A Possible Scenario for Deflation or Hyperinflation

In and amidst the developing credit crunch, the fear of deflation and hyper inflation are both present and increasing. Like a ship taking on water and rolling from side to side, the global economies are more and more swinging between deflation risk and hyper inflation risk. Volatility on commodity, financial and stock markets has never been so high (oil from $140 to $40 a barrel, some global stock markets down 50%, 0% yield on treasury stock, etc).

Where Feds around the globe have been very successful in keeping inflation under control and within the acceptable bandwidths, the increasing volatility is likely to cause havoc in the coming years. The only problem is nobody knows if it will be deflation, high inflation or both.

One scenario is that the US will accept the dangerous route of high inflation and deflate itself out of its current position. Europe is likely to do the opposite and is more likely to face deflation.

For the US, which has already increased its money supply dramatically, this is a more logical approach. Being supported by the fact that the US$ is the reserve currency the US has this option to play with. By increasing the money supply and stimulating the economy though infrastructure spent, it will also cause inflation, deflate its currency (the US$ may fall by half), therefore reducing its overseas and internal government debt, which is north of $10T, and allow its export sector to lead the economy toward recovery. This before Europe has worked its way out of the credit crisis.

For a Europe that, due to the 30s in Germany, is far more afraid of hyper inflation, it is not likely to increase the money supply extensively. Also this can only be done by the European bank and not by any of the EU counties on its own initiative.

As we are only at the end of the credit crunch and the beginning of the recession for Europe, the negative flow into the real economy still has to pass through a large number of stages and reinforcing negative cycles. Europe is therefore likely to see a structural drop in demand, leading to price decreases, leading to increased unemployment, leading to further demand reduction, etc.

An extended period of deflation is therefore more likely for Europe, leading to an overvalued Euro, stalling Europe's export leading to further deflationary pressure.

All in all, it looks like the US and Europe are on different paths in search of resolving this crisis. Their different paths are likely to lead to more problems down the road.

Stock position: None.

Comments

[Vox Rationalis:]

The author wrote: "The only problem is nobody knows if it will be deflation, high inflation or both."

What about "neither"? This is not a possibility?

"One scenario is..."

But you provide no balance, no "second scenario." The rest of the article reads as if you're quite sure of the answer.

"...the US will accept the dangerous route of high inflation and deflate itself out of its current position... For the US, which has already increased its money supply dramatically, this is a more logical approach. Being supported by the fact that the US$ is the reserve currency the US has this option to play with."

If the US were to do this, the dollar would no longer be the world's reserve currency. The ability of the US to borrow in the future would be hugely reduced. This is not an acceptable outcome.

"By increasing the money supply and stimulating the economy though infrastructure spent, it will also cause inflation, deflate its currency (the US$ may fall by half)..."

Why? I don't think you understand either the Fed's actions or the impacts of infrastructure spending. Yes, the Fed's actions would normally be inflationary, and government spending would normally be information. But these are not normal times.

The growth in the Fed's balance sheet (the growth in the money supply) is directly responsive to negative private sector money supply growth, and the vast majority of the growth to date is quite easily unwound as credit markets recover.

As for spending, a well-crafted infrastructure-based stimulus (on which the current bills mostly fail) would accelerate government demand, moving it from future years to now. The impact on future infrastructure spending would be that the government would spend less in the latter half of the decade. This would limit the cost of the fiscal stimulus to a few years of interest costs and the costs of replacing some infrastructure before the end of its usable life.

Both the current unprecedented Fed actions and the best-possible fiscal stimulus would have very little long-term impact on inflation.

"Europe is likely to do the opposite and is more likely to face deflation."

"Also this can only be done by the European bank and not by any of the EU counties on its own initiative."

Which, if the ECB follows the course you describe, may expose serious cracks in the union. A deflationary depression would seriously put the survival of the Euro in doubt.

"As we are only at the end of the credit crunch..."

You continue to make very bold assumptions.

"...Europe is therefore likely to see a structural drop in demand, leading to price decreases, leading to increased unemployment, leading to further demand reduction, etc."

There's another one.

"All in all, it looks like the US and Europe are on different paths in search of resolving this crisis. Their different paths are likely to lead to more problems down the road."

Can't speak for the ECB, but I question your conclusions based solely upon your assumptions.

Feb 10 02:41 PM

[Gedankonomist:]

Deflation is the hangover after the party.

The FED's slogan is "Avoid hangovers--stay drunk."

Feb 11 01:44 PM

[granger:]

I think both. Deflation first, then when ever is dazed and not looking,numb. they will wake 3 years later and wonder what the h--- happened.

Become a debtor now. Lock in fixed rates now. Buy durable assets now.
(now meaning next 6 months)

JMHO

Feb 12 05:26 AM