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business newsMidst of Deflationary Collapse or Brink of Inflationary Disaster? 12 Recommendations
By
Mike Mish Shedlock
Sep 07, 2011 10:30 am
Here, a 12-point recommendation list that could fix numerous structural problems, create lasting jobs, and reduce the deficit.
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Credit Cycle Understanding Is Key to Returns
It is very refreshing to see someone else writing about debt deflation and how powerless the Fed is to stop it. Instead, we see article after article by people touting high inflation, even hyperinflation.
Hyperinflation is complete silliness at this point. Were it to come, it would be an act of Congress that would create it, not an act of the Fed, and the Fed would probably have to play along (though I doubt it would). For all its many faults, the Fed does not want to destroy banks. Hyperinflation would do just that.
The Republican-dominated House wants little or nothing to do with more stimulus. Certainly US government debt is going to mount, but it is going to mount in Japan, the eurozone, and the UK as well.
Moreover, eurozone structural issues matter now, while US government debt will matter more in the years to come.
Midst of Deflationary Collapse or Brink of Inflationary Disaster?
Although the Keynesian and Monetarist economists have missed the boat on what is happening and why, Austrian-minded folks who fail to understand the importance of credit and how little the Fed can do to revive it have blown the call as well.
It pains me to see articles like On the Brink of Inflationary Disaster by Austrian economist Robert Murphy.
Clearly we are in the midst of a deflationary collapse as noted in Yes Virginia, U.S. Back in Deflation; Inflation Scare Ends; Hyperinflationists
Wrong Twice Over.
Focus on Money Supply Alone Is Fatally Flawed
Deflation is about credit; it is also about attitudes that govern the demand for credit.
As I have stated many times over the years, and in the Contrary Investor article, there is nothing the Fed can do to force businesses to expand or banks to lend.
That point explains why Austrian economists who focus on money supply alone have failed and will continue to fail.
Until consumer demand returns, businesses would be foolish to expand. Unfortunately, the Fed's misguided easing policies have stimulated commodity speculation, thereby increasing manufacturing costs, while simultaneously clobbering those on fixed incomes and reducing final consumer demand.
I wrote about the plight of those on fixed incomes in Hello Ben Bernanke, Meet "Stephanie" back in January. Please give it a read if you have not yet done so.
The Deflationary Hurricane of Deteriorating Social Mood
One of the best posts recently on social mood and deflation is by Minyanville contributor Peter Atwater.
Please consider The Deflationary Hurricane of Deteriorating Social Mood
This morning, in the aftermath of Fed Chairman Ben Bernanke’s speech on Friday, the editorial page of the Wall Street Journal noted, “Mr. Bernanke also lectured that ‘U.S. fiscal policy must be placed on a sustainable path,’ though not by cutting spending in the short-term. So the Fed chief joins the Keynesian queue of spending St. Augustines – Lord, make us fiscally chaste, but not yet.”
Everything we need to do for long-term economic, if not societal success and stability comes with very severe short-term consequences. And so the response of most policymakers (and not just those responsible for fiscal policy but also regulatory policemen like Mr. Bernanke himself) has been to advocate for short-term expansionary programs and rules, while postponing the real teeth of necessary change until some later date in the future. Basel III, for example, has a phased-in capital-strengthening requirement for the banking system that does not finish until 2019 – again, "chaste, but not yet."
I am sure that what is behind the thinking of policymakers is the notion that if we can just get through this tough “transitory” period, the economy will turn up; and at that point, whether it is fiscal or regulatory policy, our ability to handle constraints will be much, much easier to bear.
After 11 years of declining social mood, the notion that further monetary stimulus has limited use is hardly a surprise. As I have cautioned so many times, when it comes to the consumer it is not the depth of a recession that matters, but rather its length. And while for policymakers and financiers this may feel like a three-year-old recession (and for some even just a three-week-old recession!), for the American consumer this is a decade-old recession that has deteriorated well into a depression. The average American is now financially and emotionally exhausted. And given the news reports out of Washington over the past month, they are also now afraid that they are at risk of losing some or all of their government safety net, too. Like the children of fighting, divorcing parents, they are now fearful of what an increasingly uncertain future holds.
While further fiscal stimulus – particularly job-related initiatives – may slow the pace of deterioration, I am increasingly afraid that further fiscal and monetary policy actions are now impotent agents against our current social mood. Where in 2000, the future was so bright that we’d need shades, in 2011, the future for many Americans is so dark that they can’t see their way forward.
The consequence will be price deflation -- and not just further price deflation across those debt-dependent purchases like homes and automobiles, but across all categories of consumer goods. And for the first time since the 1930s, American businesses will see that lower prices are not always met with greater demand.
Price Deflation on the Way?
My definition of deflation is "a decrease of money supply and credit with credit marked-to-market." Judging by symptoms of deflation and the Fed's efforts at fighting it, the US is back in deflation now by my measure. In my model, falling prices are not a requirement for deflation.
The important point is not definition, but rather the expected conditions. Yet, the conditions I expect -- and indeed the conditions in the US right now (in aggregate) -- match deflationary scenarios, not inflationary ones.
Murphy calls for an "inflationary disaster" while Atwater calls for "price deflation across all categories of consumer goods."
I do not know if we see across-the-board price deflation Atwater calls for given peak oil constraints and an inept US energy policy that also affects food prices.However, I do expect to see falling education costs and medical costs as well as falling prices in a broad array of consumer goods and services, especially if Republicans can get a few sensible deficit measures passed.
Whether that scenario happens or not, the idea "brink of inflationary disaster" is complete silliness unless and until the Fed can revive credit, yet the Fed is powerless to do so.
So, unless Congress goes really haywire, attitudes will change and deleveraging will play out before the US experiences serious inflation. Unfortunately, Fed and Congressional policies have only served to lengthen the deleveraging timeline.
Those looking for hyperinflation or even strong inflation have missed the boat again, and again, and again, and will continue to do so, interrupted by periodic inflation scares until debt-deflation plays out.
Understanding the Deflationary Cycle
To understand what is happening, why businesses are not hiring, why housing is stagnant, and where the economy is headed, one needs a model that takes into consideration five key factors:
1. Mark-to-Market Measures of Bank Credit and Capitalization Ratios
2. Credit Cycle Theory
3. Attitudes of Banks, Businesses, and Consumers
4. Futility and Limits of Keynesian Stimulus
5. Futility of Monetary Stimulus
1. Mark-to-Market Measures of Bank Credit and Capitalization Ratios
Banks cannot and will not lend unless they are not capital-impaired and unless they have credit-worthy customers. Atwater noted Basel III was delayed until 2019. I noted on many occasions banks are still hiding investments off the balance sheets in SIVs, and mark-to-market rules have been suspended several times.
As happened in Europe, delay tactics can only work for so long before the market questions if loans on the balance sheets of banks will ever be repaid. That time is now, not 2019. Thus banks are too capital-impaired to take excessive risks, even if they wanted to. Moreover, too few credit-worthy businesses want to expand in the first place.
No positions in stocks mentioned.
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