A Deflationary Spiral? Not Likely in the U.S.

An article by Rich Toscano and John Simon of Pacific Capital Associates makes a very good case for why an extended period of CPI-deflation is highly unlikely in the U.S.

The motivation of policymakers is summarized nicely in this paragraph:

There is a powerful combination at work. Mainstream economic pundits, academics, and policymakers are united in their opinion that deflation must be prevented. They are providing a theoretical justification for highly inflationary policy, and right or wrong, this justification is widely accepted as truth. Meanwhile, from a politician's standpoint, inflation is a far more viable and easy path than deflation. This combination of real-world incentive and theoretical justification induces our monetary and fiscal leaders to overwhelmingly favor an inflationary outcome.

And with a pure fiat money system, where the whole idea of printing up hundreds of billions (if not trillions) of new dollars is quickly becoming the consensus "lesser of two evils" in how to best avoid another Great Depression, it all really boils down to whether or not they'll be successful.

They will.

Who knows what the world will look like when they're done, but they will be successful.

The entire piece is well worth a look, particularly the discussion of nine counterpoints, one or more of which have "deflationists" so excited at the moment:

- Pushing on a String
- Japan
- Lost Financial Asset Wealth
- Credit Deflation
- Debt Defaults
- Recessions
- Foreigners Won't Let Us Inflate
- The Fed Doesn't Want Inflation or a Dollar Crisis
- The Fed Will Reverse Course

The conclusion is as follows:

We in the United States have been dumping our dollars into the world for years and we continue to do so. We owe a staggering amount of foreign debt denominated in dollars and we are gearing up to borrow even more. Our legislators and the stewards of our currency are rabidly hostile to deflation -- they are hostile, in other words, to the idea of the dollar gaining purchasing power. They have shown via word and deed that they will do whatever it takes to prevent deflation from taking hold. When deflation is viewed as even a remote possibility, there are effectively no limits to the amount of money the government can create nor to what they can do with that newly minted money.

Under these circumstances, we just don't believe that the dollar is going to gain purchasing power in any sustainable way. The current deflationary storm could continue for a while yet, but the longer it goes on, the more violent and severe its reversal is likely to be.

Deflation is a choice within the current monetary regime. It is a choice that our government has shown it will not make. There are serious long-term risks inherent in our dysfunctional monetary system, to be sure -- but deflation isn't one of them.

The next look at the Labor Department's Consumer Price Index is due on Friday and the year-over-year reading as of November - the commonly accepted, definitive measure of "inflation" in the U.S. - printed at a lowly 1.1 percent.

It is possible that, with energy prices that have continued to plunge through the mid-December reporting period combined with a few other falling prices elsewhere, we'll get our first negative inflation number since 1955.

Just wait till you hear how acceptable the idea of "printing money" becomes then.

The word "deflation" (and, by inference, the threat of another Great Depression) may become President-elect Obama's most powerful tool in convincing Congress and hundreds of millions of Americans that "debasing the currency" has become our national duty.

Comments

[DiggerUK:]

The prerequisite for stagflation is "debasing the currency", a proven norm that can be shown in practice back to the time of the Roman Empire.

If the "lesser of two evils", between deflation/inflation is inflation, then be careful of what you wish for. Stagflation is a proven law unto itself and obeys no government.

What then is plan B?

Jan 13 06:44 AM

[patio:]

Overcapacity, rising unemployment, imploding leverage, lack of borrowing and/or lending, a serious retreat by consumers,increased savings, a housing market still headed further south, and consumer psychology completely 180.
Central banks doing everyhting they can, but no takers, no velocity increase at all, still money is stagnant and not going anywhere.
No certainly no recipe for defation here.
Ya know, Heli Ben can stamp his feet all he wants, and vow there will be no deflation on his watch- we'll see. The all-powerful gub'ment??? Not so much.

Jan 13 09:24 AM

[DiggerUK:]

If you read today's S.A. contribution by John Jansen, "Bernankes Speech Of The Day" it seems that plan B is more "B"ailouts.

When a man from the government says I'm here to help the last bailout with another bailout, what's a girl to do?

Jan 13 10:11 AM

[OldLimey:]

I actually attended this afternoon's speech by BB at the LSE, and DiggerUK's second comment seems to be on the mark. (LSE usually posts podcasts of speeches on its site; if it isn't there now, it will be shortly for anybody with an hour to spare.)

There was one specific takeaway for me. The clear statement that President-elect Obama's stimulus would not be sufficient in itself unless further steps are taken to stabilise the banks and the housing market.

