. However, emerging market central banks would not let that happen. They printed domestic money, in order to keep their exchange rates competitive. This kept the exports growing and allowed the US to keep their current account.

Unsurprisingly, these economies would like the deal to continue. Unfortunately, this implicit bargain was not sustainable, and today it is unwinding. It is inflation that is turning the screw. As emerging market economies have grown, commodity price inflation has increased; fuel and food inflation are rising rapidly, on account of higher living standards in places like China, Russia, India and the Middle East.

Inflation wins the day

Broadly speaking, there are three reasons why inflation and not deflation is the most likeliest outcome.

First, the Fed are again trying to use monetary policy to pump up demand. However, the recent interest rate reduction will serve to weaken the dollar, and as the dollar slides, import inflation will increase. Nor can we discount the possibility that all this excess liquidity might actually revive lending activity. It is unlikely, I agree, but Bernanke is a reckless inflator. He may bring rates down so far he could kick off another bubble somewhere.

Second, commodity price inflation is still rising. It is fueled by monetary growth in the rest of the world, which shows no signs of slowing. In many parts of the world, this monetary growth reflects a conscious decision to keep the US importing. Many key US trading partners, such as China and Japan, do not want to see a gradual reduction of the US current account. Although the dollar has fallen against the euro, the dollar has barely moved against Asian currencies. Many central banks continue to prevent their domestic currencies to appreciating against the dollar.

However, rising inflation will eventually prompt an adjustment, despite the best efforts of Asian central banks to prevent it. Furthermore, it will be our old friend, inflation, that will help the adjustment. Inflation in emerging markets is taking off, and as it does, real exchange rates will appreciate and this will eventually choke off export growth.

Finally, while recognizing the probability of a systemic banking crisis, it would need to be a truly massive one to generate deflation. Here, history is against the deflationary argument. The S&L crisis did not bring in its wake bring any deflation. The losses from sub prime have not yet reached the magnitude of that now almost forgotten crisis. While the sub prime crisis is big and nasty, it will need to get a whole lot bigger if it is to generate deflation.

So what are we looking at?

The situation today looks more like the 1970s than the 1930s. During the 1970s, the US ran up huge macroeconomic imbalances on account of the Vietnam war; it had a large current account deficit, an exploding fiscal deficit, and a weak and accommodating central bank, desperate to print money to avoid facing the consequences of a decade of bad policies. The dollar was tanking while the rest of the world had more dollars than they wanted. Does any of this sound familiar?

The US is looking at something very much in tune with the experiences of the 1970s - stagflation. It may have its very own 21st century flavour. For example, the growing banking sector difficulties may add a problem that was not evident back when Nixon was President. Nevertheless, the parallels are striking.

So I am with the inflation gang. Going forward, the US and UK economies will slow, but with inflationary pressures continuing. As unemployment increases, there will be some very limited downward pressure on domestic prices, but this will not be enough to counter the growing inflationary pressures coming world commodity prices. Moreover, those who remain in work will continue to push for higher wage increases.

As for deflation, the only market that will see falling prices will be real estate. In the case of the US, this has been going on for two years, while in the UK, prices have only just begun to slide. However, declining house prices can live quite happily with rapid inflation.

So, we are something of retro period in economics, but it is the 1970s and not the 1930s that are on the way back. Like Led Zeppelin, stagflation is on a comeback tour.


Paul B said...

Please, please, supersize me.

tom said...

Nope, I don't buy it. Deflation is still assured.

Your argument that deflation cannot happen this time around because there's lots of money elsewhere in the world doesn't stand up. Japan faced the same situation in 1990 and they still got a decade (in fact now nearly two) of deflationary downward spiral.

All these things that "can't happen", are about it.

traderboy said...

wow, some response to my little comment :)

i'll have to think about this. my gripe with the inflationistas is that it just hasn't shown up in the bond market...repeating from yesterday, TIPS spreads have not particularly moved and rate curves have remained pretty flat for a long time now. Also check the 30y Treasury hitting all-time lows in yields this week.

Even in the UK, the gilt curve has been inverted for a long time now...although this has technical issues re: government theft of pension money (as in 1. forcing people to put money into pension funds which they can't withdraw until retirement, then 2. forcing pension funds to buy long term assets like government bonds even though supply is dwarfed by the size of the funds), it's still a data point.

