Last Thursday I received an email from David Meier, Associate Advisor at the MotleyFool concerning Debt-Deflation.
David asked if I had any comments on his article Debt-deflation: Just the beginning? Here is a partial listing:
The debate rages on.Dave's research is a 70 page Slideshow On Debt-Deflation that is easy enough to read or download from Scribd.
Is inflation or deflation the bigger threat? There are lots of people -- lots of smart people -- on both sides of the debate and they present lots of good arguments. One thing that I have not seen -- and maybe I just missed it -- was an analysis using Irving Fisher's debt-deflation framework. So I decided to put one together myself and to inject my understanding of what Bernanke is try to do to stop deflation from taking hold.
The question I keep coming back to, especially as I read more about the situation Japan faced (I'm reading everything I can by Richard Koo, including his book "The Holy Grail of Macroeconomics."
And just to make sure I am not being one-sided, I am countering my fears of deflation with "Monetary Regimes and Inflation" by Peter Bernholz, which should arrive next week.
Without further ado, below is my research on debt-deflation.
Here is my response ....
You should not be afraid of deflation.
You should be afraid of policies attempting to fight it.
Deflation (rather price deflation) is actually the natural state of affairs. As productivity increases, more goods and services are produced relative to the population and prices would therefore be expected to drop.
It is the Fed, along with misguided Keynesian and Monetarist economists who think falling prices are a bad thing. Who amongst us does not like falling prices (except of course on things we own like houses, but even then who is not sick of higher property taxes that result)?
The reality is inflation benefits those with first access to money. Guess who that is? The answer is easy: banks, government, and the already wealthy. Inflation is actually a tax on the middle class and the poor who get access to money last. During the housing bubble, by the time the poor could get access to to money easily, it was far too late to buy.
Given that inflation benefits those with first access to money, any targeted inflation at all is morally wrong.
Note that Congress has passed 300+ affordable housing measures over the years and all of them failed. The irony now is Congress has simultaneously passed measures hoping to prop up the price of homes while seeking still additional money to create affordable housing.
Home prices need to fall (and will fall) to levels of affordability based on wages and wage growth regardless of what the Fed does. Thus, efforts to prop up prices are triply stupid: They are costly; They they will not work (prices will fall to where they are headed anyway); and they will delay a recovery.
Deflation is only bad in the context of the short-term pain it will involve. Moreover, it is important to remember that the pain of deflation is relative to the inflation party that preceded it. That party must be paid for either in terms of time or price.
Following the Footsteps of Japan
The irony is Greenspan and Bernanke repeatedly criticized the Bank of Japan for not writing off bad bank debts. So what do we do?
We are Following the Footsteps of Japan even though we have proven without a shadow of a doubt it is economic insanity.
Psychology of Deflation Revisited
In January 2007, someone on the Motley Fool told me "Too even compare the citizens of Japan to the US is stupid, stupid, stupid Forest Gump!"
I was also told "Fannie Mae can revive the housing bubble" and that I "ignore an enormous amount of 1990s monetary theory by Bernanke and co about how they would have dealt with Japans deflation."
Inquiring minds can read Q&A on the Psychology of Deflation to see my replies.
It now seems that Things That "Can't" Happen, did happen.
Indeed Economic Madness Is Repeatedly Endless
Bernanke's Deflation Preventing Scorecard
In case no one is keeping track, Bernanke has now fired every bullet from his 2002 “helicopter drop” speech Deflation: Making Sure "It" Doesn't Happen Here.
Misunderstanding Japan's Lost Two Decades
Richard Koo of Nomura Research Institute Ltd. says U.S. Risks Japan-Like ‘Lost Decade’ on Stimulus Exit.
I say U.S. Faces Second Lost Decade "Because" of Misguided Stimulus
Real Lesson of Japan's Lost Decades
The real lesson is no matter how much money you throw around, economies cannot recover until uncollectible debts and malinvestments are written off. That is why you have “zero interest rates and still nothing’s happening.”
The moment fiscal stimulus stops economies are virtually guaranteed to relapse until asset bubbles deflate, and malinvestments and bad debts are written off.
Bailing out the banks did nothing to fix these problems. Consumers are still saddled in debt, in underwater mortgages, with no job. Moreover, there is no driver for jobs given rampant overcapacity in nearly every sector.