1. Stabilising the banks, he said, would require revisiting TARP's original intention and relieving them of toxic assets. BB outlined three approaches: government purchase, public auction, and creation of a 'bad bank' (another 'BB'??) Given what the Swiss have done for UBS, I would think the possibility of a 'bad bank' will get increased air-time in the days ahead - but that's just my guess.
2. Stabilising the property market, he said, would require putting a floor under foreclosures. Just how this might be accomplished was not expanded upon.

So the bail-out express is certainly still rolling. With regard to the economy in general, his unscripted reply to a question on the likely trajectory of US unemployment was that he expected Q1 to be bad, but that the 'bleeding' should stop after that. What precisely he meant was not questioned any further, but one reading could be that he anticipates unemployment to peak by mid-year. However, he did not say that in so many words, and such a stretch would probably go beyond the central banker's normal remit of staying optimistic and stray into more fanciful territory.

He drew a distinction between Japanese QE, concentrating on the liabilities side of the BOJ balance sheet, and what the Fed is doing on the asset side of the balance sheet - which he referred to as 'credit easing' rather than pure, textbook QE. He said the focus of policy was to support credit markets, and he was explicitly very sanguine about the Fed's ability to shrink its balance sheet without inflationary consequences as each of the several different asset markets in which it has intervened normalise in turn.

Finally, he was also very explicit about the Fed still having plenty of tools in its tool-box notwithstanding the level of the Fed Funds rate. Amongst other things said in this context he did mention the purchase of long-dated Treasuries, but his language strongly suggested that this remains under consideration rather than being in operation.

For a man who has been under the pressure he has been for the last several months, I have to say that he came over very well. It is of course his job to do that, but it's still quite impressive. Deeply sceptical though I am about the role of the Fed leading up to and during this crisis, he came across as a decent, intelligent man with a good sense of humour. That said, I personally found the topics he chose not to touch upon rather interesting (perhaps worrying):

1. The role of the Fed's cheap and easy credit policies in recent years. He said that once the fire has been put out the fire code will need looking at - in other words, regulation of the financial system, and particularly its systemically important actors, will have to tighten. Fair enough, but there was no hint that anybody is concerned that the rope which bankers have been strangling us with was handed to them in the form of lax monetary policy.
2. The asset bubble - binge borrowing - risk mispricing - overconsumption economic model. Perhaps its just my personal prejudice, but the sense I got when listening to him was that the ship has run aground and having spent the fall bailing it out, the job now is to patch up the hole and float her off on the same course she was following before. No sense that the whole model might need rethinking - not just in the United States, but globally.
3. Debt. No mention at all of Federal deficits, the national debt, or household indebtedness. The sense was that everything will be fine again once credit markets start to function as before. There was an explicit statement that the modern economy is heavily dependent on credit. Of course, that's dead right - but I would have liked to hear more about appropriate levels of indebtedness and about the merit of investing out of saved income.

In summary, no real surprises. I don't doubt that the 'worst is over' brigade will find encouragement in his words. Others, myself included, will wonder if getting the world out of its mess really is going to prove to be as simple - in terms of broad fiscal and monetary policies - as our leaders want us to believe.

Jan 13 01:55 PM

[henarl:]

How about this for plan B ? The fed prints 10 trillion dollars and uses it to buy credit cards with a 6 month expiration date - use it or lose it. These cards will only be acceptable to either pay off existing debts, buy stocks (no derivatives), make new loans, or purchase new items - not to open or add to any type of savings account.
Then they issue these credit cards to the general population, effectively giving each man, woman & child $33,333. (if I have the math right).

That ought to switch the momentum from deflation to inflation with a vengeance, and they will probably end up spending almost that much on bailouts eventually anyway. And think how popular it would make the politicians.

Jan 13 02:04 PM

[DiggerUK:]

"Old Limey"
B.B., at the L.S.E., came over on Bloomberg as stating the bloody obvious, and not saying anything we don't already know.

The questions at the end were all very stage managed in my opinion, on the lines of how Frost interviewed Nixon.

When a man from the government, with a presentation prepared by spin doctors, says nothing to one of the worlds leading universities., and gets away unchallenged ., a voice at the back of my head whispers panic.

Jan 13 02:50 PM

[Dr. B:]

I know that I am way out of my league here - but what would happen if we suddenly declared all debt forgiven? Instead of pouring trillons into the banks to stimulate lending - imagine what would happen to the economy if the american consumer and business had not debt - no credit cards, mortage, car payment, ect... Talk about a stimulus. As a small business owner, lack of debt would certainly allow me to hire more people and start new projects.

