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This is Not the Great Depression - but it could turn into the Great
Inflation
* by Rob Lee
* November 25, 2008
In this time of economic and financial crisis parallels are being drawn
with the Great Depression. There is frantic talk of the grave perils of
deflation. In response a truly massive attempt at reflation is underway.
However, this article argues that the deflation diagnosis is mistaken.
If so the present US economic policy response is grotesquely
disproportionate and risks a return to high inflation, perhaps much higher.
Let us clear up a crucial definitional issue. Deflation is now thought
of as a decline in the average price level. The Classical and Austrian
Schools of economics though define deflation as a sustained contraction
in the money supply. Analytically this is a more powerful concept
because while it is possible for falling prices to be combined with
robust economic growth - often the pattern under the gold standard -
falling money supply is nearly always accompanied by economic
contraction. We need to refer to this distinction in what follows.
As a model for the current crisis the Great Depression does not stand up
to even cursory examination. Two catastrophic policy mistakes
transformed the severe economic downturn following the 1929 stock market
crash into a deflationary depression. The first was the general adoption
of aggressive trade protection, epitomised by the Smoot-Hawley tariffs.
One redeeming feature of the present crisis is the absence of
significant protectionist pressures. It is apparent that key global
policymakers - including President-elect Obama - understand they must
not impose new trade barriers.
The most crucial policy error though was that the Fed allowed widespread
bank failures to cause a severe contraction in money supply. This was a
key finding of the seminal work " A Monetary History of the United
States 1863-1960 " by Milton Friedman and Anna Scharwtz. The current Fed
Chairman's principal claim to academic excellence rests precisely on his
detailed knowledge of the monetary policy mistakes made then. In a
tribute to Milton Friedman in 2002 Mr Bernanke wrote the following :
" I would like to say to Milton and Anna: Regarding the Great
Depression. You're right, we (the Fed) did it. We're very sorry. But
thanks to you, we won't do it again "
It is clear from the speed, scale, and radicalism of the Fed's ongoing
response to the "credit crunch" that Mr Bernanke meant every word of
that tribute.
There are other crucial differences with the 1930's. Most bank deposits
are now federally insured. Government spending forms a much larger part
of the economy and significant components of it automatically rise if
the economy declines, while tax revenues fall. These "automatic fiscal
stabilisers" are much larger than they were then. Furthermore these
factors are replicated across the globe as fiscal stabilisers exist in
every economy now and bank deposits are widely protected.
These key factors - the absence of protectionism, inbuilt fiscal
stabilisation, and avoidance of money supply contraction - will ensure
that nothing like a deflationary depression occurs. Certainly, the
economy is in recession, probably since the turn of the year. The
downturn has clearly deepened recently, and will be worse than the
previous two recessions. However, these were by historical standards
short and mild. The period since 1982 has been described as the Great
Moderation. During this long period of virtually uninterrupted US growth
substantial imbalances have built up. Household debt ratios are at
historic highs, household savings rates have reached record lows and the
US has run large current account deficits for many years. In free market
economies it is the function of recessions to rectify such imbalances.
Given the scale of the imbalances a sustained period of below-par US
economic performance may be necessary before a healthy economic recovery
can begin.
However, there is no evidence that anything drastically out of the
post-war historical pattern is emerging. Broad money supply has at no
stage come anywhere near contraction, and in recent weeks has begun
rising again. In the last eight weeks M2 money growth has been 19%
annualised, while M1 has risen at a 47% annual rate. Hardly evidence of
deflation! There has also been a drastic reduction in oil and other key
commodity prices, providing relief to consumers and businesses. The US
has a dynamic and flexible economy which adapts quickly to changing
circumstances. Amid the current extreme stress in the financial system
an incredible degree of adjustment has already happened, in contrast to
the lack of such adjustment that condemned Japan to prolonged stagnation
in the 1990's.
Another redeeming feature of the global economy is that many emerging
economies are in good shape. The general picture is one of more flexible
economies with low inflation, sound public finances, and large foreign
exchange reserves. To the West's shame their financial systems have been
more effectively regulated. Growth in these economies will slow down
sharply but shouldn't turn negative. Crucially, China - with its high
savings rate and low debt levels - has undertaken a huge programme to
increase domestic spending. Resolution of global imbalances requires
exactly this combination of higher spending by the East and higher
saving in the West.
However, US policymakers appear oblivious of these countervailing
factors and are acting as if we are already in a deflationary
depression. The failure of a number of large financial institutions did
pose the risk of an overall contraction in money and credit. After a
period of dithering the correct policy of bank recapitalisation was
chosen, combined with bank lending guarantees, plentiful liquidity
provision, and speedy mergers and takeovers. This article is not saying
that such measures were unnecessary.
