The Federal Reserve recently acknowledged that the risk of deflation in the US, though still small, has grown. Is policy correctly aligned to confront this risk? Not yet.
With Japan as an example, nobody should need reminding that deflation is a uniquely dangerous prospect - but here is a refresher. Persistently falling prices increase the inflation-adjusted burden of debt. Insupportable debts are the core of the US economy's difficulties. If that burden grows even heavier because of falling prices, the contractionary forces will strengthen. The economy will slow further, the deflationary pressure will increase again, debts will become more burdensome, and so on. Since interest rates cannot fall to less than zero, monetary policy cannot follow inflation all the way down. This makes the deflationary circle difficult to break. Nothing is more important than preventing the economy from toppling into it.
Prices in the US fell in October by 1 per cent, the biggest such fall for 60 years. That was an urgent warning - though it does not mean that deflation has arrived just yet. Prices (excluding food and energy) are 2.2 per cent higher than a year ago. Expectations of inflation remain positive, which is crucial since expectations of inflation tend to be self-fulfilling. It would take a stunning and prolonged recession to drive inflation expectations negative, thus pushing the economy all the way over the deflationary edge. But a stunning and prolonged recession may be exactly what the US faces. At the moment, each new economic indicator shows a shocking rate of contraction.
« And for my next TARP... | Main | Housing is still the epicenter » Bernanke and the risk of deflation01 Dec 2008 01:06 pm
My new FT column:
Comments (6)Comments on this entry have been closed. |
Today's Headlines From The Atlantic |
Copyright © 2009 by The Atlantic Monthly Group. All rights reserved.
Since interest rates cannot fall to less than zero, monetary policy cannot follow inflation all the way down.
But isn't Bernanke's specialty coming up with creative monetary solutions when the traditional tools are not in play? Or has he already exhausted most of the alternatives?
Clive,
If bankruptcy judges are given the authority to modify mortgage loans, then that will raise mortgage interest rates for everyone going forward, as lenders will have to charge higher rates to compensate them for the risk of having a bankruptcy judge cram-down their loans. The owners of mortgage loans generally are willing to modify their nonperforming loans, since a modified loan is usually preferable to foreclosure. If the threat of foreclosure is completely eviscerated though (for example, by letting bankruptcy judges re-write the terms of mortgages), then what incentive will borrowers have to make payments? This policy could lead to more, not fewer, defaults.
The simple truth is that we (globally, but especially in the US) have over-leveraged (bet too much on ever increasing asset values) and over-borrowed (borrowed and spent money we do not have the capacity to repay). This has created 'phantom wealth' that never really existed and all the manipulations underway now are trying to maintain or re-create.
The truth is that we have been finally caught out. The financial emperor has no more clothes. There will be pain.
Talk of inflation and deflation are recognition that this. Both point to the same source, an accumulation of wealth without a foundation in anything real.
Inflation will help the overleveraged and debtors by decreasing the cost of covering or repaying but punishes those who have been fiscally conservative.
Deflation will help the few who have been financially conservative by expanding the value of their 'real' assets, especially cash, but punishes those in deep debt or over leveraged.
Either can tend to spiral and become destructive to the whole financial structure, almost everyone. (France was not too bad a place to be in the 1930s because they had demanded payment in gold in the years leading up to the collapse.) Mr. Crook, looking at our 1930s warns against deflation. Weimar Germany and other failed national economies warn of inflation.
What we do need is a process that parcels out the pain and puts the wheels back on the global economy.
Remember that Roosevelt's homily about 'fear itself' came only after we had bottomed out. Losses from leverage and debt had been mostly accepted. There was perhaps nowhere to go but up and the New Deal provided the kick start.
But it was WWII that finally reversed our economic prospects. Let's hope we can find a comparable but less deadly impetus.
By the way, one relatively equitable way to reduce the amount of 'phantom wealth' at the root of our economic woes is to invalidate all Credit Default Swaps which are not covered by ownership of actual CDOs. This can and should be done by legislation, first in the US and then internationally.
CDSs are wildly inflationary in that for pennies on the dollar thay are creating dollars that did not exist, and doing it at the worst time, when the economy is already hurting.
These are why Lehman had to fail. There was not enough cash anywhere to cover their wild issuance of CDS.
Owners of uncovered CDSs (CDSs for which there is no underlying CDO which they nominally insure) would be entitled to their original purchase price and nothing more.
Paying off on the uncovered CDSs at this time is wildly inflationary and benefits only a few (financially precient) speculators to the detriment of the rest of the world. An easy call in my book.
Deflation is already occuring-its' symptoms are seen in falling asset prices(stocks, commodities, non-US Treasury bonds, etc.)and more and more consumer goods-gasoline,clothing, electronics, even food, away from home(much restaurant pricing)
at least. Bernanke and the other members of the cavalcade of bozos we seen on tv daily(whether they put a 'D' or 'R' behind their name, they're all members) can't do anything about it.
It looks to me that we will have a massive deflation, followed by an even more massive inflation as the US gov't and all other major countries coordinate a massive currency devaluation to reflate the global economy. If the interest rates on TIPS go real high during deflation, I would buy them, since the colossal debts burdening the economy will eventually be inflated away by the government printing press. If they have to resort to the direct printing of currency (without borrowing) to support Federal spending, they will do it.