Deflation – more evidence

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This is a guest contribution by Kalpa, author of the Financial News Express blog.

On Monday, I included the most recent John Mauldin newsletter in my links: Thoughts on the End Game.

I find Mauldin’s read on the state of the economic world about as interesting as anyone’s each week. Thus, it’s no wonder that he now has over one million subscribers to his free weekly newsletter. Not bad for somebody with a master’s in divinity degree. He also has seven children, five adopted. He reads a lot. He knows who to pay attention to. He’s friends with some of the best and the brightest when it comes to seeing the big picture.

So, I consider myself in good company to be in the middle of reading the same book that he is right now, This Time is Different, by Ken Rogoff and Carmen Reinhart. So far on this site, I have been linking about every book review which I can find on the book, and have included some superb video interviews of Rogoff and Reinhart, too.

See: Four Ken Rogoff Videos, and Rogoff and Reinhart’s Research (which includes a PBS interview).

It is my view that this book contains a crystal ball into our future through looking back at the past. It is also my view that this book is certainly one of, if not the most important economic books of our time. It should be mandatory reading for Obama and every elected official in this nation.

Some of the book’s tenets in a nutshell. . . Our human nature of greed cannot be changed. Defaults on debts, even sovereign debts are inevitable. There comes a point when a nation decides that it doesn’t want to spend 25, 30, or 40 percent of its annual budget on interest for debt repayment. Growth slows to a crawl, making repayment difficult to impossible. The logic of repaying the debt is over-weighed by the best interests of the nation and its inhabitant’s living standards. The nation then considers its options, its ways of erasing the debt without actually paying it and ridding itself of the ball-and-chain debt burden. This time is NOT different. Politics fails. It defaults. (There are many degrees and definitions of default.)

Now, back to Mauldin’s newsletter. Not only does he discuss his view of the Rogoff and Reinhart book this week, his feature article is a review of the book as well, by Van Hoisington and Dr. Lacy Hunt. Please go back and read it, if you haven’t. Mauldin says he read it five times, “it’s THAT important.”

What is most interesting in this particular review of the book, is how Hoisington and Hunt use it to make their strong case for deflation. This is the first review of the book where I have seen that done.

Here, are some key paragraphs from their discussion:


The real question for financial participants is whether all these influences result in inflation or deflation, and the authors’ research details both outcomes. As is widely feared here in the U.S., they outline that many countries have had the right circumstances and mechanisms to inflate away their debt overhang, and, in fact, have done so by debasing their currency. Those particular circumstances are not currently present in the United States.
According to Reinhart and Rogoff the norm is that major economic contractions lead to deflation. Importantly, they call our present economic circumstances the “second great contraction.”

Thus, not only has the historical “qualitative” research on the subject of deflation chronicled the deflationary impulses emanating from overindebtedness (Fisher’s 1933 “Debt-Deflation Theory of Great Depressions”), but also modern “quantitative” methods have now essentially confirmed this conclusion. Over-indebtedness and major contractions lead to deflation.


our current economic circumstances guarantee there will be no surprise inflation. Employing those who are out of work and fully utilizing our resources will be a slow process. More importantly, it will take time to get the monetary engine reignited. Banks will have to begin lending and people and companies will have to determine that prospects are good enough to take the risk for expansion and investment. It will take years for these processes to get started because of our over-indebtedness and falling asset prices.

The consequences of excessive debt are already painful at the household level. The civilian employment to population ratio, a highly important barometer of the average household’s standard of living, fell to 58.2% in December, the lowest reading in 26 years and down from a peak of 64.7% in April of 2000 (Chart 5). Thus, the standard of living has worsened as the debt to GDP ratio has marched steadily higher. With debt to GDP still rising, a further deterioration of the standard of living is inescapable.

[Kalpa: This next paragraph describes Rogoff and Reinhart’s view of stimulus programs]
Deficit spending only provides a transitory boost to the economy. It initially raises GDP, as it did in the second half of 2009, but then the effect dissipates and later is reversed, as financial resources available to the private sector are reduced. In a separate research study Rogoff and Reinhart write, “At the height of Japan’s banking crisis in the 1990s, repaving the streets in Tokyo became a routine exercise. As a result, Japan’s gross (government) debt-to-GDP ratio is now nearly 200% and a drag on what once was a vibrant economy.” Our present high deficit situation suggests that taxes will rise (including those of state and local governments), depressing economic activity further. In addition to the expiration of the 2001 and 2003 tax cuts, the Obama administration is proposing substantial taxes on financial institutions to pay for the cost of the financial bailout. Since the tax multiplier is high, this will reinforce the drag on economic activity from the lagged effects of deficit spending.

