Inflation or Deflation? Let’s settle this once and for all

Recession means inflation or deflation?

Once the economists ascertained that the economy has in fact been contracting since November 2007, heated discussion started brewing as to whether we are heading towards a deflationary period akin to the 1930s and current-day Japan, or whether the over-eager Fed and other Central Banks around the world will over-simulate the money supply, leading us towards a potential inflationary period similar to the 1980s.

There are generally three camps. There’s the camp of deflation, headed by big names like Nouriel Roubini and bloggers like the “Mish”, coining new vocabulary by predicting an economic decent into stag-deflation. An overwhelming number of vocal critics head the inflation camp, claiming that even if deflationary pressures are present in the current economic climate, large injections of money into the banking system will devalue our money. Then there’s the hyperinflation group that extrapolate the size of money injection into the economy to signal potentially explosive inflation, thus scaring the crap out of everyone by throwing terms like “Weimar Republic” and “Zimbabwe” around.

So who’s right?

Solid evidence of deflationary pressure on economy

There are no shortages of signs pointing to a deflationary period in the economy.  For the sake of consistency, we will define deflation as a contraction in the money supply and credit.  While others may look upon deflation as decline in the general pricing index of goods, this is incorrect.  Falling prices are merely a consequence of deflation, and not the phenomenon itself.

What are some arguments for deflation?

1. The short-term credit market is frozen. Banks around the world are still assessing damages brought on by the sub-prime mortgage crisis.  Many of them, especially in Europe, still have a lot of work to do in making an accurate assessment as to the extent of their losses. Some have been effectively nationalized, while others are in limbo awaiting some form of government bailout. This in turn, implies banks are still reluctant to resume business with each other. Without a credible guarantee that the counterpart’s balance sheet is clean enough, this cannot happen.

The same scenario plagues regional banks all around the US.  After sweeps of residential mortgage defaults, many banks are now beset with mass commercial property defaults. Regardless of the low rates and cash injections from the Fed, many banks are hoarding the cash in anticipation of more bad news and write-offs. This means low levels of lending to the consumers and businesses that need it, and low levels of inter-bank businesses conducted. Liquidity is frozen.

2. Falling fuel prices, along with massive liquidation of merchandise are construed by some as signs of falling price levels. This is misleading, since sales and bankruptcy liquidations are signs of ridding the market of excessive supply, in light of fallen demands.  This is merely a symptom of the liquidity crisis that may very well be the very remedy for deflation, and does not serve as a long-term indicator of whether such trend is present.

In fact, prices need to fall in order to achieve economic recovery, by allowing greater purchasing powers for a reduced amount of spending for the consumers.  The reduced prices in effect enable to consume more in the present versus waiting to take advantage of lower prices in the future.  This restores the supply and demand equilibrium in the marketplace.

The Japanese path down deflation was due to its failure to recognize loan losses in its banks and its attempt to publicly spend its way out of the problem. In this regard, the US is attempting to imitate in the second case, while the first one is not possible through its market-to-market accounting practice.

3.  Consumers are no longer spending, businesses are no longer borrowing. The implication here is that a lack of spending will stagnate businesses, stifle investments, reduce employment, causing the government to further reduce interest rates to no avail.

The argument is that since banks are not lending and consumers no longer want (or able) to borrow, regardless of the amount of money the Fed prints or injects into the banking system, the liquidity will not circulate. Furthermore, even if the government directly deposits money into consumers’ bank accounts in the form of a fiscal stimulus, i.e. tax cut, paying down existing debts or saving will take precedence over spending.

The counter-argument is that the government is always a willing borrower of last resort.  If consumers will not borrow, then the government can always initiate public projects that will stimulate spending and hiring.

The problem with the above solution is two-fold.  One is whether public borrowing taken by the government will eventually crowd out private investments and push up interest rates to undesirable territory, potentially sparking off an inflationary train.

The second is concerns over whether such spending will in fact lift up the economy, or whether it will merely mirror the Japanese deflationary experience for the past two decades.

The Japanese path down deflation was due to its failure to recognize loan losses in its banks and its attempt to publicly spend its way out of the problem.  In this regard, the US is attempting to imitate in the second case, while the first one is not possible through its market-to-market accounting practice.

4. Dollar is holding value against all other fiat currencies. Despite some ups and downs, since the credit crunch crisis broke out in full-force in mid-2008, the greenback has held up remarkably well.  Gold did not shoot through the roof.  Dollar naysayers were disappointed, and deflationists have another piece of arsenal.

However, an across-the-board depreciation of all currencies against gold in the near future is not out of the question. While inflationists will look at gold rise as an indication of fiat money’s weakness, the deflationists will point to the same graph and view it as a hedge against uncertainties.

But deflation is a scary prospect for Americans, as the value of debt climbs higher with time. Is this a preemptive strike against potential signs of deflation lurking in the horizon?

5.  Geithner lashing out at a cheap yuan. The out-burst by Tim Geithner took many by surprise.  But there’s a case to be made for deflation here.  An under-valued Chinese yuan means more cheap imports.  And cheap import was one of the factors that exacerbated Japan’s deflation for the past two decades.

China is reluctant in letting the yuan depreciate against the dollar for good reasons.  It is the largest holder of US treasuries.  Therefore an appreciation of its own currency means massive losses on their dollar investment.  It will also undermine their export competitiveness, slow its economy, and most likely, exacerbate the global recession.   But deflation is a scary prospect for Americans, as the value of debt climbs higher with time.  Is this a preemptive strike against potential signs of deflation lurking in the horizon?

