When the elements of deflation combine in the right order, the central bank can print a boatload of money without bringing about inflation. And we may now be watching that combination come about.
~ John Mauldin
Update: This article was featured in the Canadian Personal Finance & Investing Carnival posted at Investing Thesis. Thank you!
I’m officially back from a 2-week vacation today, although I sort of cheated and put up a new post on Friday. It’s great to be back. I’d like to thank those who filled in for me with their thoughts and insights in my absence. In the meantime, however, the financial world went on without me while I caught up on some reading. I learned a lot as a result, and I’ll be sharing some of that with you over the coming weeks.
The inflation vs. deflation debate rages on, but for now, it looks like the deflationist camp has taken the lead. In the July 24th, 2010 edition of his Thoughts from the Frontline, John Mauldin listed a number of economic elements that can interact to create deflation. I thought we might look at how many of them are currently evident in the economy, or are showing signs they might pop some of the bubbles we’ve discussed recently.
Elements of Deflation
Hydrogen and oxygen combine to form water (H2O). According to Mr. Mauldin, the following economic elements can combine to to form deflation:
1. Excess Production Capacity
Put simply, production capacity is the amount of resources available to produce the products and services we require. Right now, we have more capacity than we can use. Global capacity utilization has fallen off dramatically and has yet to recover.
2. Massive Wealth Destruction
We have certainly seen a lot of wealth destruction in the form of falling home and stock prices. Deteriorating home prices mean that consumers can no longer tap the home equity ATM to fund their purchases. Declining stock markets mean that retirement savings have been depleted, forcing many to re-examine their financial plans.
3. Decreased Final Demand
The asset side of the consumer’s balance sheet has taken a massive hit while the liability side has simultaneously multiplied. This has only recently begun to lead to Keynes’ Paradox of Thrift. Consumers are beginning to save more in an effort to right their lopsided balance sheets. That’s great, but it means they will spend less, which will be a drag on the economy. It also means that companies will have less pricing power. They can’t raise prices on products for which demand is falling.
4. Massive Deleveraging
We have recently been (and arguably still are) in the throes of a major credit crisis. As a result, consumers and businesses are trying to reduce their debt levels and banks are pulling back on lending. According to Mr. Mauldin, bank losses are over $2 trillion and rising. Many banks still hold toxic assets which have not been marked to market and are therefore worth much less than the value implied on the banks’ balance sheets, if they show up there at all.
5. Money Supply Falls While Velocity of Money Slows
The growth of the money supply globally is “close to zero”. In addition, the volume of money that central banks have pumped into the system is not moving. Banks and corporations are hoarding cash in fear of another credit crunch. As long as the velocity of money stagnates, the economy will too.
6. Falling Home Prices
The housing markets in the U.S., Europe, and Japan have fallen considerably and remain weak. “Japan has seen its real estate market fall almost 90% in some cities, and that is part of the reason they have had 20 years with no job growth, and that the nominal GDP is where it was 17 years ago.” Is it really so inconceivable to think that Western nations could be headed down the same path?
7. Reduced Government Spending
We have yet to see this in many countries so far, but there certainly is a push from the austerity camp to cease and desist with ineffective stimulus programs and concentrate on paying down debt and balancing budgets. Many states in the U.S. have been forced to cut spending as they have completely run out of money and are not able to print it like the Federal government can. If the Feds ride to the rescue with aid to the states, that certainly won’t qualify them to sit in the “reduced government spending” section.
Having said that, if governments do decide, by choice or by necessity, to curb spending, that would indeed be deflationary. One could easily argue that global government spending programs are the single largest reason the financial system did not completely melt down in 2008 – 2009. Absent that boost, many global economies could easily slip back into recession.
8. Chronic High Unemployment
This factor contributes to deflation by reducing final demand. Consumers without jobs consume less. That in turn erodes pricing power for producers and can lead to further increases in unemployment as businesses cut back on labour to match decreased demand. Chronic high unemployment is certainly evident in the U.S. and if deflation takes hold globally, it will rise in other locales as well.
So it seems that most, if not all, of these elements of deflation are either already present or showing signs of emerging in the near future. What should we do about it? According to the work of Rogoff and Reinhart, “economies are more fragile and volatile and . . . recessions are more frequent after a credit crisis. Further, spending cuts are better than tax increases at improving the health of an economy after a credit crisis.”
We have seen both fragility and volatility in the financial markets over the past couple of years. The elements of deflation are there. It remains to be seen whether or not they will meld to form a full-blown deflationary environment.
Are you seeing these elements of deflation where you live?