Deflation, not inflation, is the real enemy
By Mike Whitney
Online Journal Contributing Writer
Jun 12, 2009, 00:20
The Republicans are convinced that hyperinflation is just
around the corner, but don�t bet on it. The real enemy is deflation, which is
why Fed chief Bernanke has taken such extraordinary steps to pump liquidity
into the system.
The economy is flat on its back and hemorrhaging a half a
million jobs per month. The housing market is crashing, retail sales are in a
funk, manufacturing is down, exports are falling, and consumers have started
saving for the first time in decades. There�s excess capacity everywhere and
aggregate demand has dropped off a cliff. If it wasn�t for the Fed�s monetary
stimulus and myriad lending facilities, the economy would be stretched out on a
marble slab right now. So, where�s the inflation?
Here�s Paul Krugman with part of the answer: �It�s important
to realize that there�s no hint of inflationary pressures in the economy right
now. Consumer prices are lower now than they were a year ago, and wage
increases have stalled in the face of high unemployment. Deflation, not
inflation, is the clear and present danger . . .
�Is there a risk that we�ll have inflation after the economy
recovers? That�s the claim of those who look at projections that federal debt
may rise to more than 100 percent of G.D.P. and say that America will
eventually have to inflate away that debt - that is, drive up prices so that
the real value of the debt is reduced . . . Such things have happened in the
past . . .
�Some economists have argued for moderate inflation as a
deliberate policy, as a way to encourage lending and reduce private debt
burdens (but) . . . there�s no sign it�s getting traction with U.S. policy
makers now.� (�The Big Inflation Scare� Paul Krugman New York Times)
Krugman believes that conservatives have conjured up the
inflation hobgoblin for political purposes to knock Obama�s recovery plan
off-course. But even he�s mistaken, there�s little chance that inflation will
flare up anytime soon because the economy is still contracting, albeit at a
slower pace than before. A good chunk of the Fed�s liquidity is sitting idle in
bank vaults instead of churning through the system where it could do some good.
According to Econbrowser, excess bank reserves have bolted from $96.5 billion
in August 2008 to $949.6 billion by April 2009. Bernanke hoped the extra
reserves would help jump-start the economy, but he was wrong. The people who
need credit, can�t get it, while the people who qualify, don�t want it. It�s
just more proof that the slowdown is spreading.
That doesn�t mean that the dollar won�t tumble in the next
year or so when the trillion dollar deficits begin to pile up. It probably
will. Foreign investors have already scaled back on their dollar-based
investments, and central banks are limiting themselves to short-term notes,
mostly three-month Treasuries. If Bernanke steps up his quantitative easing
(QE) and continues to monetize the debt, there�s a good chance that central
bankers will jettison their T-Bills and head for the exits. That means that if he
keeps printing money like he has been, there�s going to be a run on the dollar.
Now that the stock market is showing signs of life again,
investors are moving out of risk-free Treasuries and into equities. That�s
pushing up yields on long-term notes which could potentially short-circuit
Bernanke�s plans for reviving the economy. Mortgage rates are set off the 10-year
Treasury, which shot up to 3.90 percent by market�s close on Friday. The bottom
line is that if rates keep rising, housing prices will plummet and the economy
will tank. This week�s auctions will be a good test of how much interest there
really is in US debt.
At some point in the next year, the dollar will lose ground
and commodities will surge, causing uneven inflation. But for how long? That
depends on the state of the economy. Dollar weakness and speculation can drive
up the price of oil, (oil is up 100 percent in the last two and a half months,
from $34. to $68.) but falling demand will eventually bring prices back to
earth. Presently, there�s a bigger glut of oil sitting in tankers offshore than
any time in the last 15 years. Which brings us back to the original question;
how bad is the economy?
The answer is, really bad! Here�s a short blurb from
economist Dean Baker in an article in the UK Guardian: �The decline in house
prices since the peak in 2006 has cost homeowners close to $6 trillion in lost
housing equity. In 2009 alone, falling house prices have destroyed almost $2
trillion in equity. People were spending at an incredible rate in 2004-2007
based on the wealth they had in their homes. This wealth has now vanished.
�Housing is weak and falling, consumption is weak and
falling, new orders for capital goods in April, the main measure for investment
demand, is down 35.6 percent from its year ago level. And, state and local
governments across the country, led by California, are laying off workers and
cutting back services.
