Deflation Revisited (The Studio Version)

The Automatic Earth has been predicting a devastating deflationary period for as long as we’ve been in existence, and prior to that we did so at The Oil Drum Canada. We have always and consistently said that worrying about inflation in the next few years is completely misguided.

The debt deflation that is already underway will be so destructive to our lives and societies that we must be aware of what is coming in the short term and what we can do to prepare for it, instead of worrying about a possible inflationary period that may or may not follow afterwards.

The deflation issue has recently become much more topical, as the idea is spreading now that the larger trend in the markets has turned down. It is time to review the mechanism and rationale for deflation, given that the mainstream press is suddenly all over it. Like for instance John Hilsenrath in the Wall Street Journal:

Deflation Defies Expectations – and Solutions
The old bogeyman of deflation has re-emerged as a worry for the U.S. economy. Here’s something else to fret about: After studying more than a decade of deflation in Japan, economists have slowly realized they have no idea how it works….[..]

“This is the most significant economic issue there is out there,” Mr. Gertler says. The good news is that the Fed might not need to fear a Depression-style deflationary spiral. The bad news is that if the U.S. does fall into deflation, it could be stuck there for many years like Japan, and suffer the subpar growth that has gone with it. And because deflation is so poorly understood, policy makers could discover they have no good solutions.

Next, Don Lee has the following in the Los Angeles Times:

U.S. may face deflation, a problem Japan understands too well:
The White House prediction Friday that the deficit would hit a record $1.47 trillion this year poured new fuel on the fiery argument over whether the government should begin cutting back to avoid future inflation or instead keep stimulating the economy to help the still-sputtering recovery.

But increasingly, economists and other analysts are expressing concern that the United States could be edging closer to a different problem — the kind of deflationary trap that cost Japan more than a decade of growth and economic progress. And as Tokyo’s experience suggests, deflation can be at least as tough a problem as the soaring prices of inflation or the financial pain of a traditional recession.

When deflation begins, prices fall. At first that seems like a good thing. But soon, lower prices cut into business profits, and managers begin to trim payrolls. That in turn undermines consumers’ buying power, leading to more pressure on profits, jobs and wages — as well as cutbacks in expansion and in the purchase of new plants and equipment.

Also, consumers who are financially able to buy often wait for still lower prices, adding to the deflationary trend. All these factors feed on one another, setting off a downward spiral that can be as hard to escape from as a stall in an airplane.

For now, the dominant theme of the nation’s economic policy debate remains centered on the comparative dangers of deficits and inflation. However, economists across the political spectrum — here and abroad — are talking more often about the potential for deflation [..]

But the Fed’s chief, Ben Bernanke, appears to think deflation fears are overblown. During his semiannual testimony to Congress last week, he told senators that he didn’t view deflation as a near-term risk. In the Fed’s latest forecast, core inflation is projected to stay at the current pace this year, then gradually rise toward 1.5% in 2012. Should deflation occur, the central bank has the tools to reverse it, he said. But many question whether the Fed can do much more, given that it already has pushed interest rates to historical lows and pumped more than $1 trillion into the financial system.

Ambrose Evans-Pritchard at The Telegraph has changed his tune significantly in the last month. In June he appeared to believe that, while the situation is dire, the Fed has the tools to combat, and prevent, deflation:

RBS tells clients to prepare for ‘monster’ money-printing by the Federal Reserve
There is no doubt that the Fed has the tools to stop this. “Sufficient injections of money will ultimately always reverse a deflation,” said Bernanke. The question is whether he can muster support for such action in the face of massive popular disgust, a Republican Fronde in Congress, and resistance from the liquidationsists at the Kansas, Philadelphia, and Richmond Feds. If he cannot, we are in grave trouble.

More recently he has been sounding much more alarmed:

Stress-testing Europe’s banks won’t stave off a deflationary vortex
I suspect that Fed chair Ben Bernanke knows the economy buckled around the Ides of June, but is stymied by hawks at the regional Feds. All he can do for now is to talk down credit costs through hints of more quantitative easing, or QE2. In this he has succeeded. The yield on two-year Treasuries fell to an all-time low of 0.5765pc on Friday. It’s Weimar, all right: circa 1931, not 1923.

