Week 143 - Deflation Remains a Looming Threat

Situation: We’re not out of the woods yet. The Lehman Panic (2008) reached into every corner of the world. The Chairman of the Federal Reserve (Ben Bernanke) immediately recognized it to be an existential threat on the scale of the Great Depression. Being a lifelong student of that event, he knew our government would have to mobilize extensive fiscal and monetary resources quickly to prevent a deflation that was already underway. Otherwise, we'd be in the same predicament as Japan by having an interminable recession. Economic activity of all kinds decreases during deflation, since people soon come to realize that whatever they want to buy now will be cheaper if they wait until next year. 

Much of our economy remains at risk. For example, check out Wal-Mart’s most recent earnings report. Remember, to overcome the Great Depression it took the $4 Trillion dollars of spending required to finance World War II ($53 Trillion in today’s dollars). And it wasn’t finished until returning soldiers had completed their college educations under the GI Bill, and the Interstate Highway System had been built.  

Treasury Secretary Paulson, when faced with the Lehman Panic, had little difficulty explaining the problem and its remedy to President George W. Bush (who has an MBA from Harvard). President Bush summed up the problem for reporters with what Warren Buffett has called the most important 10 words in economic history: “If money isn’t loosened up, this sucker could go down.” Congress and the Federal Reserve mobilized more than a Trillion dollars a year to turn the economy around, and similar undertakings were soon adopted by China and Great Britain (but only later by Europe). All of the world’s major economies are still shaky, and will remain dependent on cheap credit for years to come. That cheap credit will arrive courtesy of central banks, acting in concert (see Week 76 and Week 79).

Our new Chairman of the Federal Reserve Board, Janet Yellen, has made it clear that she will not tolerate even a whiff of deflation on her watch. Her barometer for recovery is the unemployment rate, which is hard to bring down because too many companies were forced to introduce too much automation. Why? To bring costs in line with falling revenues after the Lehman Panic.

Deflation is about the downward spiral of prices. In this case too few dollars are chasing too many goods and services, which is the opposite of inflation where too many dollars chase too few goods and services. But why are there too few dollars? After all, the Federal Reserve is doing all it can to flood the banking system with dollars. Unfortunately, banks choose to leave most of that money earning interest at the Federal Reserve, funds classified as excess reserves. Bankers would like to loan that money at higher interest to “economically viable” customers, but those haven’t shown up in steadily increasing numbers. A year ago there was a sharp uptick in mortgage loans but that died down after interest rates began to climb in expectation that the Federal Reserve would soon taper QE-3, the policy of buying $85 Billion of government bonds every month in order to force interest rates lower. 

Why are unemployment rates so high in so many countries? Well, its because there aren’t enough employed people to spend money, so goods and services have to be marked down in price. That, in turn, discourages companies from hiring new workers to produce more goods and services. Now you understand why government spending (and hiring) is needed to “jump start” the economy (so-called Keynesian Economics). However, when governments are heavily indebted (and becoming more so due to the falloff in revenues) that tool cannot be applied with the necessary force. 

Looking at the bigger picture, there are two answers to the question of “when does it end?” Both have to do with the confidence employers have in the future of their local economy. One is that the global credit bubble has only been deflated in the US and Great Britain. But Europe, along with China and most other developing economies, continue to struggle trying to put in place the kind of regulation and transparency that has worked so far for the US and Britain. This includes insured savings accounts, credible and publicized “stress tests” for every bank, elimination of “off balance sheet entities” in the corporate sphere, and privatization of “state owned entities” in the government sphere. Some countries (like Argentina) are past the point where those changes could turn things around, so currency and import controls become inevitable along with devaluation of the currency. Remember: it is only reasonable to use credit if the rate of return on your assets exceeds the interest rate on the money you owe. Otherwise, the fraction of your income that is used to service debt will increase relentlessly, and eventually cause bankruptcy. For a company, that means its free cash flow won’t provide enough dollars to allow it to capture opportunities by expanding. For a government, that means there won’t be money left over to expand educational opportunities and upgrade the transportation network enough to meet the needs and expectations of a growing population. Conclusion: per capita debt has to start falling before the lingering recession can be brought to an end.