Jan 13 03:29 PM

[ngwun:]

Well i suppose if a reward is given to those who had no thrift, and nothing to those who had, next time EVERYONE can play the game. After al, why bother? Almost like what has been done already?


On Jan 13 03:29 PM J. Isaac Barthelow wrote:

> I know that I am way out of my league here - but what would happen
> if we suddenly declared all debt forgiven?

Jan 13 05:46 PM

[henarl:]

Dr. B: If all lenders' balances were cancelled, who would ever make a loan again. Talk about freezing credit !!

Jan 13 06:41 PM

[Stanley:]

the Fed and the Gov't have been throwing money at this for almost two years, and the problems keep getting worse. their actions and policies are the problem, not the solution. how did fiscal/monitary policy work out in the 30s and in Japan? seems gov't have a way of turning a 2-3 year problem into a 10+ year problem once they try to fix it. BB and most of Congress had no idea there was a housing bubble while the typical college student thought it was obvious. you give those guys far too much credit.

Jan 14 02:15 AM

[Mark in SF:]

"I know that I am way out of my league here - but what would happen if we suddenly declared all debt forgiven? Instead of pouring trillons into the banks to stimulate lending - imagine what would happen to the economy if the american consumer and business had not debt - no credit cards, mortage, car payment, ect... Talk about a stimulus. As a small business owner, lack of debt would certainly allow me to hire more people and start new projects. "

Mr. B, turn it around: Imagine if all savings were wiped out. All pension funds. All insurance company reserves. Social security reserves. Your companies cash holdings. What do you think savings are? It's all somebody else's debt.

Jan 14 03:14 AM

[samo:]

the best answer to this mess is to handout checks to the masses instead of the banks....it's really quite simple...

Jan 14 02:32 PM

[Dana Hata:]

I don't agree with the "Lost Financial Asset "Wealth"" counterargument in the linked article. Or perhaps I'm missing something. Suppose you have a simple island economy involving two people, John and Mike.

Originally, John has $1000 in cash and 0$ assets, and Mike has $100 in cash and $1000 in assets, since he owns a house presently valued at $1000. So the money supply is $2100 for this hypothetical island:

John Mike M
$1000/$0 $100/$1000 $2100

John then decides to buy Mike's house at the current market rate of $1000. Thus the new value for M is still $2100:

John Mike M
$0/$1000 $1100/$0 $2100

After awhile, John no longer wants this house, and decides to sell it back to Mike. However, Mike will not buy the house at its current price, and refused the purchase. After letting it sit on the market for a couple of months, John yields and lowers his asking price to $800. Mike then agrees to buy the house:

John Mike M
$800/$0 $300/$800 $1900

M (money supply) has this been reduced by $200 to $1900!

Now, the amount of liquid cash in this scenario never changed ($1100), and I think that's the crux of the linked article's author's argument- that perhaps the amount of liquid cash won't change. But as far as I know, money supply measurements include equities, assets, etc. I mean, certainly an asset is something you can borrow against, so reduction in the collective asset value of an economy would reduce the amount of new money creation via lending.

I'm just an amateur, so would a real economist please stand up and set this straight?

Jan 14 03:34 PM

[Dana Hata:]

It must be the case that money supply could NOT include equities or assets. My totals of what I considered "liquid cash" must be the way to calculate money supply.

However, since assets do count for something with respect to collateral for lending, their would obviously be a credit contraction effect, with lowered new money creation via loans.

Jan 14 03:49 PM

[Citizen Zeus:]

The reason why inflation over deflation is preferred by the wealthy oligarchy that largely determines the monetary policy in this country is because they own the lion's share of the assets and do not want to contemplate the loss of their own (illusory) billions of dollars on assets.

They don't need the money, but they need the psychological feeling that that they are growing and expanding in order to quell their surprisingly shallow, superfiical, and insecure sense of self-worth. Inflation is also a great way to put the screws to the labor force and workaday Joes.

Just as "disaster (terrorist, war, etc.) mania" can allow for much power to be taken away from individuals (civil liberties, etc.), so an "disaster capitalism" (making everything too expensive for people to by help create a "company town" where everyone is forced to get credit and pay unreasonable prices and forever be under the sway and power of the lender. What greater ownership can there be than to own not only property, but people themselves?

Jan 14 06:04 PM