Prudent Bear 18 Novembre 2008

There is a considerable argument between commentators at present as to whether, apart from a pretty painful recession, we are in for a bout of inflation or deflation. Both sides have apparently cogent arguments, and maintain their positions with considerable vigor. Robert Samuelson, having recently published a book “The Great Inflation” that suggested another burst of inflation was inevitable, has now produced an op-ed in the Washington Post warning of the rapidly approaching dangers of deflation – such are the dangers of publishing schedules! Having in the past suggested that inflation was inevitable, I thought it worth looking at the deflationist case.

Money supply data, first, do not suggest that deflation is imminent, although to some extent they contradict each other. M2, the broadest money supply measure now published by the Federal Reserve, was up 7.4% in the 12 months to November 3 (suggesting a potential inflation rate of 6-7% since Gross Domestic Product growth was around 1% in real terms.) The St. Louis Fed’s Money of Zero Maturity, the closest we can now get to the old M3, discontinued by the Fed in 2006, is up 10.0% in the last 12 months, suggesting a somewhat faster rate of inflation, perhaps 8-9%. More recently however the two measures have diverged; in the eight weeks to November 4 M2 was up at a 19.9% annual rate while MZM rose at a 0.7% annual rate – a huge disparity that has yet to be explained.

Nevertheless, the “gold bugs” who would normally expect to profit substantially from an upsurge in inflation have had a terrible year, indicating that their thesis has in some respects gone horribly wrong. According to Mark Hulbert on CBS Marketwatch, Harry Schultz, Howard Ruff and Jim Dines, the three leading gold-bugs and prognosticators of economic doom, have each lost between 64% and 70% on their investment newsletters during 2008. Since this was the year in which their prognostications of doom finally appear to have come true, one can reasonably ask what went wrong!

Equally the majority view, that the principal danger facing the United States is a Japanese-style stagnation lasting a decade or more with prices declining slightly making real interest rates too high, also seems misguided. Japan was close to deflation even in the early 1990s, and then followed a poisonous mix of policies that failed to recognize the loan losses in its banks while attempting to spend its way out of trouble through the public sector.

The United States is doing the latter but not the former, which it is prevented from doing by “mark-to-market” accounting. While mark to market accounting has major defects in prolonging a bubble, since it allows bankers to enter into foolish deals in the hope of short-term profits and bonuses, it is highly salutary in a downturn, preventing any semblance of wishful thinking in assessing value-impaired assets such as mortgage bonds. That’s why the entire US banking system has been forced to turn to Uncle Sam for succor; it is also why that system is now entirely unable to carry on as if nothing had gone wrong as the Japanese banking system did in 1991-98. Thus with a banking system forced into realism and interest rates that are sharply negative in real terms, deflation seems an unlikely possibility, in spite of Treasury Secretary Hank Paulson’s determination to invest every spare nickel in the economy into its most unproductive and valueless assets.

The difference between the United States and 1990s Japan is further indicated by the credit crunch: Japan didn’t really have one, in the sense of a sudden constipation in normal lending that caused the economy to seize up. That suggests again that the US trajectory going forward is unlikely to resemble 1990s Japan (for good or evil – Japan avoided a really deep recession, though it suffered an appallingly long albeit shallow one.)

The recent spate of truly terrible economic numbers, such as the 2.8% retail sales decline in October (4.5% down on the previous year) and the 32% decline in automobile sales, suggests that wherever the bottom of the recession is located, we will get there quickly. The US savings rate and the balance of payments both need to be improved by about 5% of Gross Domestic Product, so a top-to-bottom decline in GDP of at least 5% is likely,. However there is little reason for GDP to decline more than 5% top-to-bottom, or maybe 7% to allow for a little overshoot. Once GDP gets to its new equilibrium level powerful factors stabilize it and produce renewed growth – after all, at that new level of GDP the United States is once again internationally competitive, selling goods and services to customers worldwide in a way that has been impossible for a decade.

We are thus not looking at Great Depression II, in which GDP would decline 25%. To reach such an unpleasant re-run we would need a major outbreak of global protectionism, a final withdrawal of confidence by depositors in the US banking system and a swingeing increase in taxes, more than doubling the top marginal rate. President-elect Obama isn’t going to do that. Is he? If he doesn’t, and we avoid a Smoot-Hawley-style attack on world trade, then we will also avoid Great Depression – the Sequel. After all, the Depression was a primarily US phenomenon, caused and prolonged by egregious US policy errors –it was nothing like so bad in Britain, where economic policy under Chancellor of the Exchequer Neville Chamberlain was highly competent and basically the opposite of US failures.

