Deflation is Here — And The Government is Poised to Make it Worse

Consumer prices may not be deflating as quickly as Labour’s electoral chances did earlier this month, but — even after £300 billion of quantitative easing — price deflation for the first time in more than half a century is finally here. The Bank of England continues to throw everything at keeping prices rising at close to their 2 percent target. Yet it’s not working. And this is not just about cheaper oil. Core inflation has also been dropping like a rock.

I argued that “deflation was looming” for Britain last year, and feel a little vindicated that it has come to pass. But I don’t feel at all gratified about the thing itself.

In a highly indebted economy such as Britain’s — where private debt dwarfs government debt — deflation is a dangerous thing. Past debts — and the interest rates paid on those debts — are nominally rigid. Unless specifically stipulated as being inflation-adjusted (like TIPS) they don’t scale to price changes in the broader economy.

Under positive rates of inflation, inflation assists in keeping debt under control, by shrinking the present amount of goods and services and labour that equate to a nominal amount of currency. Under deflation, the opposite process occurs, and the nominal value of currency — as well as that of historical debt — rises, making the debt harder to service and pay down, especially with the ongoing accumulation of interest.

On the face of it, that is good news for net savers and bad news for net debtors. But raising the difficulty of deleveraging and debt service can often be bad for both, because debtors who cannot pay default, bankrupting themselves and injuring their creditors. It can also depress the economy, as individuals and firms are forced to stop spending and investing and start devoting more and more of their income to the rising real cost of deleveraging.

With growth last quarter dropping to 0.3 percent from 0.6 percent, this process might very well already be under way. This raises the prospect of the nightmarish debt-deflationary spiral above.

The last thing that the economy needs under that circumstance is more money being sucked out of it through slashing public spending. Sucking money out of the economy will make deleveraging even more difficult for debtors, and slow growth further as individuals and firms adjust their spending plans to lower levels of national and individual income. Yet that is the manifesto that the country elected to power in the election earlier this month. And although Osborne and Cameron can get out of it — via offsetting cuts in spending with tax cuts — if they go through with their election promises, the prospect of recession, continued deflation and rising levels of unemployment loom clearly.

What the economy really needed in 2010 was a deep and long commitment to public stimulus to provide the economic growth needed to let the private sector deleverage. Unlike the public sector, which is a sovereign creditor borrowing in its own currency — the private sector is far from a secure debtor. Private borrowers can — unlike the central government — “become the next Greece” and run out of money.

With interest rates in the last parliament having sunk down to new historic lows, such a thing was affordable and achievable. Instead, by trying to do public deleveraging at the same time as the private sector was deleveraging Osborne, Cameron and Clegg chose a much rockier path, one in which private deleveraging and public deleveraging are slow and grinding. With private debt levels still very high, the country remains vulnerable to another deleveraging-driven recession.


On Trade Unions & Inequality

This chart is pretty wow:


Florence Jaumotte and Carolina Osorio Buitron of the International Monetary Fund have some ideas about how the correlation may have been caused:

The main channels through which labor market institutions affect income inequality are the following:

Wage dispersion: Unionization and minimum wages are usually thought to reduce inequality by helping equalize the distribution of wages, and economic research confirms this.

Unemployment: Some economists argue that while stronger unions and a higher minimum wage reduce wage inequality, they may also increase unemployment by maintaining wages above “market-clearing” levels, leading to higher gross income inequality. But the empirical support for this hypothesis is not very strong, at least within the range of institutional arrangements observed in advanced economies (see Betcherman, 2012; Baker and others, 2004; Freeman, 2000; Howell and others, 2007; OECD, 2006). For instance, in an Organisation for Economic Co-operation and Development review of 17 studies, only 3 found a robust association between union density (or bargaining coverage) and higher overall unemployment.

Redistribution: Strong unions can induce policymakers to engage in more redistribution by mobilizing workers to vote for parties that promise to redistribute income or by leading all political parties to do so. Historically, unions have played an important role in the introduction of fundamental social and labor rights. Conversely, the weakening of unions can lead to less redistribution and higher net income inequality (that is, inequality of income after taxes and transfers).

I have spent a lot of time thinking about what has caused the major upswing in inequality since the 1980s.

Back in 2011 and 2012 my analysis tended to emphasize financialization and specifically the massive growth in credit creation that took place since the 1980s. I think this was a rather naive view to take.

I don’t think I was wrong to look at financialization. Obviously, unchecked credit creation is a plausible pathway for the rich to make themselves and their friends richer. I just think it was naive to not see financialization — like deunionization, like globalization, and like trends in housing wealth — as part of a broader pie.

