The Main Event: Inflation vs. Deflation
Two roads suggest very different courses of action.
Federal Reserve Bank of St. Louis President James Bullard shot a warning over the bovine bow last week, offering the US is at risk of falling into a Japan-like deflationary trap.
His comments were shared in the context of a proposed solution. Instead of insisting interest rates will remain low for the foreseeable future, he argued the Federal Reserve should focus on the next iteration of quantitative easing, namely buying Treasuries, and boosting inflation expectations.
The decisions made by the powers that be will profoundly impact whether we slip into a deflationary morass or inflate our way to another day. While a thin line defines these two outcomes, the ramifications are binary for investors. In an inflationary environment, cash is trash. In a deflationary environment, it is king.
How then do we reconcile these two seemingly disparate outcomes? In a word, carefully.
For the last eight years, the ace up the Federal Reserve's sleeve has been the US dollar. They let the greenback devalue with hopes that a legitimate economic recovery would supplant the credit expansion that dominated this decade. As it stands, we're still waiting.
The world's reserve currency has declined 33% since 2002 while everything measured in dollars reacted in kind. While that slipped by stateside players largely unnoticed, it's been a steady source of stress for foreign holders of dollar denominated assets.
We call this dynamic "asset class deflation vs. dollar devaluation" in Minyanville as policymakers pull fiscal and monetary stings in an attempt to toggle between the two. While both sides of the equation can trade lower, the deck is stacked against both rallying in kind for a sustained period of time; or at least that was the case before the sovereign sequel to the financial crisis began. (See: A Five-Step Guide to Contagion)
While cumulative imbalances brought this conundrum to a tipping point, it remains to be seen where the bears will domicile. I'm an optimist by nature but a realist when it comes to our current condition. In my humble view, two potential scenarios exist as we edge down this prickly path.
The first is continued socialization of markets, bearded nationalization of troubled institutions, and the specter of inflation. A significantly lower dollar is a necessary precursor to -- but no guarantor of -- this dynamic and could potentially "jack" anything denominated by that measuring stick. If this occurs, it will paradoxically punish savers who preserved capital, much like we saw in 2009.
This outcome is presumably preferred by policymakers as an alternative to watershed deflation. The "haves" would fare better than "have nots" as the cost of goods and services rise. It would also spur the velocity of money, which is paramount in a finance-based economy.
The other option is the destruction or reorganization of debt, deflationary pressures and an eventual pathway towards an "outside-in" recovery that will pave to the way towards true globalization. The result would be a higher dollar and lower asset classes in the intermediate term but a sustainable foundation for economic expansion thereafter.
The fact that Mr. Bullard drew attention to this latter risk is noteworthy; deflation in a fractional reserve banking system means policy makers have, for all intents and purposes, lost control of the economy. It would also impact the top tier of our societal structure tied to the marketplace, which would be problematic for politicians and the constituencies that bankroll them.
No Easy Answers
The banking system, stymied with credit dependency, is not operating normally. Hidden behind the bailouts, stimulus packages, super-conduits, term auction financing, mortgage rate freezes, foreclosure plans, working groups, Public-Private Investment Programs, and the next wave of quantitative easing are politicians attempting to engineer a business cycle that long ago lost its way. (See: Anatomy of a Recession)
The qualifier of this discussion is the elasticity of debt, which continues to be stretched by historical standards. Total outstanding credit obligations are more than 350% of GDP and the consumer (70% of GDP) is hamstrung by wealth destruction, depleted savings and lower home equity levels. When we factor the Internet into the equation -- the most deflationary invention in the history of the world -- back-of-the envelope odds suggest a 75% probability that the phantom will have the last laugh. (See: The Return of the Phantom of Deflation)
This process, should it come to bear, will take years to unwind the cumulative excesses but will ultimately yield positive results. The destruction and/or reorganization of debt would allow world economies to rebuild a solid foundation for future expansion that is entirely more stable than what we currently have in place.
While it would cause paper wealth to evaporate, rich nations will be forced to pour real money -- as opposed to cheap debt -- into developing economies as a redistribution mechanism. That path might be painful but the destination will be entirely more palatable and lead to a higher standard of living for future generations.
The timing of this evolution will be affected by the political process. Yesterday, the Federal Reserve floated the notion of buying new mortgages or Treasury bonds when its mortgage-bond holdings mature, rather than letting its portfolio shrink.
While pushing risk further out on the time continuum may be the only perceived option for our "in too deep" policymakers, it would again increase the odds that our global counterparts will yell "Uncle Sam" and attempt to extricate themselves from this monetary madness. (See: Rise of the East and Downgrade of the West)
There is a marked difference between taking our financial medicine as a function of time and price and injecting the system with drugs with hopes that the symptoms will pass. The latter continues to be the diagnosis of choice but the economic patient would be well served to understand both sides the prognosis.
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Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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