Roubini on deflation

My working theory has been that the current crisis will produce several years of deflation or at least disinflation, along with low rates, followed by higher inflation in the medium term.  The Fed's liquidity programs are not themselves inflationary (they are not, as is so often claimed, printing money, or at least not the kind that they can't unprint later).  However, ultimately somone has to pay for all this bailing out, and it will either be through higher taxes, lower spending, inflation, or all three.  An independent central bank would not allow the govenment to inflate its way out of debt; we have proven repeatedly in the last year(s) that we no longer have an independent central bank.

But enough of my thinking.  Roubini has the other side of the debate, arguing that the Fed will never let inflation happend, and instead, if need be, will push us into a double-dip recession to return to price stability.  I think he's wrong, but he's worth reading.

Finally, while in the short run a global recession will be associated with deflationary forces shouldn’t we worry about rising inflation in the middle run? This argument that the financial crisis will eventually lead to inflation is based on the view that governments will be tempted to monetize the fiscal costs of bailing out the financial system and that this sharp growth in the monetary base will eventually cause high inflation. In a variant of the same argument some argue that – as the US and other economies face debt deflation – it would make sense to reduce the debt burden of borrowers (households and now governments taking on their balance sheet the losses of the private sector) by wiping out the real value of such nominal debt with inflation.

So should we worry that this financial crisis and its fiscal costs will eventually lead to higher inflation? The answer to this complex question is: likely not.

First of all, the massive injection of liquidity in the financial system – literally trillions of dollars in the last few months – is not inflationary as it accommodating the demand for liquidity that the current financial crisis and investors’ panic has triggered. Thus, once the panic recede and this excess demand for liquidity shrink central banks can and will mop up all this excess liquidity that was created in the short run to satisfy the demand for liquidity and prevent a spike in interest rates.

Second, the fiscal costs of bailing out financial institutions would eventually lead to inflation if the increased budget deficits associated with this bailout were to be monetized as opposed to being financed with a larger stock of public debt. As long as such deficits are financed with debt – rather than by running the printing presses – such fiscal costs will not be inflationary as taxes will have to be increased over the next few decades and/or government spending reduced to service this large increase in the stock of public debt.

Third, wouldn’t central banks be tempted to monetize these fiscal costs - rather than allow a mushrooming of public debt – and thus wipe out with inflation these fiscal costs of bailing out lenders/investors and borrowers? Not likely in my view: even a relatively dovish Bernanke Fed cannot afford to let the inflation expectations genie out of the bottle via a monetization of the fiscal bailout costs; it cannot afford/be tempted to do that because if the inflation genie gets out of the bottle (with inflation rising from the low single digits to the high single digits or even into the double digits) the rise in inflation expectations will eventually force a nasty and severely recessionary Volcker-style monetary policy tightening to bring back the inflation expectation genie into the bottle. And such Volcker-style disinflation would cause an ugly recession. Indeed, central banks have spent the last 20 years trying to establish and maintain their low inflation credibility; thus destroying such credibility as a way to reduce the direct costs of the fiscal bailout would be highly corrosive and destructive of the inflation credibility that they have worked so hard to achieve and maintain.

Fourth, inflation can reduce the real value of debts as long as it is unexpected and as long as debt is in the form of long-term nominal fixed rate liabilities. The trouble is that an attempt to increase inflation would not be unexpected and thus investors would write debt contracts to hedge themselves against such a risk if monetization of the fiscal deficits does occur. Also, in the US economy a lot of debts – of the government, of the banks, of the households – are not long term nominal fixed rate liabilities. They are rather shorter term, variable rates debts. Thus, a rise in inflation in an attempt to wipe out debt liabilities would lead to a rapid re-pricing of such shorter term, variable rate debt. And thus expected inflation would not succeed in reducing the part of the debts that are now of the long term nominal fixed rate form. I.e. you can fool all of the people some of the time (unexpected inflation) and some of the people all of the time (those with long term nominal fixed rate claims) but you cannot fool all of the people all of the time. Thus, trying to inflict a capital levy on creditors and trying to provide a debt relief to debtors may not work as a lot of short term or variable rate debt will rapidly reprice to reflect the higher expected inflation.

In conclusion, a sharp slack in goods, labor and commodity markets will lead to global deflationary trends over the next year. And the fiscal costs of bailing out borrowers and/or lenders/investors will not be inflationary as central banks will not be willing to incur the high costs of very high inflation as a way to reduce the real value of debt burdens of governments and distressed borrowers. The costs of rising expected and actual inflation will be much higher than the benefits of using the inflation/seignorage tax to pay for the fiscal costs of cleaning up the mess that this most severe financial crisis has created. As long – as likely – as these fiscal costs are financed with public debt rather than with a monetization of these deficits inflation will not be a problem either in the short run or over the medium run.

Actually, it was structured by pigs

From NC:

In a hearing today before the House Oversight Committee, the credit rating agencies are being portrayed as profit-hungry institutions that would give any deal their blessing for the right price.

Case in point: this instant message exchange between two unidentified Standard & Poor's officials about a mortgage-backed security deal on 4/5/2007:

Official #1: Btw (by the way) that deal is ridiculous.

Official #2: I know right...model def (definitely) does not capture half the risk.

Official #1: We should not be rating it.

Official #2: We rate every deal. It could be structured by cows and we would rate it.

