Posts Tagged ‘inflation’

How the Consumer Price Index (CPI) could indicate false inflation?

Tuesday, August 10th, 2010

The Consumer Price Index (CPI) is one of the price indices used by the RBA to calculate the inflation figures felt by ordinary Australians. In fact, some of our pensions, wages and other payments are indexed to match the CPI.

However, sometimes the CPI really doesn?t seem to reflect the actual increase in the cost of living. According to this article, price inflation is close to 3.1%, however experts say that the increase in the cost of living feels closer to 5-6%:

There’s a disconnect between the high frequency items, which people regard as driving their cost of living and the broader measure of inflation, which includes less frequent purchases

We potentially have a scenario whereby cost of living is actually higher that is reflected in the CPI. However, the RBA will attempt to ‘manage’ inflation at the CPI rate (see Why central bankers are obsessed with inflation not breaching a certain band?), which means that they may mismanage their response to inflation.

The RBA?s response does not immediately hurt everyday Australians as much as it could. Increasing rates by small increments to fight 3% price inflation is not as bad as the increments required to fight 6% price inflation, especially if you?re heavily in debt. So let?s reverse that idea ? what about if cost of living increase is less than the CPI indicates? Suppose cost of living is increasing at a rate of 3% and the CPI was running at 6%. The RBA is vigorously increasing interest rates, whilst inflation is well ?under control?.

And this scenario could happen. The CPI is prone to overstatement of single items. The most recent CPI values for the year to June are heavily weighed down by a nearly 20% drop in Computers/Audio and a 6% drop in men?s clothes (single female technophobes must be doing it tough). A 50% rise in the cost of cigarettes could easily tip the CPI into high territory, whilst the non-smokers of Australia enjoy a lower level of inflation. Therefore, the RBA has to use other statistical hacks like “trimmed mean” and “weighted median” to smooth away the effects of once-off, seasonal or volatile price changes to arrive at an ‘underlying’ price index.

Yet, statistical hacks, regardless of how sophisticated the math is underneath them, are still not good enough. As we quoted Ludwig Von Mises in How much can we trust the price indices (e.g. CPI)?,

The pretentious solemnity which statisticians and statistical bureaus display in computing indexes of purchasing power and cost of living is out of place. These index numbers are at best rather crude and inaccurate illustrations of changes which have occurred. In periods of slow alterations in the relation between the supply of and the demand for money they do not convey any information at all. In periods of inflation and consequently of sharp price changes they provide a rough image of events which every individual experiences in his daily life. A judicious housewife knows much more about price changes as far as they affect her own household than the statistical averages can tell. She has little use for computations disregarding changes both in quality and in the amount of goods which she is able or permitted to buy at the prices entering into the computation. If she ?measures? the changes for her personal appreciation by taking the prices of only two or three commodities as a yardstick, she is no less ?scientific? and no more arbitrary than the sophisticated mathematicians in choosing their methods for the manipulation of the data of the market.

At the root of the problem with any price indices is that, as Mises said,

All methods suggested for a measurement of the changes in the monetary unit?s purchasing power are more or less unwittingly founded on the illusory image of an eternal and immutable being who determines by the application of an immutable standard the quantity of satisfaction which a unit of money conveys to him.

Basically, price indices, regardless of the level of sophistication, are not as ‘scientific’ as it seems. Central banks, however, have no choice but to rely on them to target price inflation with their monetary policy.

So, how much is the increase in your cost of living reflected by the CPI figures? Vote below!

Are deflationists missing the elephant in the room? Or are they believing in something more sinister?

Sunday, August 1st, 2010

As you scour around the blogsphere, you will see that there are contrarians who still believe that it is impossible for the US to prevail against deflation. The most extreme of deflationists is Robert Prechter (from Elliot Wave International), who is still predicting that the Dow Jones will go all the way down to 1000. Up till March 2009, it seemed that the deflationists’ argument was correct. In the Panic of 2008, deflationary forces were so strong that asset prices were even more oversold than the infamous 1987 crash. Unfortunately for the deflationists, the subsequent rally (reflation) till May 2010 was so enduring that their argument was discredited in the eyes of many.

