Closer Than I Thought?

I am often lumped together with the "deflationistas" by those who have not (taken the time to) read my books (e.g., Financial Armageddon and When Giants Fall) or my posts on the subject of the two 'flations at www.financialarmageddon.com and www.economicroadmap.com.

But the truth is that I have always expected the Great Unraveling to be a multi-phase process, with deflation coming first and then inflation (unlike some other well-known prognisticators who haven't quite gotten the progression right). In fact, here is an excerpt from the table of contents for my March 2007 bestseller:

PART TWO: RISKS

5. Economic Malaise
6. Systemic Crisis
7. Depression
8. Hyperinflation

As to when the changeover might occur, I have often indicated that I would keep an eye on the financial markets, news reports, and the actions taken by our government (and others) for guidance.

More recently, in a post entitled "The Next Phase," I suggested that we might begin to see the the supply of money being created by authorities overwhelm the wealth being destroyed by defaults and deleveraging by the end of this year.

As it happens, the relative lack of concern about inflation among policymakers and mainstream economists is leading the contrarian in me to wonder whether the turning point is even closer than that.

That premonitory sense seemed even more pronounced when I read the following Financial Times commentary by Edward Chancellor, "Inflation Looms Over Deflation Risk."

Economists of monetarist and Keynesian persuasions disagree about many things. However, they are currently united in their views on inflation. They see the risk of deflation as being far greater. This conventional wisdom is reflected in extremely low yields for government bonds in Europe and the US. Yet a resurgence of inflation may be closer than many believe.

Monetarists concede that central banks are printing money in vast amounts to stimulate their economies. This will not lead to inflation, they say. The newly minted cash is not being lent out but stored in bank vaults. The “money multiplier”, to use the technical term, has collapsed. It is no secret why this is happening. Households and businesses are over-stretched and fearful about the future. As a result, they are borrowing less and saving more. As long as such fears persist, according to monetarist logic, the Federal Reserve can carry on printing money with impunity.

The aim of the central bank’s policy of quantitative easing is to dispel the threat of deflation and get people to borrow and spend more. The “unconventional measures” being undertaken by central banks around the world are novel and unproven. If the authorities overreact to the spectre of deflation and print more money than is necessary, inflation expectations might suddenly pick up. The continued hoarding of money depends on people believing that a fiat currency, such as the US dollar, will remain a store of value in future. If this confidence dissipates due to excessive measures by the Fed, then cash would be considered a hot potato. The velocity of circulation would rise and inflation surge.

Inflation expectations might also shift if the markets lose confidence in the state of the public finances. Washington is set to produce a deficit this year of $1,800bn (£1,237bn, €1,325bn). The cost of bailing out Wall Street runs to several thousand billion dollars more. Meanwhile, the Fed has promised to expand its balance sheet by more than $2,000bn. Governments that issue debt in their own currencies and control their monetary printing presses do not tend to go bust. Rather, the sovereign default takes place covertly through a depreciation of the currency.

If market participants come to suspect the US government faces insuperable financial burdens and that the Fed is losing its political independence, inflation expectations are liable to change rapidly. Clearly, this issue is a concern to China’s leaders who, having acquired an enormous mountain of Treasury bonds in their foreign exchange reserves, are aware that Americans might seek at some stage to inflate away their foreign obligations.

Keynesian economists do not focus on inflationary expectations or on the money supply. Instead, they point to the dramatic collapse of demand in the global economy as a sign that deflationary forces will be around for a long while. Goldman Sachs estimates the current “output gap” to be about 8 per cent of global GDP. Inflation will not pick up until this spare capacity has shrunk, according to Goldman.

This argument should be viewed sceptically. There are times when inflation and economic activity move in the opposite direction. For instance, periods of rising inflation and unemployment are relatively common during emerging market crises. The US witnessed something similar during the stagflation of the 1970s. Leading indicators suggest the US economy is set to decline sharply in the first quarter. The last time these indicators were so dire occurred in 1974. Yet there was no deflation in that year. Rather the inflation rate climbed to 12 per cent.

