The US economy has been in crisis since 2008, and despite optimistic statements by officials and commentators, there are no fundamental signs that the crisis will end in the foreseeable future. The US economy has suffered a real estate collapse, a stock market crash, a banking crisis, a near systemic collapse on a global scale, a credit crisis, the worst economic downturn in the US since the Great Depression, and an unprecedented global recession.
Following two sequential economic bubbles, the dot-com bubble and the real estate bubble, no one has yet correctly called either the bottom for the US economy or the start of a US economic recovery. Nonetheless, each day, news reports, articles and statements by officials and commentators reveal new economic data and offer new analysis. Unfortunately, both the economic data and the interpretations offered by officials and commentators are contradictory.
It appears that both inflation and deflation are occurring at the same time; that the US gross domestic product and consumer spending are declining while stock prices are rising; that government spending is rising while tax revenues are falling; that consumers are deleveraging and that the flow of credit has slowed while the total of debts and liabilities in the US economy continues to rise; that the US dollar is falling while price inflation remains nominal; that interest rates are near zero for banks but rising for consumers. The seemingly contradictory facts indicate economic distortions and therefore developing systemic instabilities.
What ties all of the economic data together is the US dollar. Rather than considering what impact unsustainable economic distortions might eventually have on the US dollar, could the developing systemic instabilities instead be the symptoms of a currency crisis already in progress?
The debate over inflation versus deflation in the US economy tends to overlook the fact that both inflation and deflation are occurring at the same time but in different areas of the economy. The policies of the US government and Federal Reserve are inflationary but there are vast deflationary pressures with no relief in sight. The effects of inflation can always be seen in the long run in consumer prices, i.e., the dollar looses value as a function of monetary inflation thus prices tend to rise.
Faced with the imminent collapse of the US banking system in 2008, averting a deflationary depression, such as the Great Depression, was obviously desirable but whether the radical inflationary policies of Federal Reserve Chairman Ben Bernanke combined with US government bailouts can ultimately save US banks remains to be seen. However, a radically inflationary outcome and a corresponding fall in the value of the US dollar could ultimately be as destructive to the US economy as a deflationary collapse would have been. Monetary inflation in the financial system is a technical fix that does not address the deflation in the broad US economy. The broad US economy has continued to decline since 2008 despite having saved the banking system and despite massive deficit spending and stimulus programs.
The relationship between the banking system and the broad US economy hinges on the levels of debt in the economy. Since the mechanism of money creation is debt, the broad money supply cannot be inflated without increasing debt levels outside the banking system. Setting aside stock market crashes, it is debt defaults that create ongoing deflation via bank losses and failures.
According to the Federal Reserve Bank of St. Louis, the monetary base (MB) has approximately doubled in roughly the past 12 months. The increase appears to contradict the fact that deflationary pressures impacting US banks continued virtually unabated. Mortgage and credit card defaults have resulted in 170 US bank failures since 2007. A recent Bloomberg article indicated that the number of lenders that cannot collect on 20% or more of their loans hit an 18-year high, signaling more bank failures ahead.
The MB data reflect increases in bank reserves partly attributable to the Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF) program. Whether banks can successfully borrow their way past their losses depends not only on the magnitude of the losses relative to their revenues, reserves and balance sheets, but on future business performance. The strategy cannot work in the long run if the US economy continues to contract. While new money has flowed into banks, it cannot filter out into the broad US economy which continues to decline.
The dramatic increase in MB is not apparent in more broad measures of the money supply such as M3. M3 includes currency in circulation and all types of deposit and money market accounts as well as other liquid assets. Although the Federal Reserve ceased publication of the M3 monetary aggregate in March 2006, it is still calculated by John Williams of Shadow Government Statistics. M3 has been in a sharp decline since 2008, reflecting monetary deflation in the broad US economy.
Economic recovery cannot take place in a deflationary environment simply because money is less available to individuals and non financial businesses. In particular, small businesses provide roughly 2/3 of all jobs in the US economy and the flow of credit to small businesses has been sharply curtailed. The reduced availability of credit to consumers and non financial businesses has had a strong dampening effect on the broad US economy. Consumers are deleveraging (paying off debt) and non financial businesses, hesitant to borrow in the face of declining revenues and economic uncertainty, are cutting costs as well as jobs.
The effects of the credit crisis can be seen most clearly in the velocity of money (MZM) which shows that spending on the part of consumers and non financial businesses has slowed dramatically. MZM is the average frequency with which a unit of money is spent in a specific period of time. Saving and deleveraging on the part of consumers (as opposed to financing consumption via credit), reduced borrowing on the part of non financial businesses, and unemployment all contribute to falling MZM.