And Fauxbel -Fake Nobel- laureate Paul Krugman produces the term of the day:

downward nominal wage rigidity literature

which is part of this tortuous (pretend-) academic exercise:
Mysteries Of Deflation (Wonkish):

So here’s the underlying puzzle: since Friedman and Phelps laid out the natural rate hypothesis in the 60s, applied macroeconomics has relied on some kind of inflation-adjusted Phillips curve, along the lines of: Actual inflation = A + B * (output gap) + Expected inflation,  where the output gap is the difference between actual and potential output, and A and B are estimated parameters. (The output gap is closely correlated with the unemployment rate). Expected inflation, in turn, is assumed to reflect recent past experience.

This relationship predicts falling inflation when the economy is depressed and the output gap is negative, rising inflation when the economy is overheating and the output gap is positive; this prediction works fairly well for modern US experience, explaining in particular the disinflation of the Volcker recession of the 1980s and the disinflation we’re experiencing now.

But here’s the thing: the inflation-adjusted Phillips curve predicts not just deflation, but accelerating deflation in the face of a really prolonged economic slump. Suppose that the economy is sufficiently depressed that with expected inflation at 3 percent, actual inflation comes out only 1; expectations will actually eventually catch up, so that if the economy remains depressed we’d expect inflation to go to -1; but if the economy remains depressed even longer, we’d expect inflation to go to -3, then -5, and so on.

In reality, this doesn’t happen. Prices fell sharply at the beginning of the Great Depression, when the real economy was collapsing; but they began rising again when the economy began to recover, even though there was still a huge negative output gap. Japan has been depressed since before incoming freshmen were born, but its chronic deflation has never turned into a rapid downward spiral.

It is surprising how many commenters, many of whom have for the longest time dismissed the possibility of deflation, often in a smugly superior manner, are ignorant of what it actually is. They look at Japan and ask how a country can become mired in a long and drawn-out deflation, and why the Japanese experience is so different from the rapid and accelerating deflationary spiral of the Great Depression.

They assume that central bankers possess the tools to prevent deflation, which suggests that they think those in control in other times or places must simply be too stupid to employ them. If it were so simple to prevent deflation then it would never have occurred anywhere, and yet it has.

Many persist in viewing deflation as a price phenomenon, rather than as the monetary phenomenon it always is. They cling to the notion of the fundamentals driving the credit markets, and then wonder why it is impossible to make accurate predictions. In short, the causation runs the other way. The availability of credit drives the real economy, because credit expansions are Ponzi schemes that generate large swings of positive-feedback (self-fulfilling prophecies) in both directions. It is only the context and scale that are different.

Japan’s experience of deflation has been blunted, so far, by the enormous quantity of money that they had available to burn through, which enabled them to put off addressing the bad debt in their banking system, and by the availability of a booming global economy, which allowed them to generate wealth from exporting goods to consumer societies. We do not have these luxuries. In place of a vast pile of money, we have a vast sinkhole of debt at every level – personal, corporate, governmental.

We will not have the ability to export, partly because we produce very little of value, but also because the global market will not have the purchasing power to allow the export model to survive in any case. We will be fully exposed in the short term to the logic of our credit expansion business model, which creates primarily virtual wealth, whereas Japan was not. We will resemble Argentina (only worse), not Japan.

It is not that deflation is poorly understood, except by the mainstream, which unfortunately includes most economists. There are very clear and comprehensive explanations available for what deflation is and therefore why it is inevitable. We here at TAE have consistently, since our inception, pointed out the mechanism behind this critical aspect of our future. See for instance At the Top of the Great Pyramid, on the nature and critical importance of Ponzi dynamics, or The Big Picture According to TAE.

We have pointed out that credit expansion creates multiple and mutually-exclusive claims to the same pieces of underlying wealth-pie, thereby creating a fictitious wealth that will implode once people realize its existence and reality. Deflation is the chaotic elimination of excess claims to underlying real wealth – the collapse of a money supply that has come to be dominated by ephemeral credit and debt.

For those who are interested, one of the most concise formulations of inflation and deflation has been available for many years in the form of JK Galbraith’s A Short History of Financial Euphoria, a history of the periodic rediscovery of leverage (and the consequences thereof) written in 1990. It is short, very clear and readable, and highly recommended. Galbraith points out that financial innovation has led to the formation of many bubbles throughout history, and that the collapse of the unpayable debt thereby created, which is deflation by definition, always follows.

JK Galbraith: “A point must be repeated: only the pathological weakness of the financial memory…allows us to believe that the modern experience of….debt…is in any way a new phenomenon.”

Our current credit expansion is different only in scale, in quantity, not in quality, from what has happened time and time again in human history.