My hypothesis is that what changed is that politicians decided that greed was good and that “industrial policy” was a dirty phrase. The political structures that emerged in the wake of the Great Depression and World War 2 which together greatly limited inequality — welfare states, nationalized industries, unionized workforces, constrictive financial regulations like Glass Steagall — were severely rolled back. This created an opening for the rich to get much richer very fast, which they did.

If I’m right, it would take a major political shift in the other direction to start reducing inequality.

Japan’s Deflation Persistence

It's deflating...

Is it all about the age of the population?

One in four people in Japan will be older than 65 in 2014, compared with 9.6 percent in China and 14.2 percent in the U.S., according to data compiled by the U.S. Census Bureau.

Now, because they have had longer to accrue weal the older people tend to have more savings, or have retired and live in a fixed income, and therefore benefit from deflation But correlation is not causation. Certainly, Japan’s older population loves deflation. But the issue is the love of deflation, not the age of the population, per se. More than 80 percent of respondents in a Bank of Japan (8301) survey released this month who noticed rising prices last year said it was bad. Deflation-loving Japanese voters are the main stumbling block to Abe and Kuroda’s desire to reflate the Japanese economy back to inflation (to incentivise borrowing) and growth.

One of the peculiarities of state-backed fiat money is that it is a medium of exchange that the people of a state are expected to share. Clearly, individuals existing in a state will by definition have different motivations, different time preferences, and different conceptions of what constitutes good money. Different individuals have different preferences for inflation and deflation — while deflation helps savers, younger generations without savings are hit by stagnant wages and diminished incentives for borrowing. Inflation incentivises borrowing, and deflation incentivises saving, but these things are both to a great degree two sides of the same coin — deposited savings are lent out by banks. So when a population comes to love deflation and savings soar — and about 56 percent of household assets were in cash or bank deposits in 2012, according to a Bank of Japan report — the glut of savings depresses interests rates. With the value of savings rising, savers have little incentive to spend. This, ceteris paribus, constrains spending.

Abe and Kuroda are fighting to break Japan out of the liquidity trap. They have specific growth and inflation targets — 1% inflation, and 3% income growth and have a clear plan to hit those targets. But fighting against the widely-desired status quo — that is, deflation — in a democratic state is difficult. If Japanese people love deflation, they will vote for it at the polls. If Abe and Kuroda are to succeed in reigniting inflation, they need to convince Japanese savers to change their minds about inflation, and challenge the idea that saving in Yen is a desirable thing. After all, saving is not confined solely to the state-backed fiat currency. In a more inflationary environment, savers often choose to save through ownership of assets whose prices are increasing — land, real estate, commodities and currencies other than the state-backed fiat currency. In principle, there is no reason why Japan’s ageing population may not prove capable of moving its desire for savings into different media, and letting the Yen inflate. In practice, deflation and saving in Yen is cemented as a norm. That may prove extremely difficult to overcome.

Does Syria Want a War?

We know for sure that Syria intentionally shot down a Turkish — and thus protected by NATO — warplane in its airspace. We also know that Syria is comfortable enough to admit it.

The AP reports:

Syria said Friday it shot down a Turkish military plane that entered Syrian air space, and Turkey vowed to “determinedly take necessary steps” in response.

It was the most clear and dramatic escalation in tensions between the two countries, which used to be allies before the Syrian revolt began in March 2011. Turkey has become one of the strongest critics of the Syrian regime’s brutal response to the country’s uprising.

Late Friday, Syria’s state-run news agency, SANA, said the military spotted an “unidentified aerial target” that was flying at a low altitude and at a high speed.

“The Syrian anti-air defenses counteracted with anti-aircraft artillery, hitting it directly,” SANA said. “The target turned out to be a Turkish military plane that entered Syrian airspace and was dealt with according to laws observed in such cases.”

It seems pretty clear that the Syrians know the consequences of their actions. NATO (including deluded US hawks who are happy to ignore the disastrous consequences of the drug war on the US border while talking up more intervention in the middle east) and the NATO-backed Syrian opposition has been looking for any excuse to get stuck into a new interventionist mission. We know that the NATO-backed opposition were prepared to try and get a British journalist killed in a false flag operation in order to trigger a Western intervention.

So why did Russia-armed Syria do it? And why (given the age of F-4 aircraft, it could easily have crashed of its own accord giving the Syrians a lot of plausible deniability) are they not at least denying that they shot it down?