Presently, we view the inflationary environment as benign because: 1) the U.S. economic system is overleveraged and academic research confirms that this circumstance leads to deflation; 2) monetary policy is, and will continue to be, ineffectual as efforts to spur growth are thwarted by declining asset prices, loan destruction, and adverse regulatory influences; 3) the federal government’s spending spree will necessarily cause taxes and borrowings to rise, further stunting any economic growth. These factors ensure that inflation will be quiescent. Interest rates easily can and do rise for short periods, but remaining elevated in a disinflationary environment is contrary to the historical experience. We are owners and buyers of long U.S. Treasury debt.

Van R. Hoisington

Lacy H. Hunt, Ph.D.

Did you all note that last sentence? We are owners and buyers of long U.S. Treasury debt. This letter came out on Sunday, Jan. 24th. You might consider their advice wise, given today’s Bloomberg article, Treasuries Gain Before Fed as Greek Bond Drop Spurs Safety. Some quotes. . .

Treasuries rose as a plunge in Greek bonds drove investors to the safety of U.S. government debt before Federal Reserve policy makers issue their decision on interest rates. U.S. debt also gained as new home sales unexpectedly fell in December. The policy-setting Federal Open Market Committee will probably keep the target rate for overnight bank lending near zero, a Bloomberg survey shows.
……”The Greece story is adding a bid to Treasuries,” said Andrew Brenner, managing director at Guggenheim Capital Markets LLC, a New-York based brokerage for institutional investors. “If Greece continues to go down the tubes, the euro is going to come under pressure as the rest of Europe will have to come to the rescue in one way or another, putting their economies in worse shape.”

……Treasury one-month bill rates turned negative for the first time since March. The rate on the four-week security dropped to negative 0.01 percent, the lowest since it reached negative 0.015 percent on March 26. The U.S. sold $10 billion of four-week bills yesterday at a rate of zero percent, the second auction of the securities in three weeks at zero percent. “There’s some flight to quality with concern around sovereign risk around the globe, like Greece,” said Anshul Pradhan, an interest-rate strategist in New York at Barclays Plc, one of the 18 primary dealers that are required to bid at Treasury auctions. “Secondly, the bill universe is likely to shrink as the Treasury continues to term out debt so there’s risk aversion with demand.”.

……”The expectation is for the Fed to keep the funds rate the same and continue to support a low rate policy for quite some time,” Kevin Giddis, head of fixed-income at brokerage firm Morgan Keegan Inc. in Memphis, Tennessee, wrote in a note to clients. “We are far from figuring out the U.S. economy and we are far from solving the housing and banking crisis. This is why I find it hard to venture too far away from U.S. government debt.”

…….The International Monetary Fund said in an update to its Global Financial Stability Report yesterday that the global financial system remains “fragile.” In a separate report, it said low inflation will allow the world’s central banks to keep down interest rates…
But, really, there’s no place to hide in these times. Rogoff and Reinhart also say that things appear normal until they aren’t. We don’t get much warning to pull out of these treasuries, if need be. At least, that’s my impression.

So, back to my title, today. Are we in deflation? It was a stupid title, really. There is currently no doubt that we are in deflation. Don’t forget that one of the media’s accepted norms of defining deflation is too simple. They just use price of goods trends. Money supply, lending, velocity, wages, employment, growth, and overall conditions are all factors.

That brings to me to my last subject for today. Japan. We all know that Japan is the poster-child for a nation living through deflation. Things are not getting better there. They are getting worse. Reinhart says that the U.S. is not doing anything much different than Japan so far. We are hiding the bad debt in the big banks through lack of transparent accounting, we are increasing our debt through stimulus, and we are politically failing our challenge. Warnings are getting louder lately that Japan is in danger of defaulting. I wish someone smarter than myself would write a good article on what the consequences of that would be.

Last night, PBS’s Nightly Business Report did a good segment on deflation (focusing on prices and wages) in Japan. I highly recommend watching it.

This is their introduction to the segment: Thanks to declining demand, Japan’s economy is facing a deflation problem. As Correspondent Lucy Craft explains in tonight’s report, deflation is a more difficult problem for central bankers to tackle than inflation. And, if Japan doesn’t figure out its deflation problem soon, it could face a double-dip recession. Learn more about Japan and deflation below.

Here is the video link. Watch minutes 16 through 12 (counts down backwards) for the Japan segment.

To conclude, yes, we are in deflation. For the time being, anyway. (That was an easy one.)

Source: Kapla, Financial News Express, January 27, 2010.

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