�If there is evidence of a recovery in this story, it is
very hard to find. The more obvious story is one of a downward spiral as more
layoffs and further cuts in hours continue to reduce workers� purchasing power.
Furthermore, the weakness in the labor market is putting downward pressure on
wages, reducing workers� purchasing power through a second channel.� (Dean
Baker �Cheerleading the Economy,� UK Guardian)
Don�t be fooled by the cheery news in the media. The economy
is hanging by a thread and recovery is still a long way off. The only way to
dig out of this mess is to address the underlying problems head-on. That means
removing the toxic assets from the banks, revamping the credit system, and
rebuilding battered household balance sheets. If these issues aren�t resolved,
the problems will drag on for years to come. And even if they are fixed, the
economy is still facing a long period of deleveraging and retrenching followed
by an anemic recovery. Obama�s fiscal stimulus might give the GDP a jolt in the
third quarter, but without help from the government checkbook, economic
activity will stay in the doldrums.
Last month, personal savings increased to nearly 6 percent
while consumer credit fell by $15.7 billion, the second largest decline in debt
on record. According to Brad Setser of the Council on Foreign Relations, �Total
borrowing by households and firms fell from over 15 percent of GDP in late 2007
to a negative 1 percent of GDP in q4 2008.� How can these losses to the GDP be
made up when private borrowing has vanished without a trace? Consumers have shut
their wallets, locked their purses and are refusing to take on any more debt.
Despite government efforts to restart the credit markets by backing up loans
for 0 percent financing on auto sales and an $8,000 tax credit on the purchase
of a new home, (which is tantamount to subprime lending) consumers are digging
in their heels. All the hype about inflation hasn�t sent them racing back to
the shopping malls or the auto showrooms. Consumers have reached their
saturation point and they are not budging. It�s the end of an era.
The unemployment picture is getting bleaker and bleaker.
Last week�s report from the Bureau of Labor Statistics concealed the real
magnitude of the job losses by using the discredited �Birth-Death� model which
exaggerates the number of people reentering the workforce.
Here�s what former Merrill Lynch chief economist David
Rosenberg had to say about last Friday�s BLS report: �The headline nonfarm
payroll figure came in above expectations at -345,000 in May -- the consensus
was looking for something closer to -525,000. The markets are treating this as
yet another in the line-up of �green shoots� because the decline was less
severe than it was in April (-504,000), March (-652,000), February (-681,000)
and January (-741,000). However, let�s not forget that the fairy tale
Birth-Death model from the Bureau of Labour Statistics (BLS) added 220,000 to
the headline -- so adjusting for that, we would have actually seen a 565,000
headline job decline.�
The BLS figures have been denounced by every econo-blogger
on the Internet. The figures are another example of the government�s
determination to airbrush any unpleasant news about the recession.
Here�s a better summary of the unemployment numbers from
Edward Harrison at Credit Writedowns: �The Business Birth-Death Model added
220,000 jobs to the headline seasonally-adjusted number. Without this number,
we are looking at a loss of 565,000 jobs. . . . The number of jobs lost in the
last 12 months increased from 5.34 million in April to 5.51 million in May. . .
. Other indicators suggest that the shadow supply of discouraged workers not
counted in the numbers will now return to the labor force, pushing up the
unemployment number. For example, the U-6 unemployment number was a gargantuan
16.4 percent, the highest ever.�(Edward Harrison, Credit Writedowns)
Unemployment now stands at 9.4 percent (16.4 percent?) and
will continue to rise whether there�s an uptick in economic activity or not.
Businesses are shedding jobs at a record pace, and slashing hours at the same
time. The average workweek slipped to 33.1 hours (down two hours from April) a
new low. It goes without saying that unemployment is highly deflationary
because jobless people have to cut out all unnecessary spending. Beyond the
500,000 layoffs per month, wages and benefits are also under pressure, making a
rebound in consumer spending even less probable.
This is from Brian Pretti�s article �Place Your Wagers�: �The
year over year change in the Employment Cost Index (ECI) is the lowest number
in the history of the data. . . . in the absence of household credit
acceleration . . . aggregate demand [will fall].
The year over year change in wages has never been this low
in the records of the data . . . Wages and salaries. . . . are all in negative
rate of change territory. They are ALL contracting year over year.