Our view, on the other hand, belongs to the inflationists’ camp. From what we can see, there is a big elephant in the room that deflationists miss. But as we think about the deflationists’ argument, it suddenly dawn on us that perhaps deep in the soul of the deflationists’ argument is the belief of what some may call a “conspiracy theory.” Of course, we guess not all deflationists hold (or even aware of) such a belief. But the more extreme and strident a deflationist hold on to the deflation argument, the more we suspect that they are holding on to the belief of the “conspiracy theory.” Although we do not know whether that “conspiracy theory” is true or not, it certainly helps to explain the extreme position held by some deflationists.

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If the Australian economy ?booms? further, how is it setting the stage for a bigger bust later?

Wednesday, July 28th, 2010

Not long ago, the former Prime Minister of Australia, Kevin Rudd warned that Australia is facing a demographic crunch, which if not solved, will have grave implications on the Australian economy in the long-term. To put it simply, everything else being equal, Australians are getting older and older, which means that the Australian economy will not be able to continue increasing its production of goods and services. That means that the economic growth will slow, stagnate and eventually turn negative. On top of that, the Australian economy seems to have a problem with ?skills shortage,? which is threatening future economic growth (see Skills shortages shaping up as risk to economy).

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Why central bankers are obsessed with inflation not breaching a certain band?

Sunday, July 25th, 2010

If you follow central bankers all over the world, you will notice that for many of them, their monetary policy (under normal economic circumstances) targets a particular rate of price inflation. In Australia, the RBA targets price inflation to be around the 2-3% band, according to their preferred measure of price inflation. In the US, the band was 1-2% (we doubt they are in the position of targeting price inflation now, given that they are now in the zone of unconventional monetary policy). It is not the same for every central bank though. For example, Singapore?s central bank, Monetary Authority of Singapore (MAS), based their monetary policy on the exchange rate.

By now, you may wonder why the RBA specifically target the band of 2-3%? Why not 4-5%? Why not 9-10%? Why not even higher so that price inflation will ?inflate? away the debt of the masses, as in the 1970s?

Around 4 months ago, Saul Eslake wrote a very insightful article (unusual for a mainstream economist),


These inflation targets were chosen because, when inflation is about ”2-point something”, people tend not to notice it. And when they don’t notice it, they tend not to do things to protect themselves against it that are likely to lead eventually to prices rising at a faster rate.

By contrast, when inflation is, say, 4 per cent or higher, experience amply demonstrates that people do notice it – and they start to do things to protect themselves against its adverse consequences, such as seeking higher wages, or (in the case of businesses) putting up prices in anticipation of faster increases in costs.

The inevitable result is that, sooner or later, inflation starts rising at a faster rate than 4 per cent, and the central bank is eventually obliged to raise interest rates to slow the economy sufficiently to bring inflation back down to 4 per cent again. But when it has done so (at some cost in terms of unemployment), people start doing the same things again to protect themselves against the effects of 4 per cent inflation.

In other words, a 4 per cent, or higher, inflation rate is unlikely to be sustainable in the way that a 2 or 3 per cent inflation rate has been. It is likely to result not only in inflation being more volatile, but also in economic activity being more volatile and, probably, slower on average.

You may notice that this is what we implied in an article that we wrote back in December 2008: Demand for money, inflation/deflation & its implication. Once you understand the logic, you will be able to see the application of systems thinking. In other words, once price inflation goes over a tipping point, it becomes a dynamic process whereby money supply will balloon in an ever increasing positive feedback loop, resulting in higher and higher price inflation rate, which if not arrested, becomes hyperinflation.