As deflation makes money more scarce (falling M3), consumer and business spending slows down (falling MZM) exacerbating falling business revenues, business failures, and unemployment, which in turn put additional stress on US banks. This is the short formula for a deflationary depression. Comparing the present situation to the Great Depression, the main difference is that deflation due to bank failures is being prevented, or at least slowed down.
Since inflation is the result of debt there must be an optimum or “healthy” level of debt for an economy relative to its gross domestic product (GDP). Since GDP growth is stimulated by inflation and inflation requires increased levels of debt, maintaining an optimum level of inflation requires debt levels not to increase disproportionately.
At a glance, it seems that US GDP, while in decline, remains near an all-time high in nominal terms. Interestingly, the GDP growth curve mirrors that of cumulative CPI, which is directly a function of inflation.
Looking at the percent change in GDP tells a different story. The way that the US government measures GDP has changed over time. John Williams of Shadow Government Statistics still measures GDP using the pre-Clinton era formula.
While the rate of decline in US GDP may be questioned, the fact of decline remains, i.e., the US economy is in recession. Whether nominal GDP indicates sustainable economic growth depends on the levels of inflation and debt in the economy. Specifically, if nominal GDP growth is accompanied by a disproportionate rise in debt, GDP growth is unsustainable at best and illusory at worst.
US unemployment data point to a further contraction of GDP. In an economy where GDP growth has been associated with rising debt levels and where consumer spending accounts for roughly 2/3 of GDP, unemployment cannot be considered a trailing economic indicator and might instead be seen as a leading indicator.
A further drop in consumer spending can be expected as a function of rising unemployment. The policy response of the US government has had little effect in terms of GDP or unemployment.
The key question with respect to US GDP is whether total debts and liabilities in the US economy are sustainable. If not, new borrowing on the part of consumers and non financial businesses cannot take place and deflationary pressures will persist in the broad US economy. Karl Denninger (The Market Ticker) has published a number of articles discussing debt levels in the US economy.
US mortgage and consumer debt levels, as well as asset values, have been in decline since 2008. At the same time, public debt has accelerated due to a dramatic increase in US government borrowing. Unfortunately, government spending on behalf of consumers and non financial businesses cannot offset deflation or halt the overall slowdown of the broad US economy.
Current debt levels in the US economy may not be sustainable. Federal and household debts and liabilities for the entire US economy, not including commercial debt, total $332,326 per citizen, or approximately $862,000 per household. While it may be interesting to conceptualize debt levels in terms of individual or household liability and to consider whether tax revenues will be sufficient to service a far larger public debt, what is most important is how debt levels relate to GDP.
Excessive debt levels point to excessive inflation in the past and suggest that GDP growth, having been over-stimulated, will contract more severely than expected. Similarly, bank balance sheets must contract for debt levels to return to sustainable levels. Consumer debt, however, is not the main problem. As unfunded liabilities come due, the US public debt will rise and servicing the public debt will grow significantly compared to tax revenues.
According to data from the Federal Reserve and the US government, the rise in debt levels has been pulling away from GDP growth at an accelerating rate since the mid 1990s. With GDP in decline, or in sharp decline as measured using pre-Clinton era methods, the ratio of total debts and liabilities in the US economy to GDP is unsustainable under any realistic GDP growth scenario.
Unsustainable debt levels are the root cause of ongoing deflationary pressures in the broad US economy. There are only two ways to eliminate excessive levels of debt: deflation and inflation.
The policy response of the US government and Federal Reserve has made clear that deflation will be prevented as far as it is possible to do so, i.e., to avoid a deflationary depression. The largest banks have been preserved under the “too big to fail” theory and the US government, as has been demonstrated in the past year, stands ready not only to borrow and spend whatever amount of money may be necessary without regard for the public debt or future tax or budgetary consequences, but also to take on virtually unlimited liabilities. The question is: will it work?
Although the US dollar rallied in 2008 as the global financial crisis brought world economies to a precipice, the US dollar in 2009 appears much less attractive.
Setting aside the US dollar inflation of past decades associated with the excessive levels of debt in the US economy today, a rapidly expanding Federal Reserve balance sheet and quantitative easing (“money printing”) are directly weakening the US dollar while foreign appetite for US debt is waning. On a global basis, there is a growing shift away from the US dollar both as a reserve currency and as an international medium of exchange, as well as a developing US dollar carry trade threatening to put additional pressure on the dollar.
The apparent choice between inflation and deflation may itself be illusory because both assume the US dollar can survive the developing systemic instabilities in the US economy and growing pressure on the dollar. Since monetary inflation is tied in lock-step to debt levels, an inflationary policy response might produce only unsustainable economic distortions. It is too late to put the inflation genie back in the bottle, thus there is no fundamental way to stop the slide of the US dollar in the long run.