�Absent household balance sheet reacceleration in leverage,
it sure seems a good bet forward corporate earnings are now as dependent on
household wages, salaries and broader personal income as at any time in recent
memory. And corporations to protect margins and nominal profits are pressuring
wages and salaries downward.� (�Place Your Wagers� Brian Pretti, Financial
From a workers point of view, things have never been worse.
Demand is falling, employers are slashing inventory and handing out pink slips,
and entire industries are being boarded up and shut down or shipped overseas.
Economists Barry Eichengreen and Kevin O�Rourke make the
case that, in many respects, conditions are deteriorating faster now than they
did in the 1930s. Here�s what they found:
- World industrial
production continues to track closely the 1930s fall, with no clear signs
of �green shoots.�
- World stock markets have
rebounded a bit since March, and world trade has stabilized, but these are
still following paths far below the ones they followed in the Great
- The North Americans (US
& Canada) continue to see their industrial output fall approximately
in line with what happened in the 1929 crisis, with no clear signs of a
turn around. (�A Tale
of Two Depressions,� Barry Eichengreen and Kevin O�Rourke, VOX)
Their conclusion: �Today�s crisis is at least as bad as the
Yeah, times are tough, but what happens when housing prices
stabilize and the jobs market begins to pick up; won�t that put the Fed�s
trillions of dollars into circulation and create Wiemar-type hyperinflation?
Many people think so, but Edward Harrison anticipates a
completely different scenario. The author takes into account the psychological
effects of a deep recession and shows how trauma can have a lasting effect on
consumer habits, thus, minimizing the chance of inflation. It�s a persuasive
�Here�s what he says, �Richard Koo goes further in his book �The
Holy Grail of Macro Economics.� Here, he argues that the unwind of great
bubbles suffers from what he labels a �balance sheet recession.� In essence,
companies go from maximizing profits, as they had done in normal times, to a
post-bubble concern of reducing debt. Regardless of how much priming of the
pump monetary authorities do, the psychology of debt reduction will limit the
effectiveness of monetary policy as a policy tool.
�In my view, the catalyst for this change of psychology is
the �debt revulsion� that ushers in the panic phase of an asset bubble
collapse. (Charles Kindleberger highlights the various stages of a bubble and
its implosion in his seminal book �Manias, Panics and Crashes.� In this
particular bubble, debt revulsion began post-Lehman Brothers. What we have
seen, therefore, is a reduction in leverage and debt as the most leveraged
players have gone to the wall. But, more than that, the household sector has
gotten religion about debt reduction as the savings rate has increased
dramatically since Lehman. In fact, I would argue that companies learned their
lesson about debt from the aftermath of the tech bubble. It is the household
sector in the U.S. (and the U.K.) which is heavily indebted. Therefore, if the
psychology of a balance sheet recession does take form, it will be the
household sector leading the charge.
�In sum, the psychology after a major bubble is very different
than the psychology before its collapse. The post-bubble emphasis becomes debt
reduction and savings, making monetary policy ineffective, not because
financial institutions are unwilling lenders but because companies and
individuals are unwilling borrowers. These are forces to be reckoned with for
some to come.� (Edward Harrison, �Central banks will face a Scylla and
Charybdis flation challenge for years� Credit Writedowns)
Seductive interest rates, lax lending standards and nonstop
public relations campaigns, persuaded millions of people that they could live
beyond their means by simply filling out a credit application or fudging a few
numbers on a mortgage loan. These are the real victims of Wall Street�s
speculative bubble-scam. For many of them, the agony of losing their home, or
their job, or filing for personal bankruptcy will be felt for years to come. At
the same time, the experience will keep many of them from getting in over their
heads again. The same phenomenon occurred during the Great Depression. The pain
of losing everything shapes behavior for a lifetime, which is why the savings
rate has spiked so dramatically in the last few months. There�s been a tectonic
shift in attitudes towards consumption and there�s no going back to the pre-bubble
If Harrison is right, our decades-long spending-spree is
over and people will be looking for ways to live more modestly, pay-as-they-go
and avoid red ink. This is good news for the economy�s long-term strength, but
bad for short-term recovery. Deflation will persist even while savings grow and
consumption comes more into line with personal income. The dollar will fall
hard if Bernanke continues to load up on Treasuries, but with a few slight
adjustments, he should be able to avoid a full-blown currency crisis. Thus,
Zimbabwe-type hyperinflation is unlikely; the ongoing slowdown should keep
inflation in check.
Whitney lives in Washington state. He can be reached at firstname.lastname@example.org.
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