If you want deflation, you would love Germany

Sunday, July 11th, 2010

From our previous article, one of our readers was very indignant at the current state of affairs. As he wrote,

During inflationary times, those who speculated made more money than those who held cash. so you could argue that those who held cash felt the "inflationary pain" but why wasn’t the government pressured politically to do something as they were when they get spooked by deflation?

Then when deflationary times come its the turn of those who held cash to benefit while those who already made their money out of speculation and over leveraging to feel the "deflationary pain", after all they did take too much risk.

I don’t think its fair or right for governments to manipulate the economy to prop up the prices of the investments of the speculators (who helped create all these bubbles in the fist place). Basically that means that they got to make a lot of money out of speculating but they didn’t take any real risk as government will step in to do "something" about the pain.

If the don’t feel the pain they will continue recklessly speculating.

Meanwhile that very same "something" the governments will do to help the speculators avoid pain will probably mean devaluation of the currency one way or another so that once again those who did not speculate and over leverage will feel the pain.

The governments actions will tend to encourage more people to speculate! I would like to see deflation happen, does anybody else feel the same way???

On the first point, why are governments more spooked by deflation than by inflation? The simple reason is that in a democracy, the mob rules. Unfortunately, the mob is heavily indebted as a whole. All we have to do is to look around and see that the culture of debt is deeply ingrained in society. For young people, not only is it fashionable to get into debt, it is very difficult not to get into debt. For example, buying your first home is enough to put you in debt for decades.

The last time governments became spooked by inflation was in 2008 when oil and food prices shot through the roof (see Who is to blame for surging food and oil prices?). If governments continue its policy of doing ?something? about deflation for a sustained period of time, we believe it will be a matter of time before prices of necessities will resume its surge again. As usual, the blame will be put on ?shortages? and ?speculators.?

But not all governments in the world are biased towards inflation. Germany is the exception here. The trauma of the hyperinflation during the Weimar times is seared into the German consciousness. As a result, they will avoid anything that hints of inflation. Unlike the English-speaking countries, politicians in Germany who stick to discipline, austerity, balanced budgets and stand against moral hazards see their popularity go up.

Coincidentally, Germany is also the most important member of the Euro zone. As a result, their attitude towards inflation is being imposed on Europe. In the recent G-20 meeting, the G-20 endorsed a halving of budget deficits by 2013 as the target.

But as George Soros wrote in a recent article,

The situation is eerily reminiscent of the 1930s. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banking system and the economy may not be strong enough to do without fiscal and monetary stimulus.

The Great Depression of the 1930s is one of deflation. In Soros? opinion, the G-20?s endorsement of government de-leveraging has increased the risk of deflation today.

So, in the coming months, we can see why the deflation argument will be gaining the upper hand.

When to start speculating again?

Thursday, July 8th, 2010

As we wrote before in Notice the change of narratives in the financial markets?, the theme for the coming months is likely to be deflation (contraction in the supply of money and credit). The symptoms of deflation will include falling asset and commodity prices and appreciation of the US dollar.

The reason why deflation is gaining the upper hand is that governments are not renewing their appetite for maintaining the crutch (economic ?stimulus?) to keep the economy from sinking. In Europe, the government themselves are deleveraging (see Keep up spending- Who?s right? Europe or America?).

But as contrarian investors, we have to keep one step ahead. As deflationary forces gather steam, eventually the government will be spooked. Eventually, they will be pressured politically to do ?something? about the situation. That ?something? will ultimately boils down to turning on the monetary printing press.

For example, as this news article reported, there is an expectation that the Chinese government will do ?something? if stock prices continue its downward trajectory. In the US, RBS recently warned its clients to be prepared for a ?monster? money-printing operation from the Federal Reserve (long before RBS released this, readers of this blog already know beforehand that this will happen- see Bernankeism and hyper-inflation).

When governments do ?something? about the deflationary pain, it will be a signal to shuffle your money back into speculation.