However, the scale of the policy response has already gone way beyond
preventing monetary contraction. This is most dramatically illustrated
by the expansion in the Fed's balance sheet. In the last ten weeks total
Federal Reserve Credit increased by $1290bn. This is an increase of 151%
over the same period a year ago, and an annualised rise since Sept 10th
of 755%! This degree of expansion in "base" money is without precedent
in the Fed's history.
The Fed has been granted extraordinary powers and is using them to the
full. It has made huge loans to the financial system while accepting
collateral that is not transparent and of dubious quality. It has bought
private company equity and large amounts of commercial paper. The Fed
has not officially acknowledged it yet but these policies amount to
"quantitative easing" - the deliberate "printing" of money directly
injected into the economy. It may prove very difficult for the Fed to
extricate itself from these policies, with dire consequences for the
Fed's credibility.
Let us look at fiscal policy. The official federal budget deficit
figures exclude significant off-budget items. A truer picture of fiscal
commitments is therefore provided by changes in total US Treasury Debt
outstanding. In the five fiscal years prior to 2008 the average annual
rise in debt outstanding was $555bn - already a large figure. In the
year ending Sept 2008 debt rose by nearly double that to just over $1
trillion ($1025bn) - already reflecting some bank rescue costs and
additional stimulus measures. In the first few weeks of the 2009 fiscal
year debt has already risen by another $650bn. With President-elect
Obama indicating a push for further large stimulus total debt could rise
by $2 trillion or more this year and next. It is particularly disturbing
that this massive debt expansion takes place just before the "baby boom"
generation start adding to fiscal pressures by retiring in large numbers.
The recession is putting downward pressure on prices, as will recent
dollar strength. Commodity prices have declined markedly. Consumer
prices may therefore register a small annual decline in coming months.
This will not be the prelude to deflation. The stronger dollar is the
function of an intense de-leveraging process which temporarily boosts
dollar demand. It will unwind soon enough and probably with alarming
speed. Foreign creditors may prove unwilling to finance still high US
current account deficits when they are trying to rebuild their own
economies. They are likely to have better use for their reserves than
buying still more US Treasury paper. The long feared dollar crisis may
finally make its appearance.
By the end of next year the US may have near zero interest rates, a
fiscal deficit of 8% of GDP or more, and a chronically weak currency.
This is a classic recipe for inflation. It is a myth that a weak economy
necessarily means low inflation, especially if the size and role of
government are expanding. Company failures and low investment weaken the
supply side of the economy but improve pricing power for the survivors.
Once the credibility of the currency and policy has gone people and
businesses seek to protect themselves in real assets. Inflation can rise
then very rapidly even in a weak economy. I expect US inflation in the
5-10% range by the end of 2010 and in 2011.
The inflation outlook thereafter depends on the policy reaction. If
policymakers do not regain their grip the longer term outlook becomes
seriously disturbing. I began this article by rejecting the Great
Depression as a model. I have begun to study a very different but
equally alarming model - the Weimar Republic hyperinflation in post
World War One Germany. It is too early to postulate such extreme
outcomes for the US. However, I draw your attention to the opening
sentences of the classic work* on that period ( paraphrased slightly):
" On July 31st 1914 the Reichsbank suspended the convertibility of its
notes into gold.......On August 4th 1914 a new law authorised the Reichsbank
to discount short-term bills issued by the Treasury, together with
commercial bills, as cover for its notes.....thus was initiated a monetary
inflation that was without precedent in history
........the inflation ended (in 1923) on the day that the Reichsbank ceased
discounting Treasury Bills"
The new powers and policies adopted by the Fed will seem impossibly
arcane to most people. They are not. They could be very dangerous. My
preliminary look at the Weimar experience suggests potentially ominous
parallels. If the Fed embarks on the road of monetising Treasury debt
the longer term inflation outlook becomes more frightening. I intend to
watch Fed and Treasury actions intently. I suggest you do too.
* The Economics of Inflation - A Study of Currency Depreciation in Post
War Germany. Author: Constantino Bresciani - Turroni.
Rob Lee is an economist who has been involved in investment markets for
over 30 years, the last few in nominal retirement in the UK.
http://tinyurl.com/57nfky
--
Steven L.
Email: s...@e...net
Remove the NOSPAM before replying to me.
In order for there to be inflation there needs to be "too much money chasing
too few goods". A commonly told example is people driving wheelbarrows of
money to the store to buy a loaf of bread in germany of the 30's. Do you
know anyone with wheelbarrows of money? Can you postulate any circumstances
in modern day america where we would get in such position that everyone has
gobs of money? No store is going to charge $10000 for a loaf of bread if no
one can pay it. Bottom line is that even when there are more dollars out
there, you cannot have significant inflation at the common consumer level
unless those consumers are getting more of those dollars.
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