But an even larger problem is that civil unrest occurs when a country can’t or won’t provide a future vision for its citizens, and take concrete steps in that direction. When a government finds itself facing large general strikes (e.g. Greece, Spain and Cyprus in the past few years), or starts warring on its citizens (e.g. several Middle Eastern countries even more recently), stock markets around the world tend to suffer. Why is that? Because the ability of a government to service its debt is critically dependent on the day-to-day functioning of its economy (people going to work and paying taxes). That debt is held by banks, sovereign wealth funds, and hedge funds around the world. They count on receiving regular interest payments, and especially the return of their principal when the loan comes due. When private corporations make loans to governments that repay less than the full amount, as Greece has done recently, the next time a heavily indebted government has to borrow money it may face creditors who demand a rate of interest that is somewhat higher than that country’s nominal GDP (i.e., its Return on Assets). That spreading effect is called "contagion." It affects the wealth of the International Monetary Fund (funded mainly by the US) and money center banks everywhere. Almost every drop in the US stock market over the past 5 yrs has been due, in part, to economic paralysis or domestic unrest occurring somewhere outside the US. For details read Chapter 16 of "After the Music Stopped: the Financial Crisis, the Response, and the Work Ahead," by Alan S. Blinder (former Vice Chairman of the Federal Reserve Board), Penguin Books, 2013. 

You will need a way of telling whether deflation or inflation is expected by the markets. Gold is a currency that can be substituted for fiat (paper) money during periods of economic crisis. The amount of gold in the world just manages to keep up with the growth in population, so its price cannot be inflated or deflated (except by speculation). The price of gold falls when economic storms pass, as well as when deflation occurs. On the other hand, the threat of inflation knocks down the price of Treasury Notes, whereas, deflation causes a sharp increase in their value (see Table). Over the past two yrs, the price of gold has fallen ~25% because the economy has been steadily improving. Inflation, however, is so low (under 1%) that it creates a worry about deflation. But 10-yr Treasury Notes, instead of being more valuable are becoming less valuable. That is, their price is falling as interest rates rise. So, deflation is not an immediate worry but the Federal Reserve must continue to perform its high-wire balancing act.

Bottom Line: Deflation risk will haunt the world’s economies for as long as it takes those economies to stop growing their per capita debt. But I doubt if deflation will quite happen. Why? Because central banks are learning to “print money” in whatever amounts necessary to keep excess reserves high and interest rates low. Look at Japan, for example, where recent monetary policy changes have dovetailed with fiscal policy changes in an attempt to flood the economy with money to stop a grinding deflation that’s been going on for almost 20 yrs. And it just might work. (Japan has the advantage that almost all of its government debt is in the hand of its own citizens.) Underwater economies have to use those excess reserves and low interest rates to grow, which unfortunately amounts to taking money and investment opportunities from older people and offering those to better educated younger people. This will inevitably happen because the pain that politicians experience from trying to manage economies that are increasingly sluggish will otherwise only grow. Large and growing interest payments will eventually rein in government spending for the aged and infirm. Social safety nets may start to fray but jobs in the private economy will come to be prized over those in the shrinking public sector. That means taxes can be used to pay down debt, allowing governments more room to spend on growth: industrial policies designed to promote education, competition, and job growth in the private economy (which is, after all, the main source of government revenues).

Risk Rating: 5 (things could go either way).

Full Disclosure: I regularly buy inflation-protected US Treasury Notes but don’t invest in gold. In other words, I actively hedge against the risk of deflation but don’t hedge against the risk of hyperinflation--aside from being primarily invested in stocks (which respond somewhat to hyperinflation).

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