Does gold hedge against inflation/deflation?

Tuesday, February 2nd, 2010

It is often parroted by mainstream media that gold is a hedge against inflation. Sometimes, you will hear that gold is a hedge against deflation. Also, from our previous article (Will gold mining shares hedge against deflation again since the Great Depression?), we established that even though gold stocks hedges against deflation during the Great Depression, it does not necessarily apply to today’s situation. However, one of our readers said that Marc Faber reckoned that gold and gold stock hedges against deflation.

Isn’t this very confusing? How does gold hedges against inflation and deflation?

The answer is explained clearly in our book, How to buy and invest in physical gold and silver. For those who have not read that book, we will give some hints to the answer.

First, “inflation” and “deflation” are over-generalised words. Gold is a hedge against a narrow subset of “inflation” and “deflation.” The corollary is that in certain cases of “inflation” and “deflation,” you will lose using gold as a hedge. In page 20 of How to buy and invest in physical gold and silver, we have a story of Mr Goldberg who died a miserable man because he had nothing to show for his long-term commitment to gold.

As we said in How to buy and invest in physical gold and silver, the fundamental reasons for accumulating gold as a hedge are:

  1. Lack of confidence in fiat money (to function as money)
  2. Lack of trust in the financial system

Inflation is only one of the possible symptoms of point 1. Likewise, deflation is also one of the possible symptoms of point 2. The implication is that it is possible to see these two symptoms without holding those two fundamental reasons in your heart (i.e. see some forms of price inflation/deflation and yet still trust in fiat money and the financial system). Indeed, inflation has been with most of the world in the past 20 years. Deflation has been with Japan for the past 20 years. That is why there are many people (especially those from the mainstream media) who are deriding gold and gold-bugs.

But any time you have good reasons to lack confidence in fiat money and/or trust the financial system, it will be the time you will want gold as a hedge before the symptoms show up unmistakably as inflation/deflation.

To help you understand, we will give an example. During the Great Depression, banks were collapsing en masse. If your bank fails, then your cash at bank disappears into thin air. If everyone’s cash at bank disappears, then you can be sure there will be falling prices because there will be a sudden shortage of cash- everyone will want to hoard whatever physical cash they have on hand. In such a situation, if you own lots physical gold then you need not fear. You can always go to the Federal Reserve (remember, it was still the gold standard back then) and exchange your gold for physical cash. Or in theory, you can transact in physical gold only.

Today, during the Panic of 2008, banks were dropping dead like flies. That’s also a good reason to own gold or government bonds (we imagine that you can insist that the government pays you the yields with physical cash instead of depositing them at a wobbly bank). But then someone like Kevin Rudd announced that the government is going to guarantee all cash at bank. If there’s going to be falling prices (deflation) and if the financial system is going to function, then government bonds and term deposits will be better than gold. If there’s going to be mild inflation and if everything is going to be fine and benign as in the past 20 years (e.g. no currency crisis, no collapse in the financial system), then cash at high-yield bank accounts will be better than gold too.

Remember. as we wrote in our book (How to buy and invest in physical gold and silver), gold will only do exceptionally well at the extremes.

Here is a quiz question for you: if there’s going to be a collapse in the global financial system (as Marc Faber described as “deflation could only be triggered by one event: a total collapse of the existing global credit bubble”), would you rather own physical gold or gold stocks?

What to do for potential first home-owner?

Tuesday, December 1st, 2009

Recently, we had a conversation with a young bloke who is currently renting. He has a strong desire to buy a house that he can call it his own home. In other words, he is a potential first home-buyer.

But seeing that house prices are very expensive in Australia and that they are artificially inflated by easy credit and favourable tax laws for property ‘investments.’ Furthermore, he sees the corrupt State Governments’ land release policy as the cause of land ‘shortages’ in Australia. Furthermore, he believes that politicians, with all the powers and capabilities that they have, never allow property prices to crash, perhaps even encouraging further property price inflation (see What goes in the mind of the Rudd government as it extends FHOG?). With governments all over the world resorting to stimulus, bailouts and money printing, he can see that they are all hell-bent on the policy of monetary inflation.

