Will deflation win?

August 21st, 2008

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In just a few months ago, the talk in town was price inflation. Oil, food and commodity prices were rising, as we wrote Who is to blame for surging food and oil prices?. Today, the talk is different. US house prices have never stop falling. Gold, oil and base metals are falling. There is even talk about the end of the commodity boom, the end of the commodity “super-cycle.” Economic slowdown and recessions are the expectations of the market.

Long time readers of this publication should never be surprised to see this is happening. As we said back in March last year in Inflation or deflation first?,

If you have been with us long enough, you may have heard us mulling over both the threats of inflation and deflation on the global economy (see Spectre of deflation and Have we escaped from the dangers of inflation?). You may be wondering whether we are contradicting ourselves. How can both threats exist simultaneously? Since one is a general rising of prices and the other is the opposite, are they not mutually exclusive?

At this current phase of the financial crisis, we are experiencing deflation. It is reported that the US M3 money supply is currently “collapsing.” A falling money supply is the definition of deflation, for which the symptoms will be falling asset prices, which if prolonged enough, will lead to falling consumer prices. But before we go off to celebrate falling prices, remember that this is an evil type of deflation because it is the type that is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on. The angelic type of deflation is caused by rising output and production, which is clearly not the case in the debt-addicted Western economies but more true for China with its government-forced savings.

When the US money supply shrinks, it increases in value relative to the other currencies as the US dollar gets repatriated back to make up for the dwindling supply of cash back in the US. That’s why we are witnessing a rally in the US dollar and a fall in commodity prices as there is a mad scramble to liquidate whatever assets to raise cash.

With the current legal powers, the US Federal Reserve is quite powerless to stop deflation (see Are we heading for a deflationary type of recession?). It can cut interest rates, but it cannot force people to borrow. Even at 2% Fed fund rate, the shrinking M3 money supply is proof that monetary policy is still tight (see What makes monetary policy ?loose? or ?tight??). Will the Fed continue to cut interest rates? It had already tried but failed a few months, which resulted in skyrocketing oil and gold prices. We doubt Ben Bernanke is going to try it again.

Meanwhile, the US Treasury is preparing open up the bottomless coffers of the US government to nationalise Freedie Mac and Fannie Mae, who are essentially insolvent. The question is, with the US budget deficit already in the red (plus the massive current account deficits), where is the money going to come from to do that? If a savings-less individual spend more than he/she earns, that individual is basically bankrupt. But for governments, it is a completely different story. They can make up for the shortfall by borrowing from the public by selling newly issued government bonds. As a last resort, it can sell the bonds to the Federal Reserve, which is called “monetising debt” or printing money.

Will it get that bad? It can if the deflation threatens to shock and awe the entire nation into a Greater Depression. By then, as we said before in A painful cleansing or pain avoidance at all cost?,

Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.

Therefore, as we advised before in Recipe for hyperinflation,

Therefore, watch what the US government is doing with the monetary ?rules? in its attempt to fight deflation.

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