Is it possible that the wider Eurasian anti-American coalition led by the Russians and the Chinese are confident that NATO will not intervene out of fear of triggering a wider war? After all the Russian naval base has been a great obstacle to NATO intervention. Libya didn’t have any Russian bases, and it took far less internal violence for NATO to intervene there.

Is it even possible that the Eurasians are trying to provoke NATO into another costly and damaging war? After all, the American Empire is much more indebted and militarily overstretched than it was before 9/11. Osama bin Laden’s goal of dragging the United States into the middle eastern quagmire, and thereby bankrupting America has been an unmitigated success. Could the Eurasians be trying to provoke a regional war in order to weaken NATO and draw attention away from their own weakened economic picture?

Or is this just a case of an overzealous Syrian military commander taking a potshot at an unidentified flying object and provoking a diplomatic crisis?

As someone who does not believe that war is in any way an economic stimulus and should be avoided beyond self-preservation, I hope that this crisis — and the wider Syrian situation — can be defused.

Those who want to see a big military-Keynesian stimulus may be hoping for an escalation…

Enter the Swan

Charles Hugh Smith (along with many, many, many others) thinks there may be a great decoupling as the world sinks deeper into the mire, and that the dollar could be set to benefit:

This “safe haven” status can be discerned in the strengthening U.S. dollar. Despite a central bank (The Federal Reserve) with an avowed goal of weakening the nation’s currency (the U.S. dollar), the USD has been in an long-term uptrend for a year–a trend I have noted many times here, starting in April 2011.

That means a bet in the U.S. bond or stock market is a double bet, as these markets are denominated in U.S. dollars. Even if they go nowhere, the capital invested in them will gain purchasing power as the dollar strengthens.

All this suggests a “decoupling” of the U.S. bond and stock markets from the rest of the globe’s markets. Put yourself in the shoes of someone responsible for safekeeping $100 billion and keeping much of it liquid in treacherous times, and ask yourself: where can you park this money where it won’t blow up the market just from its size? What are the safest, most liquid markets out there?

The answer will very likely point the future direction of global markets.

Smith is going along with one of the most conventional pieces of conventional wisdom: that in risky and troubled times investors will seek out the dollar as a haven. That’s what happened in 2008. That’s what is happening now as rates on treasuries sink to all-time-lows. And that’s what has happened throughout the era of petrodollar hegemony.

But the problem with conventions is that they are there to be broken, the problem with conventional wisdom is that it is there to be killed, roasted and served on a silver platter.

The era of petrodollar hegemony is slowly dying, and the assumptions and conventions of that era are dying with it. For now, the shadow of that old world is still flailing on like Wile E. Coyote, hovering in midair.

As I wrote last week:

How did the dollar die? First it died slowly — then all at once.

The shift away from the dollar has quickly manifested itself in bilateral and multilateral agreements between nations to ditch the dollar for bilateral and multilateral trade, beginning with the chief antagonists China and Russia, and continuing through Iran, India, Japan, Brazil, and Saudi Arabia.

So the ground seems to have fallen out from beneath the petrodollar world order.

Enter the Swan:

We know the U.S. is a big and liquid (though not really very transparent) market. We know that the rest of the world — led by Europe’s myriad issues, and China’s bursting housing bubble — is teetering on the edge of a precipice, and without a miracle will fall (perhaps sooner, rather than later).

But we also know that America is inextricably interconnected to this mess. If Europe (or China or both) disintegrates, triggering (another) global default cascade, America will be stung by its European banking exposures, its exposures to global energy markets and global trade flows. Simply, there cannot be financial decoupling, not in this hyper-connected, hyper-leveraged world.

And would funds surge into US Treasuries even in such an instance? Maybe initially — fund managers have been conditioned by years of convention to do so. But how long  can fund managers accept negative real rates of return? Or — much more importantly — how long will the Fed accept such a surge? The answer is not very long at all. Bernanke’s economic strategy has been focussed  on turning treasuries into a losing investment, on the face of it to “encourage risk-taking” (or — much more significantly — keep the Treasury’s borrowing costs cheap).

All of this suggests a global crash or proto-crash will be followed by a huge global money printing operation, probably spearheaded by the Fed. Don’t let the Europeans fool anyone, either — Germany will not let the Euro crumble for fear of money printing. When push comes to shove they will print and fiscally consolidate to save their pet project (though perhaps demanding gold as collateral, and perhaps kicking out some delinquents). China will spew trillions of stimulus money into more and deeper malinvestment (why have ten ghost cities when you can have fifty? Good news for aggregate demand!).

So Paul Krugman will likely get something much closer to what he claims to want. Problem solved?