In other words, he distrustfully and cynically sees that the property market is rigged against him. But what can he do? Should he just take the plunge and buy a property, be a debt slave and should he lose his job, hope that the government will engage in moral hazard to bail him out? Or should he wait for the house price crash that may not happen? In any case, he sees that his wages is not going up any time soon, which means he greatly fears missing out.

What should he do? It’s da*n if he do, da*n if he don’t situation.

This is an example of the harmful effects of inflation on society. The beauty of inflation for politicians is that it is a kind of invisible tax on workers. Instead of increasing tax on your salary (which is exceedingly obviously), inflation erodes the purchasing power of your wages and you degrade your standard of living through higher debt burdens and prices. As we wrote in How to secretly rob the people with monetary inflation?,

The common people on fixed salaries and who do not own any ?assets? will have to bear the brunt of price inflation. … A redistribution of wealth from the last ones in the queue to the first one in the queue! Usually, the latecomers are the most vulnerable members of society.

Unfortunately, our friend is one of the latecomers. Generation Z will be the laggards too.

The problem with inflation is that it penalise those who work hard and save. In the US, with interest rates below the rate of price inflation, the government is forcing people to speculate (and risk their savings) in order to merely stand still. As we wrote in Harmful effects of inflation,

With inflation, there is less incentive to be productive and more incentive to hoard, speculate and gamble. This in turn will reduce productivity and increase price inflation, which further increase the incentive to be less productive.

This is what one of our readers has to say,

I lived in Russia during the hyperinflation of late 80s-early90s. It was exactly as you say: people and businesses were not interested in producing goods. The only path to success was speculating. God save Australia from such times!

If property prices are going to be more bubbly in future, the only way for young people to have any chance to own a property is to speculate. If the government is committed to inflation and moral hazard to solve economic problems, young people will see that there is no point in working insanely hard to save up to buy a house. They will see that the only way will be to speculate in stocks, commodities, gold, silver, foreign currencies, CFDs, options, etc than to work hard. They will chase whatever that is liquid and goes up in price and if they are more aggressive, short whatever that is coming down in price. Some may even turn to speculating in property itself with leverage.

Monetary inflation makes it far more profitable to speculate than to work hard. That’s why our friend is saying, “I’m learning to speculate.”

Does rising house prices imply a housing shortage?

Thursday, August 27th, 2009

There is a common argument that Australia has a housing shortage because prices are rising. The flawed reasoning goes like this: “Under the ‘irrefutable’ law of demand and supply, if prices rise, it must be due to demand outstripping supply i.e. shortage situation.”

This flawed reasoning has its roots in the mainstream Neo-Classical school of economic thought. Under this school, the market is assumed to be in equilibrium. As we wrote in Soft landing hope built on faulty framework assumptions

But this is a very erroneous assumption built into the framework of mainstream neo-classical economic thinking. Does the economy always have to return to equilibrium the way an elastic band spring back into its previous relaxed state? Can there be other forces that can pull the economy further and further out of equilibrium until a breakdown occurs?

In Neo-Classical reasoning, equilibrium is when the supply curve meets the demand curve. If prices go up, and the market has to be in equilibrium as assumed, then it has to imply that the supply curve had shifted left and/or demand curve had shifted right. Subsequently, prices had to rise to ease the demand-supply imbalance. With rising prices, many of these housing ‘experts’ then go hunting for reasons (that suits their vested interest) to explain the ‘shortages.’

In the real world, the market need not necessarily be in equilibrium. In fact, it can go out of equilibrium and remain so for an extended period of time, independent of the housing shortage/surplus situation. In Australia’s housing market, we have identified two major factors:

Price rise expectation
The first factor is price inflation expectation. As we quoted Ludwig von Mises in What is a crack-up boom?

