Flaws in the Deflation Case
The majority of economists/analysts remain in the deflation camp. Despite the bleak picture, many seem seem to believe that large-scale monetization of our debt won’t happen. For example, Mike Shedlock, aka Mish, just posted a thought-provoking piece. In it, he scoffs at the idea of hyperinflation in the US. He dismisses it as ridiculous given the size of the problems we face. And he makes a good pitch. Mr. Shedlock is a sharp analyst, evidenced by his huge following on the web.
While I disagree with his deflation view (more on that below), Mish does make some excellent points about the headwinds we’re facing. Plus, it’s always good to audit your own beliefs by listening to opposing arguments. So let’s examine the case for deflation. Central to it are three daunting forces in the US: Rising unemployment, the ongoing annihilation of household wealth, and the debt-collapse of Q1 2009. As Mish says:
Think consumers are about to go on a spending spree after a massive $13.87 trillion collapse in net worth? Think banks are going to start lending with this employment picture and household debt? I don’t and boomer demographics makes the situation even worse. Don’t forget the bleak employment picture. There is no source of jobs.
The deflation camp has a solid case at first glance. The picture is bleak indeed. In a truly laissez faire economy, equities would utterly collapse, making this 40% drop look paltry. Unemployment and wages would plummet, resulting in dramatic deflation. As companies fail and people lose their homes, a horrific deflationary spiral would ensue. But there’s a gaping hole in this argument: Our economy is far from lassaize faire. It’s arguably one of the most manipulated and subsidized in the world.
Some in the deflation camp seem to believe our government will allow a massive collapse to happen, without attempting a clumsy (and likely counterproductive) rescue. Printing money is a key component of any government bailout/rescue. Most deflation articles fail to address this, specially these aspects: what effect quantitative easing will have, and whether the Fed will reign in money supply when it’s required. More on that later. First let’s look at just how awful the economic picture is. Knowing the size of the problem is key to understanding how drastic Gov/Fed will need to be, if they are to have any effect at all.
Things Are Really, Really Bad
De-leveraging has barely begun. California is on the verge, the first of many states. Boomers are retiring, medicare costs will skyrocket. The wave of mortgage resets in Alt-A Loans in 2010/11 will be a nightmare (bigger than sub-prime). The case for deflation seems clear, but only if you remove the Fed and Gov intervention from the picture.
Don’t forget, the same players who got us into this mess are still in control. Their response will be predictably bad. For proof, look at the way things have been handled so far. Their answer to a debt crisis is more debt, re-flating the bubble. And the size of this problem is unprecedented:
Don’t forget the $99 trillion in unfunded healthcare and retirement obligations (wsj). It’s no surprise that some are positioning themselves short equity/long cash. Short is probably not a bad place to be for the very near future. But like it or not, inflation will eventually benefit debt-laden companies with good cash flow (they get to pay off their debts with devalued currency). That’s a horrible model, but it seems inevitable.
Governments find the temptation to “fix” these collapses irrestible. And those fixes result in reverse-Darwinism. Companies that should fail don’t, upsetting the entire equilibrium of the invisible hand. For those who think that our leaders will act prudently, and ignore the temptation of inflate, I urge you to recall some of the Gov/Fed actions that got us into this mess:
- Keeping interest rates so low for so long
- Increasing bank leverage to 40x, repealing Glass-Steagll
- Unsustainable deficit spending to fund war/military budgets
- Shifting of mortgage risk to the public via GSEs like Fannie and Freddie
- Allowing elected officials to be openly bribed by instutions they regulate
Will Gov and Fed Stand Idle as Disaster Strikes?
If Mish and others are right, we’re not anywhere close to true recovery. A bigger crash is inevitable, and all we have done is postpone it. I happen to agree. Where we differ is on how the government and Fed will respond. I don’t think they will act to curb inflation when the time comes. Given the size of the problems we face, they will eventually be forced to monetize our debt.
Richard Fisher, head of the Dallas Fed, is probably the loudest “inflation hawk” they have. And even he is making the deflation case. So the Fed, like always, is focused on the immediate future. Since inflation is not an immediate concern, they put it off , essentially saying “we’ll cross that bridge when we come to it”.
In a recent WSJ interview, Mr. Fisher attempted to soothe worries about hyperinflation. While it is reassuring to hear Mr. Fisher say the Fed won’t monetize our debt, he is a black sheep, an anomaly among Fed Presidents. And even he doesn’t sound convinced:
I think the trick here is to assist the functioning of the private markets without signaling in any way, shape or form that the Federal Reserve will be party to monetizing fiscal largess, deficits or the stimulus program [from this wsj piece, a must-read]
Without signaling? Why not say, “While assuring them that we are committed to not monetizing our debt. We’re not going to do it, period.” Because he’s only one voice, and hugely outnumbered. I like Fisher, he seems like one of the smarter Fed guys. When the time comes to pull in the reigns, his voice will surely be drowned out.
How far will they go to stave off massive economic turmoil; a collapse on the scale that Mish and others forsee? Very, very far. No government wants the it to happen on their watch. The digital printing presses are likely getting warmed-up.
Inflation: Easier to Swallow
Politically, inflation is infinitely more palatable than the alternatives. Voters loathe tax increases, and rightly so. Yet we have also become dependent on ever-expanding programs like medicare. Something has to give, and I think inflation is the easiest option.
The American public is largely complacent. As long as you don’t raise their taxes or slash their benefits, rebellion is unlikely. But if you jack up taxes or cut spending on the scale required to fix this problem, we may see serious social unrest. It’s really that big of a problem. Which is why I remain in the inflation-camp. For more on the effects of continued government intervention, see “Beware Bears: More Bailouts and Inflation Loom”.
Disclosure: No positions in any stocks mentioned.