Nope. You can’t solve deep-rooted structural problems — malinvestment, social change, deindustrialisation, global trade imbalances, systemic fragility, financialisation, imperial decline, cultural stupefaction (etc, etc, etc) — by throwing money at problems. All throwing more money can do is buy a little more time (and undermine the currency). The problem with that is that a superficial recovery fools policy-makers, investors and citizens into believing that problems are fixed when they are not. Eventually — perhaps slowly, or perhaps quickly — unless the non-monetary problems are truly dealt with (very unlikely), they will boil over again.

As the devaluation heats up things will likely become a huge global game of beggar thy neighbour. A global devaluation will likely increase the growing tensions between the creditor and debtor nations to breaking point. Our current system of huge trade imbalances guarantees that someone (the West) is getting a free lunch , and that someone else (the Rest) is getting screwed. Such a system is fundamentally fragile, and fundamentally unstable. Currency wars will likely give way to economic wars, which may well give way to subterfuge and proxy wars as creditors seek their pound of flesh, and debtors seek to cast off their chains. Good news, then, for weapons contractors and the security state.

A Tale of Two Bens

Paul Krugman has an interesting post up on Ben Bernanke’s contrasting economic policy positions. Simply, the younger Bernanke was much more Krugmanite than the older Bernanke:

[The younger Bernanke] endorsed, at least as possibilities:

– Targeting long-term interest rates
– Currency depreciation
– Money financed deficit spending
– A Krugman-style inflation target

After 2003, however, his menu seemed to have been reduced to:

– Guidance on future short-term rates (the rates the Fed sets)
– Purchases of long-term bonds and other nonconventional assets
– “Oversupplying reserves”, that is, just pushing up the monetary base

Krugman concludes — quite rightly — that Bernanke has been “assimilated by the Fedborg.” Krugman should probably know that Ben’s main goal has nothing whatever to do with inflation, or “aggregate demand” or currency depreciation. Nothing. These are all handmaidens to one thingthe rate that the Treasury is paying on its debt.

America is in an impossibly tough fiscal position:

Even at the government’s impossibly cheap projections, a lot of money is going to be pushed out from the Treasury to creditors.

And so the Fed’s main implicit goal is to keep Treasury rates as low as possible without excessive inflation  — the more inflation, the more creditors will ditch Treasury debt, thus forcing the Fed to monetise more. This is a foreign policy imperative: the bottom line is that America has gotten herself deeply in hock to foreign creditors. The Fed’s task is to keep the creditors buying debt, and to minimise rates so as little capital gets out of America as possible. Ben Bernanke has become precisely what many American accuse China: a currency manipulator.

There are a few secondary goals: reflating housing is one (more home equity means more consumption), and reflating equities is another. But all of these are subordinated to keeping rates cheap and thus delaying America’s inevitable fiscal (and thus foreign policy) meltdown.

Of course, under present circumstances, this is an impossible task. And without another round of QE, rates are rising.

From Bloomberg:

U.S. government securities lost 1 percent from the start of the year to March 29, Bank of America Merrill Lynch indexes show.

And that — in one sentence — is why Bernanke will be printing again soon.

Out of the Liquidity Trap?

Professor Krugman has produced an interesting graph that — according to his calculation — suggests that while we’re not quite out of the liquidity trap, we are getting closer:

It’s a useful contribution, that shows just what the Federal Reserve does in terms of trying to match interest rates to the broader inflationary outlook. The liquidity trap at the zero bound is clearly visible — the Fed cannot cut rates below the zero bound, which renders traditionally monetary policy essentially useless. (Austrians will of course interject here that traditional monetary policy is worse than useless, but that is another story for another day).

If the liquidity trap is ended, we should eventually see higher demand (Krugman’s point is broadly that stimulus would fight off the problem of the liquidity trap and solve the problem sooner). The Krugmanites think that demand is the only problem, and higher demand (even if that is down the line and later than Krugman would like it) will cure our economic woes.

I completely disagree and believe that depressed demand is not the main problem, but merely a symptom. I believe that the credit contraction that occurred in 2008 was a direct product of various non-monetary challenges that America faces, almost none of which have been solved, or will be solved by an end to the liquidity trap:

The three main problems are a lack of confidence stemming from high systemic residual debt, deindustrialisation in the name of globalisation (& its corollary, financialisation and that sprawling web of debt and counter-party risk), and fragility and side-effects (e.g. lost internal productivity due to role as world policeman) coming from America’s petroleum addiction.

In the months and years to come we will see who is right.