Posts Tagged with deflation

Deflation or Reflation

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If you follow FinTwit (financial twitter for my readers who are less hip or who have other things to do with their lives than follow economic tweets on Twitter. Hi Mom!), you know that the main theme right now is Reflation. The common hypothesis goes that now that we have a vaccine, as soon as we reach some unknown but foreseeable level of protection, the economy will bounce back, people will start going to restaurants again, and everything will be fine. In theory, all this will result in inflation that shows up in a variety of places like stocks and gold and Bitcoin. Reflation is the predominant meme. It’s an attractive one especially if you have a kind of short term, first order view of the world.

However, there is a much less dominant theory but one that I think has more merit. Steven Van Metre and Travis Kimmel talked about it in depth over at Real Vision this week and that theory is that we are still due for a deflationary period in the short term (12-24 months) where many of the effects of COVID on the economy that have been kicked down the road through forbearance and other can kicking activities start to show up.

When COVID first hit, we had a massive dislocation in the market. The world economic function sort of just rolled over and died briefly. Stocks plunged, bonds exploded upwards and the Fed largely struggled to get control of the situation at that moment. Since that time, there’s been a Presidential election (in case you live under a rock), a great deal of can kicking and a general run up in stocks and a very specific run up in Bitcoin. Yields are starting to climb again in bonds (the 30 year treasury is approaching 2%) and it really does look like inflation is on the rise.

However, we still have millions of people on unemployment. Unemployment rate in the US is currently 6.7% which granted is a massive improvement over the April 2020 numbers of around 15% but is still exceptionally high for the last 20 years. The improvement seems to be stalling in recent months as well. On top of of that, 2.7 million people are still in some sort of forbearance program with their mortgage. At some point, the music has to stop and people are going to have to start paying again. And eventually the extended COVID relief will stop.

All this leads me to think that we are likely a few years from a real inflationary period. Some of the forbearance programs are payment plans but others may be a lump sum required upon expiration of the program. People aren’t going to suddenly have that kind of cash laying around and they are going to get foreclosed on. The service sector has obviously been obliterated and new restaurants aren’t exactly easy to start up and be profitable. In general, it seems like there are some less flash and crash events but more “slowly grinding lower” type events on the horizon.

As the government programs begin to expire, all the past will come due in some way. Best case, terms of loans get extended into the future. However, in a capitalist society, I wouldn’t count on servicers operating in the best interest of their clients. More likely to me is that based on some house price data, they think they can just foreclose and then sell the property to someone else. This is fine if it’s gradual and spread out. It’s not fine if it happens suddenly in a contagion.

One way out of the deflationary winds would be if the government came up with some plan to make good on the debts that will come due. However, this would be politically difficult in my mind. If it did happen, it would likely be truly inflationary though there still exists the very real problem of people not having jobs. You hear people refer to the money that’s come from the government as “stimulus” but there is nothing stimulating about $600 a person. That’s just aid, aid that is brief, small and unlikely to cause a real inflationary event. There are a great number of people still suffering and that’s just a drop in the bucket compared to a 12 month lump sum mortgage payment coming due or an end to unemployment benefits.

What do I think that means for investing? Not entirely sure as I’m just barely knowledgeable on the subject. However I do think that bonds still have room to run for 24 months even though they have shown some weakness in recent months. Granted, bonds look just as bubbly as stocks in some ways but if it turns out that we really do have to pay for all this can kicking, bonds will go up as the Fed turns the spigot back on for QE 85 or whatever. The next 6-12 months will be key and it will largely be dependent on how the government programs wind down.

On Exporting Deflation

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Returning to our characters of a few weeks ago, we remember that Bob and his country had increased the supply of waffles thus making the export of Bob’s organic grass-fed butter cheaper. This happens because other countries like Nigel’s can now get more waffles on the pastry currency market and can buy more of Bob’s butter. There is a slight (or not so slight in our example of doubling the waffle supply just so Bob could sell more butter) inflationary pressure in The Land of Guns and Large Border Fences. Another effect of this decision is a slight deflationary pressure in Nigel’s Land of People With Below Average Dental Hygiene (LOPWBADH).. The reason this is so is because of the connectedness of the two countries via the pastry exchange market. The Nigel’s clotted cream now costs more to export it to Bob’s country. On the surface this looks inflationary because the prices went up. But when thinking about inflation or deflation, it’s important to consider both prices and demand. Because Nigel will now sell less clotted cream, he may have to lay off Colin, his dairy manager. Colin may then have to get a lower paying job which means he has fewer crumpets to spend. This lack of demand on a broader scale leads to deflationary pressures.