However, if the recession is to be limited to a drop of 5-7% in GDP (itself somewhat worse than the 1974 and 1979-82 recessions, both around 3.5% of GDP) then at the present rate of decline we will reach bottom pretty quickly, in no more than 9-12 months. That tallies also with the housing price decline; house prices have already declined more than 20% nationwide, and from valuation considerations probably have no more than 10% or at most 15% to go. The banking system has already been bailed out by the Feds and probably won’t have to be bailed out again, but will see a gradual containment of losses in the next few quarters (with one or more huge incompetents finally slithering into bankruptcy.) The stock market has nearly reached its equilibrium of around 7,800 on the Dow (based on its early 1995 level of 4,000, inflated by nominal GDP growth since then). Although the market will doubtless overshoot on the downside, the dollar loss from a further decline to say Dow 5,000 is less than we have already experienced in the decline from 14,165 to below 9.000.

While US GDP is still declining sharply inflation will remain quiescent. Oil, minerals and agricultural prices will be on a generally downward trend, as the rest of the world, in particular the high-population growth centers of China and India, find their growth restricted by declining US demand. However, China has already indicated that it will not allow a US recession to stall its own growth; instead it has announced a 2-year stimulus program of $580 billion, about 15% of GDP. Thus commodity prices will remain supported by the continuous surge in Chinese and to a lesser extent Indian demand. US inflation will slow somewhat from its summer peak of close to 6%, but will not go into reverse, even while output continues its sharp decline. A renewed decline in the dollar, inevitable once US savings rates begin to recover and the tsunami of foreign capital into US bonds lessens, will cause the recent decline in import price inflation to reverse. Meanwhile cost increases already present in the system will work their way through to prices, causing continued modest upward momentum.

Even if inflation is declining gradually as output declines, it will not have time to become deflation in the 9-12 months before output reaches bottom – if we were about to experience Great Depression II the decline would be more prolonged, but we’re not. Once output has bottomed out, the inflationary picture changes radically. Budget deficits in the United States, the EU, China, India and Japan will be enormous, causing sharp rises in interest rates as government bonds “crowd out” the private sector. Money supply, which will have been increasing because of the very low nominal interest rates, will now be grossly excessive for the shrunken GDP.

Costs, which were held down by the wave of bankruptcies in the contraction, will once again increase as supply comes once again to balance demand. For one thing, higher interest rates and capital costs (through lower equity prices) will themselves produce a sharp upward ratchet effect on corporate break-evens, both in the US and more especially in emerging markets where capital will be scarce.  Lower production volumes against which fixed costs can be amortized will also increase unit costs. The overall effect will be sharp upward pressure on prices -- those continuing to sell at a loss to keep the factory at its most efficient output level and workers employed will be rapidly driven out of business.

Inflation will thus resurge, both domestically and internationally, and will quickly reach the double-digit level at which central bank action to restrain it becomes unavoidable (amusingly, unexpectedly awful inflation figures are likely to appear before the January 2010 end of Fed Chairman Ben Bernanke’s term, forcing him to admit while still in office that his “deflation” warnings were hogwash.) Interest rates will gradually be forced upwards to inflation-plus-4% levels in the last months of 2009 and throughout 2010, producing a second “dip” of recession in 2011 and a non-inflationary recovery in 2012-13.  The turn from economic decline (but not truly deflation) to inflation will be well indicated by the gold market, which can expect to surge as the economic bottom is approached.

As often happens, the “gold bugs” will turn out to be right in the end, even if their performance during 2008 has been dreadful – for those that survive, 2009 is likely to be a banner year. Deflationists will proclaim each slowing inflation figure in the early months of 2009 to be evidence for their case, though in reality those months will see not true deflation but simply slowing inflation accompanied by sharp descent into recession. However in the long run, monetarists will prove to have been right – and the decade of excessive money supply expansion from 1995-2008 will impose its final penalties on the unfortunate US and global public. Monetarists will also have the satisfaction of knowing that higher real interest rates will have become inescapable, and that overexpansion of money supply will never happen again – until some future generation of idiots has forgotten the economic history of these decades.

(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

by Martin Hutchinson the author of "Great Conservatives"

Source >  Prudent Bear | nov 17