He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief: accordingly he restricts his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding.

This observation is true for generic commodities that can be purchased with cash alone- in contrast, houses are almost always purchased with debt. The belief that prices will always go up forever and ever can create its own artificial demand. The insidious thing with this belief is that it is a self-fulfilling prophecy- belief leads to increased ‘demand,’ which in turn leads to higher prices, which reinforced the belief, which in turn leads to increased ‘demand’ and so on and so forth. When this happens, higher prices lead to even higher ‘demand.’ Such artificial demand can act as a sink-hole for whatever quantity of supply until money runs out in the financial system (which is not possible under today’s a fiat credit system). The Dutch Tulip Mania (which burst in 1637) is an example of the power of belief. Indeed, there must a ‘shortage’ of tulips at that time, according to Neo-Classical supply-demand ‘fundamentals.’

This is the same dynamic working in hyperinflation, where everything (not just houses) rises in prices. It was just last year that there’s talk of food shortages (see Who is to blame for surging food and oil prices?). Today, we hardly hear of food ‘shortages’ after deflationary Panic of 2008.

Availability of credit
As we all know, almost everyone borrow money to buy houses. Very few buy them with cash. What if banks decide to withdraw all credit in the economy? Obviously, people’s purchasing power of houses will fall as they can only rely on their cash savings to buy houses. Consequently, the ‘demand’ for housing will collapse immediately. As we said before in Another faulty analysis: BIS Shrapnel on house prices,

Where is the housing ‘demand’ going to come from as credit becomes more expensive? The only way for most people to buy a property is to borrow money. If credit becomes more expensive (i.e. harder to borrow money), obviously the ‘demand’ for properties will fall as well.

Conversely, when there’s more and more easy credit are available, more and more borrowed money can be used to bid up house prices. This can go on until the debt servicing burden becomes too big to bear.

How the two factors interact with each other
People’s expectation that prices will rise (abetted by belief that there’s a housing ‘shortage’) will lead to higher prices. Unlike the Dutch Tulip Mania of the 17th century, today’s financial system can spew out more and more credit continuously (see Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model). This means that self-reinforcing artificial demand can be fuelled by more and more credit, which helps prices to rise.

Then, through the principle of imputed valuation, increase in house prices at the margins will result in every other house to be re-valued upwards. As we said before in Spectre of deflation,

One thing many people fail to understand is that values of financial assets can vanish as easily as they are created in the first place. It is a fallacy to believe that just because money has to move somewhere from one asset class to another, the overall valuation in the financial system cannot contract. The very fact that all the money in the world cannot buy up all capitalisation is proof of that fact. This leads us to the next question: how do financial assets derive their value?

As we mentioned in The Bubble Economy, we have to understand the principle of imputed valuation. Suppose you have a house which you bought for $100,000. What happens if one day, your neighbour decide to sell his house (which is similar to yours) for $120,000? When that happens, your house would have to be re-valued upwards to $120,000 even though you had done absolutely nothing. The same goes for stocks. All it needs for a stock to increase in value is for a pair of buyer and seller to transact at a higher price. As long as the other shareholders do absolutely nothing, that higher price will be imputed into the values of the rest of the stocks. Thus, when asset values rise, all it takes is a handful of them to trade at higher prices in order for the rest to be re-valued upwards. If assets can ?increase? in value that way, it can ‘decrease’ in value that way too.

What is more worrying is that assets of such imputed values are used as collaterals for further borrowing, which becomes the borrower’s liability.

When the values of the houses sold at the margins are imputed to the rest of the houses, it result in higher valued collateral for more granting of even more credit. More credit adds another round of self-reinforcing feedback loop.