Banks do not want to lend in this kind of environment so they don't. Businesses do not want to expand in this kind of environment so they don't. Meanwhile the Obama administration is making matters worse by increasing taxes on small businesses and proposing everyone pay for health insurance, with businesses forced to offer a plan or pony up part of the cost.
This too is giving small businesses an incentive not to hire. Housing prices are too high yet the Administration and Congress are hell bent on propping up prices. The solution is to let prices fall until they are affordable.
Illusion of Stimulus
Recoveries based on stimulus are nothing but an illusion. Here is a snip worth reading from U.S. Faces Second Lost Decade "Because" of Misguided Stimulus written by my friend "HB" about Christina Romer, chair of Obama's Council of Economic Advisers.
I know Christina Romer best for her misinterpretation of what happened in 1937-38. She believes that the fallback into full-scale depression from 'depression light' (as evidenced by unemployment in 1938 almost returning to the highest levels of the depression trough 32/33) is proof that it was a mistake to tighten policy (fiscal and monetary) too early.Understanding Velocity
In other words, according to her, if the Fed had continued pumping as furiously as possible, then everything would have been alright.
In reality, the entire inflationary mini-boomlet-within-the-depression was simply an illusion. 'GDP growth' that is bought with monetary pumping and feckless fiscal spending only misdirects and ultimately consumes even more scarce capital.
Fiscal stimulus may temporarily give the impression of a recovery, but it is not a genuine recovery. It makes things worse. The moment the pumping is abandoned, the true state of affairs is simply unmasked. That is what happened in 37/38 - a slight tightening of monetary policy revealed the fact that the mini-boomlet was as unsound as its predecessor boom in the years prior to the '29 crash.
It would not have been possible to hide this reality forever. There is nothing, absolutely nothing, that government intervention can achieve in terms of 'fixing' the economy. The choice was in either abandoning the unsound policy and the unsound investments it produced, or careen toward a complete destruction of the currency system.
Once again, I stand amazed at how people can look at this, and look at Japan, and look at the housing bubble/bust sequence, and still believe that monetary pumping and deficit spending are viable tools of economic policy when a bust occurs. It really boggles the mind, reminding me of Einstein's definition of insanity, 'doing the same thing over and over again and expecting a different result'.
David had several slides on velocity. The important point he missed is that velocity of money is a result not a cause of anything to come.
Velocity is falling because the Fed is printing hoping to stimulate the economy but banks are not lending because
1) credit risks are high
2) there is rampant overcapacity everywhere, thus businesses have no reason to expand
3) credit worthy consumers do not want to borrow
The attitudes of lenders and potential borrowers have changed. Under these conditions, the more Bernanke prints, the lower velocity will go.
Spending Collapses In All Generation Groups
Please consider Spending Collapses In All Generation Groups
It's no secret that boomers fearing an underfunded retirement have sharply cut spending. However, it's not just boomers cutting back. Consumer attitudes toward debt have changed across all age groups.
Bernanke can flood the world with "reserves" and indeed he has. However, he cannot force banks to lend or consumers to borrow.
Here is a simple analogy that everyone should be able to understand: You can lead a horse to water but you cannot make it drink. And if the horse does not want to drink, it was a waste of time and energy to lead the horse to the water.
In a debt-based economy, it is extremely difficult (by monetary policy) to produce inflation if consumers will not participate. And as noted above, demographics and attitudes strongly suggest consumers have had enough of debt and spending sprees.
Government bodies like Congress can theoretically produce inflation but Japan tried and failed for years.
In the US and globally we are in uncharted territory. Odds are we will see many things we have never seen before as stimulus after stimulus fails to produce desired results.
I ask you to consider Twelve Reasons For A Job Loss Recovery.
Humpty Dumpty On Depression Conditions
The conditions now are very similar to what happened in the great depression, discounting for the moment this reflationary effort by the Fed that is doomed to fail.
For more on the conditions one would expect to see in deflation please consider
Humpty Dumpty On Inflation.
Some of those conditions have changed since December. However, bank failures, total bank credit, and short term treasury yields near 0% have not. Moreover, long term yields have ticked up but they are still at historic lows compared to anything but the lows last December.
It is important not to confuse a recovery in the stock market with an economic recovery.