This lack in aggregate demand is a side of the inflation-deflation discuss that you’ll rarely see in financial press because it’s the part of the equation central banks have almost no control over. We’re currently seeing this in Euroland where the economies of the monetary union have been under significant downward pressure for months as unemployment remains stubbornly high in many countries. When you don’t have a job, you don’t buy either clotted cream or expensive imported grass fed butter. The continued deflationary pressure can quickly spiral downwards. Once upon a time, deflation was a normal part of the economic cycle and when every major currency in the world was tied to a hard asset, typically gold, there was a general deflationary pressure because you can’t increase the money supply without increasing the production of the hard asset. These days, with no country tied to a hard asset, deflation is supposedly a thing of the past (though the time may be returning as the Chinese government has been buying gold in large quantities, another fact you won’t see mentioned in the financial press). And in fact, deflation is a terrifying prospect for governments and citizens that are heavily indebted. During deflation, the cost of debt rises as the currency appreciates.

Imagine a scenario where 50% of your income goes to servicing your credit card debt. What happens if you suddenly make less money or if the interest rates rise? Big trouble, that’s what happens. Now your debt to income ratio goes up and you either have to do without things or begin to think about defaulting on the debt. Our reliance on debt as a society both consumer and government means deflation is extraordinarily dangerous. For example, it takes half the tax revenue of the country of Japan to service their public debt. What happens if interest rates rise in Japan? Suddenly, they struggle to pay their obligations. That’s why they (and many other countries) can’t afford to let interest rates rise. Their answer is to adopt a policy of zero interest rates by manipulating the market with made up money.

Europe is currently on the precipice of deflation. To fight it, the European Central Bank has announced a $1.3 trillion (give or take a euro or two) stimulus program aimed at increasing the inflation rate and stabilizing the fall in prices. Leaving aside whether this will even work, what effect does this have on other countries? This intentional devaluing of the Euro will lead to stronger currencies in the trading partners of Europe. Those stronger currencies now have to contend with the deflationary aspects which is exactly what is hoped for by the Eurozone. This beggar thy neighbour approach eventually causes other countries to retaliate leading to a currency war which many people think we are currently in. This is the meaning of exporting deflation.

So how is the problem actually solved? A decreasing reliance on debt is the first start. In normal times (like the 1800s) deflation was part of the business cycle. As deflation would occur, people, businesses and countries would deleverage, reducing their debt. Eventually, the economies would cycle back to inflation. In today’s world, deflation can’t even be allowed to occur because of the debt levels of countries. The goal is permanent growth because without it, we can’t pay our debts. But permanent growth funded by increasing debts is a fantasy world that doesn’t have a happy ending. A country like Japan has no choice but to try and print money (the Bank of Japan currently buys almost all of the country’s public debt) to service their debt and increase inflation. This is a grand experiment of our central banks unseen before in history. In the short term, it means the Japanese yen will continue to lose value to the dollar and the European stock markets are likely to increase just like the US stock market went up over the past several years during our own quantitative easing. In the long term, it’s anyone’s guess. What happens if Japan defaults? What happens if the ECB’s trillion euro package doesn’t work? At some point, the levels of debt have to be reduced either by the difficult process of deleveraging or by default. Neither will be pleasing and the farther down the road we kick the can, the harder it will get. Eventually, the road will end on a cliff and we may all just tumble over it.

Marching Towards Another Depression

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A fascinating article at New Deal 2.0 details the steps we are taking towards a likely second Great Depression. At a time when economies are teetering on the edge of recovery and a second recession, governments are starting to make noises, particularly in Europe, about reducing deficits as a model for responsible financial health. Unfortunately, this is the exact opposite response governments should be taking as reducing a governmental deficit will naturally result in deflationary pressures on the private sector because the two are necessarily related.

Governments have two main ways to reduce deficits, increase taxes and reduce spending, both of which are deflationary. Doing either at a time when unemployment runs at 10% in most First world countries would result in huge burdens on the private sector. Governments are currently running large deficits because we just came out of one of the worst recessions the world has ever seen. Unfortunately, the bigger problem is that a huge portion of the government spending during those recessions actually resulted not in job creation but in an amazingly brazen transfer of wealth from the middle class to the wealthy through paying bondholders at par value and keeping the oligarchs in the big banks solvent.

Bailing out the banks instead of the common people was a monstrous mistake but not one that needs to be compounded now by cutting spending which will necessarily affect the very same classes of people negatively that the bank bailouts did through reduction of public services and increased unemployment. The fact that our elites are even considering this shows how little they understand of the situation. Or playing more cynical, how little concern they have for the plight of the middle and lower class.

What we need are statesmen and leaders who can clearly explain why the current budgets deficits are necessary and then begin to formulate plans to redirect stimulus not to the oligarchs in power but to the people most affected by the economic disaster. Instead, we have captured men and cronies in power who will continue to rape the middle class until they no longer can, either because there is no middle class left or because they have been deposed. Until the system is reformed and our political leaders once again serve the interests of the many instead of the power of the few, I don’t see how we aren’t in for dark days ahead.