Continuing on with our regularly scheduled progam

Keynes quote (via Krugman):

Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.

China vs. India

There is an interesting piece comparing potential future growth in China and India over at VoxEU. The author defends the growth potential of China against a common-sensical viewpoint that a country like China who has built its economy on the back of manufacturing exports faces a tough road in a likely rich world recession in the near term, and what can only be a long-term rebalancing of consumer spending in these highly leveraged economies over the medium term. His argument doesn't deal with this head on though, so much as in an oblique manner -- he argues that the difficult thing to build in the long-term are strong state institutions, such as those China has, while having a thriving private sector is relatively easy to create, given that all it requires is deregulating industry and letting it "hustle" to use his word for it. Of course, the wording already reveals the basic fallacy of the thinking, which is that state institutions are on par with a dynamic private sector in terms of their impact on long-term growth. This is only true if you take "state institutions" to mean the thoughtful setting up of markets, that is, the tending of the non-zero sum garden that truly allows an economy to flourish. The author, however, has in mind the much more rigid state institutions in place in China, where the economy is still controlled top-down to a large extent. This may make for faster growth, and maybe even be harder to build (though I would debate this point), but in the long-run that kind of centralization cannot help but be inflexible. It works until it doesn't.

Zen trade

Yves points to a very interesting paper on exactly what a globally balanced world would look like in real terms. The surprise finding is that the biggest beneficiary of all this is Japan. Japan is actually interesting me more and more these days.

The US as a share of the world economy falls by just 4.5% while Japan's rises by 3.3%. The inflexible case, however, requires a much more radical realignment in the relative size of the major economies. The US declines by nearly 30% relative to the world while Japan grows by over 26%. (Combining the numbers, the adjustment would require over a 50% devaluation of the US dollar in terms of the Japanese yen).

Maudlin Melodies

John Mauldin typically posts some pretty good stuff at a reasonable frequency and with an emphasis on longer more thoughtful pieces, as opposed to the quick one off that has become the blogging norm. Today he has something from David Rosenberg, Merrill's chief economist. Rosenberg is pretty bearish, as is anyone in their right mind, frankly, though there's nothing that I would call new in what he's saying. A few things did catch my attention though. First, screw GDP:

More to the point, if you're waiting as an investor for GDP to actually turn negative, you're going to miss a lot of action along the way. I think the best example is to just go back to Japan. They had a real estate bubble that turned bust and they had their own credit contraction back in the early 1990s. Guess what; Japan didn't post its first back-to-back contraction of real GDP until the second half of 1993. By the time the back-to-back negative that people seem to be waiting for happened, the Nikkei had already plunged 50%, the 10-year JGB yield rallied 300 basis points, and the Bank of Japan had cut the overnight rate 500 basis points, which said a thing or two about the efficacy of using the traditional monetary policy response of cutting interest rates into a credit contraction (as we're now finding out here in the US).

Second, not everything gets marked to market instantaneously:

I was around in the 1980s, and I remember that it played out very similarly. What people called resilience and people called contained and people called decoupling were all very pleasant euphemisms for lags. That's what they are; they're lags. There are built-in lags. Housing peaked in 1988, rolled over, the credit crunch intensified in 1989 when RTC got into real action. Then 1990 ... two years after housing peaked, we had this very surprising consumer recession that caught even the Fed off guard.

Perhaps I'm just constitutionally bearish, but I feel like it's just common sense to suggest that the depth of the pullback in the US will eventually have an impact al over the world. But not right away. People take time to adjust to the reality that a lot of the wealth created in the last 10 years was illusory, and that the baseline is much lower than they think because they aren't accounting for the fact that we had one giant credit bubble that came in two episodes. We're not going back to 2005, but 1995.

In-de-flation

The inflation-deflation question is to me the trickiest macro-economic call at the moment, probably due to the fact that it is really a political question at bottom. If we still used gold as money, the limited supply would mean that when the music stopped after the exuberant debt creation party, the room still had the same number of chairs. The fact that we print money calls this into question, though it does not assure it, as you still have to get that money into people's hands so that they spend it and it flows through the system. Interfliudity makes an interesting comment on this point, which speaks directly to the two great examples of modern deflation:

Japan's experience in the 1990s and the US' in the 1930s are often cited to suggest the inevitability of deflation, despite monetary policy heroics. But in both cases, the deflating country had a large, positive international asset position. To the degree money was owed by foreigners in domestic or pegged currency, the "national interest", looking past winners and losers, was to tolerate deflation.

This actually has a compelling ring to it -- to inflate or deflate is a political question that depends on whether you are a debtor or a creditor. If you are a net creditor nation, even though deflation is painful in domestic economic terms, it's even worse to let your debtors off the hook. As a net debtor, there's no reason to accept the pain of deflation, and the political calculation will always be to inflate.

The question in the current case of the US is to wonder aloud whether the US can engineer a quiet bailout where we exchange China and the gulf's ongoing support of the dollar for an agreement to actually pay these bills (i.e. not inflate). This would allow us to avoid the nastiness of a default, including a major currency collapse and a severe recession, and gradually bring our balance of payments in line via years of subpar growth and reduced standards of living. Theoretically you could engineer a kind of cancelling of the inflationary and deflationary forces -- debt restructuring as opposed to simple default. I'm not sure that's a geopolitically viable course of action unfortunately.