The many cases for inflation

1. Increase in money supply. Many deemed the phasing out of US M3 back in 2006 to be highly suspicious, and some have extrapolated a sharp increase of M3 in recent months.  Once the velocity of the said cash injection takes off, it spells a highly inflationary environment. See #6.

2. Gold and silver price increases. Many looked on the stagnation, and even decline in precious metals last year with confusion. Investors that bet large on gold and silver failed to see their anticipated return, and were for the most part, stunned by the strength of the US dollar.

Rest assured that the relative dollar and yen strengths had nothing to do with their intrinsic valuation strengths.   Many hedge funds were forced to liquidate their holdings late 2008 to either cover their other positions or to meet redemption by jittery investors.  De-leveraged sales were converted into US dollars, largely explaining the initial boost.

As the British and Eurozone economies started showing signs of deep fractures, but still unable to assess the extent of damage, nor find coherent strategies to meet the challenge, investors parked their money in US dollars as the devil that they thought they knew (at least a little bit better).

The strength in Japanese yen follows a similar story.  Many traders were forced to execute reverse carry trade, resulting in mass sale of investments made in foreign currencies and a run-up to purchase the yen.

Many predict 2009 as the year of the gold, where monetary inflation of all major currencies will reduce the overall spending power of the fiat money, and gold will be one of the few safe guardians of value.

But the worrying sign is that the dollar is falling against country that we import from. That is to say, buying things from China will become more expensive. That spells inflationary pressure.

3. Dollar valuation holding steady? The dollar index measures the strength of the greenback against a basket of foreign currencies consisting of the euro, Canadian dollar, yen, pound, Swedish krona and the Swiss franc. Initially set at 100, the index has gone as low as the 70s before recovering last year to around the mid-80s nowadays. Given most of those currencies are now also falling at breakneck speed, that index is unlikely to go too much lower. It’s important to remember that it’s not dollar that is holding or gaining strengths, but the simple fact that almost every fiat currency in the world is becoming increasingly worthless.

But the worrying sign is that the dollar is falling against country that we import from. That is to say, buying things from China will become more expensive. That spells inflationary pressure.

4.  Stimulus package. The stimulus package proposed by the US government will fund the construction of bridges, schools, and other public infrastructure projects. The justification behind the package is to somehow create jobs, so people can become more eligible for credit and spend more. Economists would point to the size of the stimulus package and worry about the amount of debt the government is taking on behalf of its citizens.

This completes the monetary injection of #1, where the government will be the borrower of last resort (if businesses and consumers can not be induced to spend), and banks will have the reserves on hand to lend.

The problem will start when the initial effects of the stimulus has been felt, and businesses go back to borrowing, but finding the interest rate has risen due to the crowding out effect. Businesses will then operate at a higher price level, passing the cost onto consumers. The cycle of inflation starts.

Comparing the adverse political effects of deflation that is sharp and domestic, to the much more opaque evils of inflation, who do you think will win out?

5.  Who wins from inflation? As a large debtor nation, the US loses massively in the case of a deflation, which perhaps explains why it was on the lips of Bernanke not too long ago. Then wouldn’t it make sense that the US will do everything in its power to avoid such a scenario?

Some question the competency of the Fed and the government, and whether they can in fact manipulate the market at its will. The answer? They can’t, but they will. The monetary injection will ensure the banks have enough liquidity to lend, once the stimulus package is put in place. What about risks of over-inflation? Highly probable. But the Fed deems an inflationary environment more favourable than a stagnant or deflationary environment.

Since most western countries (UK, Japan, Eurozone) will also face similar inflationary pressures and consequent depreciation of their currencies, the weaknesses of the US dollar may not be apparent for some time. One of the more visible deprecations will take place against the Chinese yuan.

Is the yuan under-valued at the moment? Yes, but not as much as the US would like it to be. In the next few years, the Chinese yuan may be pressured to appreciate against the western currencies, either politically, or in the more likely case, by market forces.

Since the call for re-valuation of yuan has been loud and clear for quite some time, a sudden jump in prices of Chinese import will not come as a shock to the American public. It certainly is easier to explain: it’s external, it’s long over-due, and it’s not a bad thing for US borrowers.

Therefore, purchasing power destruction is much more desirable and politically manageable, since the effects are more or less hidden in price inflation. The effects are illusionary gains through price level gains, versus the exaggerated weaknesses of a fallen investment portfolio.

Let’s look at it another way. The effects of tolerating deflation means an even higher number of bankruptcies, combined with a large tax spike to avoid debt defaults.  While higher prices and interest rates are more favorably tolerated as “the way things are” in a market economy.  Comparing the adverse political effects of deflation that is sharp and domestic, to the much more opaque evils of inflation, who do you think will win out?

In terms of financial prowess, American is weakening relative to the rest of the world.  But in the end, the argument for this very technical economic question comes down to this.

Are you betting FOR, or AGAINST, America?  To put it another way, will America allow a re-distribution of power occur as a result of this financial crisis, and if so, how much is it willing to give away?

I don’t know the answer to this question.  But I know that militarily, and by extension, politically, America is by far the one and only superpower in the world.  Perhaps more feared than loved, it is still “the Prince”.

As Barack Obama and Warren Buffet have put it: “It never pays off to bet against America.”

Now wager your bet.

picture source: bluehedgie

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