The British economist Peter Warburton of Economic Perspectives raises fresh doubts about the output gap in an intriguing new paper (“Making the Case for an Early Return of Inflation”). Mr Warburton argues the expansion of global trade over the past couple of decades exerted downward pressure on inflation. During the boom years, the global supply chain was tuned to perfection, he says. The credit crisis, however, has fractured this supply chain; companies have gone bust, working capital has been hard to come by, and inventories have been run down. As a result, the productive capacity of the global economy has shrunk and the world has become more inflation prone. “An aggressive stimulus package to aggregate demand,” writes Mr Warburton, “which seeks to restore the status quo ante will encounter inflationary tendencies at lower levels of activity than before”.

The deflationary consequences of the credit crisis may persist for some time. However, an early revival of inflation is not off the cards. Prudent investors should start implementing measures to protect their portfolios against such an outcome.

Comments

[Jan Burr]

My view is that the weakness in the dollar and any "black swan" event will lead to inflation as the trillions overseas are used to buy anything they can, to get rid of them as fast as they can. Because it will be dollars and not their own currencies they are using in most cases, the price of the commodities in their own currencies and even demand may not rise a large amount. If they spread the dollars over all commodities, gold and silver and stock pile and do other things like buy real estate here, etc. anything would seem possible.

The final collapse in the dollar and hyper-inflation would happen at some time in that process, wouldn't it?

We could be in a depression and prices would be going through the roof because all raw materials and imports would be going through the roof, I think

[killben]

The link says ...

"The continued hoarding of money depends on people believing that a fiat currency, such as the US dollar, will remain a store of value in future. If this confidence dissipates due to excessive measures by the Fed, then cash would be considered a hot potato. The velocity of circulation would rise and inflation surge."

The other way of looking into it is that it might not be so easy for U.S. to act on its own and inflate its way out of this mess since any debasement of the dollar is not going to be taken lightly by its trading constituents and hence this provides a natural check and balance to creation of inflation. Thus it is unlikely that Fed can print its way to inflation!

Also your basic assumption debasement of dollar leads to spending and therefore demand and inflation is incorrect as it is more likely they will move into gold and send it up to the moon while not doing anything for the demand for other products.

[scottt]

In other words ......... children.......... the weatherman says it will snow very hard today ..... but the other weatherman says its gonna be scorching hot and dry...... but , just remember , ya dont need a weatherman to know which way the wind blows .

[Jr Accountant]

This is exactly why Bernanke's goal has been irrelevant from Day 1... battling deflation, deflation, deflation. At what cost? Apparently Dr Bernanke does not have even the most remedial understanding of what happens when you crank up the presses.

Foreign holders of dollars have already started unloading them - and a large part of why Geithner and Bernanke are so misguided is that they fail to take these sorts of actions into account when sailing to the rescue of mismanaged institutions in the SS Bailout.

[Namke von Federlein]

I think that the debt clock on your web site explains it better than anything else. While I was reading the post (and I am a very fast reader) - the debt of the USA increased by over one million dollars.

Thank you for the fine way that you combine the technicals without forgetting the essentials. I'm so tired of hearing about people referred to as 'consumers'. Cancer is a consumer. People are producers. You can't consume what you don't have.

I've been reading econ blogs for six months. If I saw the word 'productivity' used twice, that would be a lot. Since when did the word productivity get (rather conveniently) erased from the vocabulary of economists? In fact, I've noticed (as far as I can remember) that you have never used the word on your blog?

Would you be able to blog about productivity? I think that the so-called credit crisis (which is actually a freedom crisis - wage slaves and debt slaves) will bring a huge boost in productivity around the world.

The problem (as you have pointed out on your blog) - it will happen as barter (tax revolt outside of the money supply). So, while the banks crash, the average person will achieve self-sufficiency. But, ouch, tax revenues will disappear? And so will the USA as a federated country? The April 1st tea party is not about happy taxpayers in lala land?

I remain optimistic - but that is only because of few blogs like yours (that Obama and the Repubs have admitted they ignore). They ignore them at their peril?

Thanks for your fine work!