Pre-requisites for a substantial house price fall in Australia
All we need for house price to fall substantially in Australia is (1) a reversal of house price rise expectation and/or (2) tighter credit and/or critical mass of debt servicing failure (which can be caused by rising unemployment- see RBA committing logical errors regarding Australian household finance). When that happens, the self-reinforcing feedback loop for higher prices will become a self-reinforcing feedback loop for lower prices.

Look at UK…
There are many ‘experts’ who argued that house prices are falling in the US due to ‘over-supply’ and that Australia’s housing ‘shortage’ will prevent a house price fall. These experts conveniently failed to look at the UK. Just do a Google search on “housing shortage” site:uk and you will find many reports of a housing ‘shortage’ in the UK too.

We all know what happened to the UK housing market.

Will governments be forced to exit from ‘stimulus?’

Tuesday, August 25th, 2009

Currently, there’s a belief in the financial markets that the worst of the Global Financial Crisis (GFC) is over and that it’ll be blue sky from now on. Indeed, it is possible that the the US economy may see a positive GDP growth in the next few quarters to come.

But here, as contrarians, we see a different picture. As we quoted the Bank for International Settlements (BIS) in Bank for International Settlements (BIS) warning on stimulus spendings, the ‘green shoots’ of growth is largely contributed to government bailouts, ‘stimulus’ spendings, money printing and cheaper money (e.g. zero interest rates in US).

Make no mistake about this: Government interventions cannot be sustained forever without increasing negative consequences in the longer term. Governments cannot ‘stimulate’ the economy. In fact, the word ‘stimulus’ is the most misleading word in economics lexicon because it conveys the idea of a surgeon ‘stimulating’ a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch. The longer the economy leans on the government crutch, the more dependent it will be on the government. Eventually, the government will become the economy. For those who haven’t already, we encourage you to read Preserving jobs at all costs leads to economic stagnation and Are governments mad with ?stimulating??.

Letting the economy lean on crutches indefinitely will result in decreasing economic health as time goes by. Furthermore, there’s always the risk that the side-effects will pressure governments to remove the crutches. As we quoted the BIS in Bank for International Settlements (BIS) warning on stimulus spendings,

Perhaps the largest short-term risk associated with the expansionary policies is the possibility of a forced exit. Monetary and fiscal authorities of the major economies have so far been relatively unconstrained in their ability to follow expansionary policies. This need not last. An extended period of stagnating economic activity could undermine the credibility of the policies in place. Governments may find it hard to place debt if market participants expect the underlying balance to remain negative for years to come. Under such circumstances, funding costs could rise suddenly, forcing them to cut spending or raise taxes significantly.

How will a pressure for a “forced exit” from crutches (bailouts, stimulus, money printing and cheaper money) happen? We can look no further than China as an example where ‘stimulus’ is most effective. As we wrote in Will August 2009 be the top for the year in China?,

Forcing credit growth in this case does not result in economic ?stimulation.? Instead, the result was a dangerous asset price bubble. Apparently, the Chinese government flipped its position and decided to rein in the bubble before it’s too late.

China is right now in a dilemma. Turning the credit tap off will result in many projects failing, which in turn will result in bad debts. Not turning the credit tap off will result in price inflation and asset price bubbles.

The problem with economic crutches is that there will be negative side-effects. It is only a matter of time before excess liquidity leaked into asset and commodity prices. Initially, this may not be a problem. But as we saw last year (see Who is to blame for surging food and oil prices?), this will eventually result in acute problems of price inflation (unless the next deflation pressure comes, for which it will be déjà vu again). If governments decide to withdraw the economic crutches, they risk letting the already weakening economy fall into deflation. If they decide not to withdraw them, they risk letting acute price inflation run amok.

What is likely to happen is that governments will attempt to walk on the middle ground by pretending to ‘fight’ inflation (e.g. raising interest rates too slowly and talk tough on inflation) and support the economy at the same time, hoping that the economy will turn out fine. It may work initially, but it’s a matter of time before the public will see through it.

Tougher times is ahead for everyone.