THE BEAR'S LAIR Inflation or deflation?
By Martin Hutchinson
There is a considerable argument between commentators as to whether, apart from
a pretty painful recession, the US economy is in for a bout of inflation or
deflation. Both sides have apparently cogent arguments, and maintain their
positions with considerable vigor. Robert Samuelson, having recently published
a book The Great Inflation that suggested another burst of inflation was
inevitable, has now produced an op-ed in the Washington Post warning of the
rapidly approaching dangers of deflation - such are the dangers of publishing
schedules! Having in the past suggested that inflation was inevitable, I
thought it worth looking at the deflationist case.
Money supply data, first, do not suggest that deflation is imminent, although
to some extent they contradict each other. M2, the broadest money supply
measure now published by the
Federal Reserve, was up 7.4% in the 12 months to November 3 (suggesting a
potential inflation rate of 6-7% since gross domestic product growth was around
1% in real terms.) The St Louis Fed's Money of Zero Maturity, the closest we
can now get to the old M3, discontinued by the Fed in 2006, is up 10.0% in the
last 12 months, suggesting a somewhat faster rate of inflation, perhaps 8-9%.
More recently, however, the two measures have diverged; in the eight weeks to
November 4, M2 was up at a 19.9% annual rate while MZM rose at a 0.7% annual
rate - a huge disparity that has yet to be explained.
Nevertheless, the "gold bugs" who would normally expect to profit substantially
from an upsurge in inflation have had a terrible year, indicating that their
thesis has in some respects gone horribly wrong. According to Mark Hulbert on
CBS Marketwatch, Harry Schultz, Howard Ruff and Jim Dines, the three leading
gold-bugs and prognosticators of economic doom, have each lost between 64% and
70% on their investment newsletters during 2008. Since this was the year in
which their prognostications of doom finally appear to have come true, one can
reasonably ask what went wrong!
Equally the majority view, that the principal danger facing the United States
is a Japanese-style stagnation lasting a decade or more with prices declining
slightly making real interest rates too high, also seems misguided. Japan was
close to deflation even in the early 1990s, and then followed a poisonous mix
of policies that failed to recognize the loan losses in its banks while
attempting to spend its way out of trouble through the public sector.
The United States is doing the latter but not the former, which it is prevented
from doing by "mark-to-market" accounting. While mark-to-market accounting has
major defects in prolonging a bubble, since it allows bankers to enter into
foolish deals in the hope of short-term profits and bonuses, it is highly
salutary in a downturn, preventing any semblance of wishful thinking in
assessing value-impaired assets such as mortgage bonds.
That's why the entire US banking system has been forced to turn to Uncle Sam
for succor; it is also why that system is now entirely unable to carry on as if
nothing had gone wrong as the Japanese banking system did in 1991-98. Thus with
a banking system forced into realism and interest rates that are sharply
negative in real terms, deflation seems an unlikely possibility, in spite of
Treasury Secretary Hank Paulson's determination to invest every spare nickel in
the economy into its most unproductive and valueless assets.
The difference between the United States and 1990s' Japan is further indicated
by the credit crunch: Japan didn't really have one, in the sense of a sudden
constipation in normal lending that caused the economy to seize up. That
suggests again that the US trajectory going forward is unlikely to resemble
1990s Japan (for good or evil - Japan avoided a really deep recession, though
it suffered an appallingly long albeit shallow one.)
The recent spate of truly terrible economic numbers, such as the 2.8% retail
sales decline in October (4.5% down on the previous year) and the 32% decline
in automobile sales, suggests that wherever the bottom of the recession is
located, we will get there quickly. The US savings rate and the balance of
payments both need to be improved by about 5% of gross domestic product, so a
top-to-bottom decline in GDP of at least 5% is likely. However there is little
reason for GDP to decline more than 5% top-to-bottom, or maybe 7% to allow for
a little overshoot. Once GDP gets to its new equilibrium level, powerful
factors stabilize it and produce renewed growth - after all, at that new level
of GDP the United States is once again internationally competitive, selling
goods and services to customers worldwide in a way that has been impossible for
a decade.
We are thus not looking at Great Depression II, in which GDP would decline 25%.
To reach such an unpleasant re-run we would need a major outbreak of global
protectionism, a final withdrawal of confidence by depositors in the US banking
system and a swingeing increase in taxes, more than doubling the top marginal
rate. President-elect Barack Obama isn't going to do that. Is he?