Don't just take my word for it. Please consider Leading indicators and the shape of the recovery by Paul Krugman?
Michael Shedlock has an awesome takedown of ECRI’s claim that its indicators (a) have successfully predicted turning points in the past (b) point to a sold recovery now. I’d add that this is a really, really bad time to be relying on conventional indicators.
Why? Basically, because in a zero-interest rate world — the three-month rate was .066% last I looked — especially one that’s suffered from a collapse of the shadow banking system, conventional indicators don’t mean what they usually mean. Increases in the monetary base aren’t especially expansionary. The yield curve more or less has to slope up, even if no recovery is expected. And so on.
So historical correlations, to the extent that they exist — and as Shedlock points out, ECRI is claiming a much better record than it really has — can’t be counted on to prevail. There’s really no alternative to making fundamental analyses of the macro situation.
This is a once in several generational event. I bet the ECRIs leading indicators applied in April of 1930 would have looked quite similar.
One thing is for sure, is that Krugman does not hold any grudges. I sure have to give him credit for that. I also happen to agree with Krugman when it come to free trade for which we are both strong proponents.
Unfortunately however, there is a rising tide of protectionism in Congress and this Administration. Note that the Smoot-Hawley Tariff Act is one of the things that made the Great Depression much worse.
States are repeating another mistake by raising property taxes.
Keynesian Model Broken Beyond Repair
The Keynesian and Monetarist models are broken beyond repair.
It is amazing that so much love exists for a man whose ideas have been thoroughly discredited on many occasions. Here is a little blurb from the American Journal of Economics and Sociology.
The crisis policy devised by John Maynard (Lord) Keynes, which seemed to work well during World War II and in postwar reconstruction, met its nadir in 1975. Contrary to Keynesian theory, formalized in the Phillips Curve argument that inflation and mass unemployment are mutual trade offs, double digit inflation and record unemployment made further deficit spending an impossible policy.In case you fail to understand the implications, Keynes is arguing one cannot have a recession and inflation at the same time.
Did The Keynesian Economists Give Up Their Theories Confronted With Japan?
The answer is no. Stagflation in the 70's discredited Keyensian theory as did Japan's building bridges to nowhere.
Keynesian economists now say the problem was Japan simply did not act fast enough.
The amount of global monetary stimulus thrown at curing the deflation problem is staggering. Yet here we are with the same debt overhang, no jobs, and no way to pay off that debt. Deflation looms larger than ever because of Central Bank efforts to fight it.
Let's return to the beginning. It's important to remember that inflation and deflation about not about prices but rather about the expansion of money supply and credit. Concern over prices is putting the cart before the horse.
Fantasizing In Academic Wonderland
Keynesian academic models do not work in a real world, with real people, where attitudes and global forces such as global wage arbitrage are in play. The Fed cannot force consumers to borrow or banks to lend. Nor can the Fed create jobs. Congress can create makeshift jobs but as we have shown above, makeshift jobs cannot possibly create a solid economic foundation.
In response to the above someone is sure to tell me how negative interest rates could be used to force banks to lend. My response is forcing banks to lend cannot and will not work in actual practice.
One reason Bernanke wanted to pay interest on reserves was to slowly recapitalize them over time. One cannot achieve that while forcing them to lend. Moreover forcing banks to lend will do nothing but increase further writeoffs.
Again, it is important to look at how things operate in a real world model, with real consequences, as opposed to fantasizing in academic wonderland about how to force banks to lend.
Fiat World Mathematical Model
Logically speaking, when the problem is debt is to high, it is insane to think a spending spree will fix the problem. Even a 6th grader would be able to understand this, but Keynesian and Monetarist academic wonks just cannot manage the task.
Greenspan stimulated the economy in 2002 and all we have to show for it is a collapsing housing bubble and still more debt.
Instead of following a Keynesian model that does not work, please consider a Fiat World Mathematical Model.
I believe Steve Keen and I have it correct. In a credit-based, fiat-currency model, deflation will always manifest itself as debt-deflation. Price deflation is a meaningless sideshow.
I am not sure how far along we are with debt deflation given that much depends on how far and how long the Fed and Congress attempts to fight it. The preliminary results however, do not look very good. I expect a second lost decade in the US, just as happened in Japan.
Mike "Mish" Shedlock
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