Robert Prechter, author of Conquer the Crash (2002), has been explaining deflation to anyone who would listen for many years.

A trend of credit expansion has two components: the general willingness to lend and borrow and the general ability of borrowers to pay interest and principal. These components depend respectively upon (1) the trend of people’s confidence, i.e., whether both creditors and debtors think that debtors will be able to pay, and (2) the trend of production, which makes it either easier or harder in actuality for debtors to pay.

So as long as confidence and productivity increase, the supply of credit tends to expand. The expansion of credit ends when the desire or ability to sustain the trend can no longer be maintained. As confidence and productivity decrease, the supply of credit contracts….[..]

When the burden becomes too great for the economy to support and the trend reverses, reductions in lending, spending and production cause debtors to earn less money with which to pay off their debts, so defaults rise. Default and fear of default exacerbate the new trend in psychology, which in turn causes creditors to reduce lending further. A downward “spiral” begins, feeding on pessimism just as the previous boom fed on optimism. The resulting cascade of debt liquidation is a deflationary crash.

Debts are retired by paying them off, “restructuring” or default. In the first case, no value is lost; in the second, some value; in the third, all value. In desperately trying to raise cash to pay off loans, borrowers bring all kinds of assets to market, including stocks, bonds, commodities and real estate, causing their prices to plummet. The process ends only after the supply of credit falls to a level at which it is collateralized acceptably to the surviving creditors.

(Prechter has a free e-book on deflation available (free registration required) here).

Investment analyst John Mauldin, among others, has recently started to view deflation as a threat, even though he doesn’t appear to understand exactly why he should:

Deflation dissected
Saint Milton Friedman taught us that inflation is always and everywhere a monetary phenomenon. That is, if the central bank prints too much money, inflation will ensue. And that is true, up to a point. A central bank, by printing too much money, can bring about inflation and destroy a currency, all things being equal. But that is the tricky part of that equation, because not all things are equal. The pieces of the puzzle can change shape. When the elements of deflation combine in the right order, the central bank can print a boatload of money without bringing about inflation. And we may now be watching that combination come about.

The role of credit is not clear here in this excerpt. Inflation is the expansion of the supply of money and credit versus available goods and services. Some 95% (or more) of our money supply is credit, and by no means all of it was created by any central bank. There have been numerous engines of credit expansion during the mania years – fractional reserve banking, the whittling away of reserve requirements, lack of attention paid to credit-worthiness, securitization, derivatives, the development of the shadow banking system, conflict-of-interest at the ratings agencies, fraud etc. When the all-inclusive credit Ponzi scheme crashes – meaning that the overwhelming supply of virtual wealth disappears and we are left with only real wealth – we will have insufficient money to run our global economy.

When the money supply is inadequate, we will be trying to do the equivalent of running a car with the oil light on, which is to say that we will be trying to run an economy with insufficient lubricant in the engine. Money is the lubricant in the engine of the economy in the same way that oil is the lubricant in the engine of a car. Without enough lubricant, the engine will seize up, and then it will not be possible o connect buyers and sellers purely for want of money, exactly as happened in the Great Depression.

The credit contraction we are seeing is an early warning signal for the real economy. Since the large-scale trend change of late April (counter-trend rallies not withstanding), we are witnessing a change of perspective among the commentators, reflecting a loss of confidence and increased fear. Confidence IS liquidity in a very real sense, and as the contagion of fear spreads, liquidity will disappear. The suspension of disbelief that the long rally brought is over, and that will lead to the next phase of the on-going liquidity crunch.

Some commentators do understand at least part of where we are going and why, like Max Keiser:

The Market Is a Hologram Masking Deflation
At first it looked like the liquidity stimulus was going to revive the economy and there was an anemic bounce in 2009, but that death rattle has now expired and the primary trend of falling real estate prices, falling wages, and deteriorating bank balance sheets has reasserted itself and threatens to take the economy down again dramatically (read: depression). The question of a ‘double dip’ is misleading. The economy started down a depressionary slide in 2008 and hasn’t looked back.

Extend and pretend cannot persist forever. There’ll come a time when that proverbial kid will holler: “He has no clothes on!”. At some point we will see investors trying to sell distressed assets, and then we will realise what they are actually worth (i.e. what someone will actually pay for them). When we see that they are worth pennies on the dollar, and that whole asset classes need to be repriced overnight, we will see the reality of deflation. That, almost at a stroke, will mark the destruction of the virtual wealth created during the long expansion years.

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