If he doesn't, and we avoid a Smoot-Hawley-style attack on world trade, then we
will also avoid Great Depression ll. After all, the Depression was a primarily
US phenomenon, caused and prolonged by egregious US policy errors - it was
nothing like so bad in Britain, where economic policy under Chancellor of the
Exchequer Neville Chamberlain was highly competent and basically the opposite
of US failures.
However, if the recession is to be limited to a drop of 5-7% in GDP (itself
somewhat worse than the 1974 and 1979-82 recessions, both around 3.5% of GDP)
then at the present rate of decline we will reach bottom pretty quickly, in no
more than nine to 12 months. That tallies also with the housing price decline;
house prices have already declined more than 20% nationwide, and from valuation
considerations probably have no more than 10% or at most 15% to go.
The banking system has already been bailed out by the Fed and probably won't
have to be bailed out again, but will see a gradual containment of losses in
the next few quarters (with one or more huge incompetents finally slithering
into bankruptcy.) The stock market has nearly reached its equilibrium of around
7,800 on the Dow (based on its early 1995 level of 4,000, inflated by nominal
GDP growth since then). Although the market will doubtless overshoot on the
downside, the dollar loss from a further decline to say Dow 5,000 is less than
we have already experienced in the decline from 14,165 to below 9,000.
While US GDP is still declining sharply inflation will remain quiescent. Oil,
minerals and agricultural prices will be on a generally downward trend, as the
rest of the world, in particular the high-population growth centers of China
and India, find their growth restricted by declining US demand. However, China
has already indicated that it will not allow a US recession to stall its own
growth; instead it has announced a two-year stimulus program of US$580 billion,
about 15% of GDP. Thus commodity prices will remain supported by the continuous
surge in Chinese and to a lesser extent Indian demand.
US inflation will slow somewhat from its summer peak of close to 6%, but will
not go into reverse, even while output continues its sharp decline. A renewed
decline in the dollar, inevitable once US savings rates begin to recover and
the flood of foreign capital into US bonds lessens, will cause the recent
decline in import price inflation to reverse. Meanwhile cost increases already
present in the system will work their way through to prices, causing continued
modest upward momentum.
Even if inflation is declining gradually as output declines, it will not have
time to become deflation in the nine to 12 months before output reaches bottom
- if we were about to experience Great Depression II the decline would be more
prolonged, but we're not. Once output has bottomed out, the inflationary
picture changes radically. Budget deficits in the United States, the European
Union, China, India and Japan will be enormous, causing sharp rises in interest
rates as government bonds "crowd out" the private sector. Money supply, which
will have been increasing because of the very low nominal interest rates, will
now be grossly excessive for the shrunken GDP.
Costs, which were held down by the wave of bankruptcies in the contraction,
will once again increase as supply comes once again to balance demand. For one
thing, higher interest rates and capital costs (through lower equity prices)
will themselves produce a sharp upward ratchet effect on corporate break-evens,
both in the US and more especially in emerging markets where capital will be
scarce. Lower production volumes against which fixed costs can be amortized
will also increase unit costs. The overall effect will be sharp upward pressure
on prices - those continuing to sell at a loss to keep the factory at its most
efficient output level and workers employed will be rapidly driven out of
business.
Inflation will thus resurge, both domestically and internationally, and will
quickly reach the double-digit level at which central bank action to restrain
it becomes unavoidable (amusingly, unexpectedly awful inflation figures are
likely to appear before the January 2010 end of Federal Reserve chairman Ben
Bernanke's term, forcing him to admit while still in office that his
"deflation" warnings were hogwash.)
Interest rates will gradually be forced upwards to inflation-plus-4% levels in
the last months of 2009 and throughout 2010, producing a second "dip" of
recession in 2011 and a non-inflationary recovery in 2012-13. The turn from
economic decline (but not truly deflation) to inflation will be well indicated
by the gold market, which can expect to surge as the economic bottom is
approached.
As often happens, the "gold bugs" will turn out to be right in the end, even if
their performance during 2008 has been dreadful - for those that survive, 2009
is likely to be a banner year. Deflationists will proclaim each slowing
inflation figure in the early months of 2009 to be evidence for their case,
though in reality those months will see not true deflation but simply slowing
inflation accompanied by sharp descent into recession.
However, in the long run, monetarists will prove to have been right - and the
decade of excessive money supply expansion from 1995-2008 will impose its final
penalties on the unfortunate US and global public. Monetarists will also have
the satisfaction of knowing that higher real interest rates will have become
inescapable, and that overexpansion of money supply will never happen again -
until some future generation of idiots has forgotten the economic history of
these decades.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-08 David W Tice & Associates.)
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