Eurozone curves also flat...Japanese long bond yields are low...WHY IS THIS INFLATION NOT SHOWING UP IN ANY OF THE BOND MARKETS???

Lord Wragley of Myre said...

Flight to quality, dear traderboy, flight to quality. US long bond will peak in approximately one week and then plummet as inflation fears take hold again. Pip! Pip!

ukhousingbubble said...


Japan certainly shows that it can happen. However, I don't think we will see deflation in the UK or US.

The Japanese bubble started from a long period of sustained growth In the mid-1980s, no one could have imagined that Japan could crash. Then there were those household savers, who supplied the cash to keep Japan's extraordinary investment-to-GDP ratio going.

The bubble started when banks and firms started to speculate into real estate, equity and at the same time firms kept on investmentm. Asset prices soared and eventually it fed through into inflation.

One day, the Japanese central bank woke up and said, "crap, we have inflation". They tightened, the bubble burst, and left firms with crippled balance sheets and banks with a huge stock of bad and doubtful loans.

However, the Japanese household kept on saving. Money kept on flowing into the banks. However, the banks didn't know what to do with the money. Companies didn't want it; they just wanted to use existing cash flow to pay off their debts.

Yields came down, credit declined, and the economy went into a recession. This recession was due to consumers saving too much, and firms neither borrowing nor investing from retained earnings. Banks also didn't want to borrow, since their balance sheets were in such bad shape. Japan went into deflation and monetary policy became useless.

There are some parallels with the US and UK, for example, the bubble, but there is one major difference; households owe huge amounts of money. My sense is that if they default in any great numbers, that foreclosure/reposssessions will quickly clean out this debt, and prevent an asset deflation of the kind seen in Japan.

Anyway, that is what I think, for what it is worth.

Thanks for the comment, Tom.


ukhousingbubble said...

Trader boy,

I don't have a particularly convincing story for the lack of movement on long term interest rates. However, here is my best shot.

I think it has something to do with ongoing foreign inflows, particularly from China and the middle east. This guys are prepared to accept low and possibly negative interest rates, because they want to keep the US spending.

If they started to withdraw their cash for say the US t-bill market, long term rates would go up, and the US would certainly enter a recession. This would reduce the US current account and the major surplus countries (China, Middle east and Russia) would also slow.

So, why would TIPS spreads stay low? There still remains too much liquidity about, and in general seach for higher yield, even these spreads have remained compressed.

I am not sure I have you convinced, but that is my best attempt to answer a highly useful question.

Thanks for the comment, trader boy.


ukhousingbubble said...

Your lordship,

Apart from your good self, what quality are you talking about?

To where should I fly?


Ali Jalali said...

Brilliantly acute Op Ed piece in today's NYT by the cogent James Grant. He says inflation--and soon.

Lord Wragley of Myre said...

Quality, Alice? Fly to my castle in the Vale of Cromlach, dear lady, and there we will disport ourselves to the lascivious pleasing of the lute. (I guarantee this is one house that will not fall stone by stone when housing collapses--the walls are 6.7 inches thick and have stood since the reign of Edward III.)

tom said...

Alice, what you've just described about Japan is almost a carbon copy of what is currently happening in the US/UK! And I agree with you that households will default en masse. That is hugely deflationary!

What you are seeing at the moment is a credit revulsion, not amongst consumers (yet) but amongst businesses and banks. They don't want to borrow any more - they can't afford the debt servicing costs! At the same time, banks are hiding their losses for as long as they can. Again - this exactly mirrors the Japan experience.

The problem with the inflation theory is one of "where does the money come from?" We are already seeing huge writedowns and I'm betting huge defaults are not far away. These are all examples of destruction of credit! The only way this bubble can end with inflation is if the government begins to print huge amounts of debt free money - Zimbabwe style. Unfortunately the US/UK governments cannot do this! Why? Because to do so would send market interest rates through the roof! And as the UK/US govts are already in huge debt themselves, they would never be able to afford the debt servicing costs.

andy in nz said...

I am still in the deflation camp, in the 70's there was no China acting as factory to the world, our economies were prtected closed shop affairs.

Wages claims will be met with stony silence from head office and threats to outsource jobs. Now not every job can be outsourced and that is where you see massive wage pressure, think health care.

Also how much of a bigger slice of employment is service based, when unemployment ticks up, people spend less on these services (financial, food, retail) and hey presto you get a downward wage price soiral.

just a thought.