An Age Of Deflation?

by: John M. Mason

More and more is being written about the need for the United States, and the world, to restructure its economy. This comes out very clearly in the opinion piece by A. Gary Shilling in Bloomberg, "Why Global Economies Face an Age of Deflation."

I know this seems very contradictory to the monetary position taken by Ben Bernanke and the Federal Reserve System, but, analysts, myself included, are looking for reasons why the economy is not responding more abundantly to the monetary stimulus provided by the Fed, and why the Open Market Committee of the Federal Reserve System believes that this degree of monetary stimulus will have to continue through 2014 and into 2015.

Certainly, expectations of economic growth in the world are not robust. The United States is expected to grow at a rate in the 2.0 to 2.5 percent range. In the 1982 to 2000 time period, the United States growth rate was around 3.7 percent.

The situation in the eurozone is seemingly deteriorating: "The European economy appears to be slowing further, private-sector data showed Thursday, raising the possibility that the recession will deepen even as the crisis in Cyprus undermines faith in the future of currency union."

The slowing is not just in the "south" but evidence show "the German and French economies, the two largest in the eurozone, losing steam." But, there is also continued economic slowing in England, and China, and elsewhere.

Leading this decline is a massive amount of deleveraging taking place in the world. Whereas the central bankers are attempting to stop this deleveraging, they have achieved little as of this date.

According to research done by Carmen Reinhart and Kenneth Rogoff, published in the book "This Time is Different," long periods of financial leveraging during a period of credit inflation require a long period of deleveraging to bring things back into perspective. Shilling builds on the fact that we are now going through this period of deleveraging.

The "legacy" commercial banking system, the financial sector most closely connected to the Federal Reserve, is deleveraging. Not only are commercial banks being required to bump up their capital ratios, they are being faced with other regulatory pressures and costs that are limiting their willingness to lend. Many commercial banks are in the process of doing their own downsizing as they try to sell assets or write off assets that are not performing, especially, as Shilling mentions, writing down "off-balance sheet" vehicles that were obtained during the financial wizardry of the past 15 or 20 years. Shilling particularly looks at what is happening to the household savings rate to explain why consumer spending may be especially weak in the near future and unlikely to respond to government stimulus.

From the early 1980s through 2005 the household savings rate in the United States fell from about 12 percent to about 1 percent. This period was the height of the federal government's policy of credit inflation, which was especially reflected in the government housing programs and an increasing bubble in the prices of homes. People substituted "savings" from the "equity" being built up in these assets for savings from their income. Of course, many, many homeowners learned a lesson from this period, a lesson that is and will impact consumer spending in the future.

Shilling is not expecting the savings rate to rise "by one-percentage-point annual gain." This, he argues, "would slice 1.5 percentage points off consumer spending gains as well as GDP growth."

But, the structural issues go on. How can we add to this dilemma? Well, Shilling argues that fertility rates have dropped below the replacement rate in most industrialized countries. This will restrain economic growth. Second, education systems need to be revamped for the twenty-first century. The emphasis of education must be changed or it will reduce productivity growth. Third, the government needs to get away from an emphasis on consumer spending, and housing and financial assets, "which do little to enhance productivity and can curtail growth."

Furthermore, the position of the United States in the world has changed. We have gone from "hot" wars and "cold" wars to an emphasis on peace. Shilling points to the fact that in years of "war" wholesale prices increase. In peacetime years, they fall. "As the U. S. withdraws from Iraq and Afghanistan and as defense spending declines, peacetime conditions are likely to prevail."

It can be noted at this point that the United States withdrawal from world leadership in foreign affairs and world leadership in economic affairs -- as exhibited by the sinking world economy -- is the subject of a very interesting new book that I will be reviewing in the next week or so. This book is by Peter Temin and David Vines and is called "The Leaderless Economy." In this book the authors examine how England, the previous world leader fell from world leadership in the 1920s and 1930s, and how the United States has fallen from world leadership in the present period. It is a very interesting read.

Part of the point of the "fall" in world economic leadership is that more and more countries strike out on their own and currency wars erupt and trade wars erupt. Shilling points to this looming threat to global growth and cooperation in the actions of Prime Minister Shinzo Abe's new government in Japan.

"In periods of prolonged economic pain, notably the global recession of 2007-2009 and the subpar revival that has followed, international cooperation gives way to an every-nation-for- itself attitude that often takes the form of protectionism. Many countries are now pursuing competitive devaluations to spur exports via a cheaper currency and to impede imports."

The bottom line, to me, is that there are many structural imbalances that exist in the world today that must be worked out before we can return to more normal periods of economic activity. These imbalances developed over an extended period of time. They will not be reduced over night.

But, the Federal Reserve and other central banks within the world continue to push on. Mr. Bernanke, a world-class scholar of the Great Depression, and other central bank leaders do not want to err on the side of not providing the economy with too little liquidity. Thus, they are throwing all the "spaghetti" they can against the wall to see what sticks.

The consequence of this monetary excess may not be to lessen what people need to do to restructure their lives and balance sheets and, hence, get the economy growing faster.

The consequence of this monetary excess, I argue, will only work to enhance the income polarization that exists in the United States and elsewhere. There are two effects. The first, mentioned by Shilling, is the increased income polarization that comes about "because higher earners are less likely to spend their money than people with lower incomes. According to the Federal Reserve's Survey of Consumer Finances, read median net worth fell by 39 percent from 2007 to 2010, yet income polarization caused the mean to fall just 20 percent. "

The other effect: wealthy people can take advantage of what the Fed is doing. Thus, they can, and they are, playing off the Federal Reserve's generosity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.