Now to the big subject of the day. Inflation. You'd think evidence of even bigger deficits in the U.S. is clearly inflationary. But not everyone thinks so. The new prophet of doom, Dr. Nouriel Roubini, says at least four factors are setting up what he calls "Stag Deflation" (as opposed to the stagflation of the 1970s, where you had no growth and rising prices).
Roubini's four forces of Stag Deflation are: a slack in goods markets, a 'recoupling' of the rest of the world with the U.S. recession, a slack in labour markets, and a sharp fall in commodity prices. These factors would, "reduce inflationary forces and lead to deflationary forces in the global economy," he writes in an article in Forbes.
"Aggregate demand is now collapsing in the U.S. and advanced economies, and sharply decelerating in emerging markets," he writes. "There is a huge excess capacity for the production of manufactured goods in the global economy, as the massive, and excessive, capital expenditure in China and Asia (Chinese real investment is now close to 50% of gross domestic product) has created an excess supply of goods that will remain unsold as global aggregate demand falls."
You'll have to bear with us a moment, dear reader, as we work out what this means. First, though, is Roubini right? Well, he's certainly right that there's a big fall in aggregate demand in the U.S. It's obviously passing through to manufacturers and commodity producers (China and Australia). But won't monetary and fiscal policy designed to combat deflation...you know...cause inflation?
Roubini takes that point head on. He says the liquidity measures taken on by the Fed to get credit flowing and recapitalise U.S. banks are not all inflationary. He says once liquidity is restored to the credit markets (banks begin lending, money market funds starts buying commercial paper again) the central bank can simply "mop up" excess liquidity before it seeps into the real economy to cause inflationary damage.
And what about the tendency of governments to fight debt deflation with inflation? Not a worry either, says Roubini. He says that most of the household debt in the U.S. is short-term variable rate debt that's resistant to being "inflated away" by cranking up the printing presses. Is he right?
Well it all comes down to how much money the Fed and the Treasury are going to need before the recapitalisation of the American financial sector is over and how they plan to raise that money. The banks will probably need more capital than anyone's expecting. And there are other landmines down the road.
In short, the Treasury and Fed will need more money. Roubini assumes the Fed can simply remove the lending back stops it's provided once the market returns to normal. But what if it doesn't and the Fed can't? What happens next?
Governments get money three ways, taxing, borrowing, or printing it. You can rule out an increase in taxes large enough to fund the Fed's needs. It won't happen with an economy already contracting. Even if Obama raises taxes when he's elected, it won't be enough to meet the Fed's immediate needs. That leaves borrowing and printing.
On September 17th, the U.S. Treasury announced a Supplementary Financing Program. It initiated the program at the request of the Federal Reserve. The Fed needed the Treasury to go out and sell more bonds so the Fed would have money to fund its various lending back stops. The Fed was nearly broke.
Since then, thanks largely to the huge flight to Treasuries sparked by deleveraging and the collapse of the dollar/yen carry trades, the Supplementary Financing Account set up by the Treasury has fed the Fed nearly $560 billion. Some of that may have gone to AIG. Some of it to Fannie and Freddie. Some may go to Chrysler, Ford, and GM. Who knows?
But the main point, from Roubini's perspective, is that as long as the Fed can finance its lending with new borrowing from the Treasury, it's not inflationary. The only thing that would make this armada of liquidity measures and loan guarantees and bailouts truly inflationary is if the Treasury couldn't go out and sell new bonds to gullible foreign investors. As long as the Treasury can sell more bonds, the Fed can make more loans without sparking inflation.
But if we're right and the bond bubble began bursting in late October, well then the Treasury's line of credit with global savers is nearing an end. Global creditors will be reluctant to finance American deficits. In order to borrow, the Treasury is going to have pay much higher rates of interest to reflect the credit risk the U.S. government has become.
Trouble is, the U.S. can't afford to borrow at higher interest rates right now. So that leaves the option Roubini thinks is least likely: printing money. The fancy term for it would be "monetising the debt."
That means the Fed would buy public debt issued by the U.S. Treasury with freshly printed money. And THAT, we reckon, is super inflationary. Any time you start rolling out new greenbacks to pay for new bonds which you give to corporations in exchange for their garbage securities, you're going to damage the confidence people have in the currency (the U.S. dollar).
But then, Roubini has been right about an awful lot lately. It's possible the Fed will not be forced to monetise the debt. It's possible that a global contraction is truly deflationary. We don't really know. But we're not nearly as sanguine as Roubini that you can expand the monetary base as quickly as the Fed has and be confident it can all be mopped up later without causing inflation. Try getting motor oil out of an engine and back into the bottle.
Dan Denning
for The Daily Reckoning Australia
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About the Author
Dan Denning is the author of 2005's best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 and has covered financial markets form Baltimore, Paris, London and, beginning in 2005 Melbourne. He’s the editor of The Daily Reckoning Australia and the Publisher of Port Phillip Publishing.
Comment by ralph hill on 31 October 2008:
"But then, Roubini has been right about an awful lot lately. It's possible the Fed will not be forced to monetise the debt."
Do pigs fly ?
Do politicians spend too much ?
Clearly, the only way out of the crack-up is to replace politicians with flying pigs !
Or put it this way, the rascals in DC and their spending habits would put the proverbial 'drunken sailor' to shame. Does anyone half way sober or partially lucid really expect either REFORM or HONESTY from a bunch of windbags with that track record?
Comment by Greg Atkinson on 31 October 2008:
I have sort of just given up trying to make any guesstimates about the short to medium term economic outlook at the moment. Now we have governments in semi-panic mode, we have to be wary of the next "bright idea" and what unintended consequences it will have.
But with so much money being pumped into the system I do think we wake up with a nice inflation induced hangover at some point.
As for Roubini, well he is certainly having his 15 minutes of fame! Before this market debacle he was a bit of an unknown and I just hope most of his future predictions turn out to be duds, otherwise we are all in for a rough ride.
Comment by kojacq on 31 October 2008:
I think that what Professor Roubini says can possibly come true, but only if the monetary authories: central banks, banks, governments & treasuries; allow it to happen, however, to take the other side to his arguments, one can also say that:
1) the slack in the goods market can be partially made up by the major emerging economies: China, Brazil, Russia, India, thus allowing a reduced amount of growth in these economies, but certainly not a recession. Is China's 9% reduced growth rate classified as a recession? Certainly not. If certain countries can continue to grow, albeit at a much smaller pace, then that would refute the complete global deflationary argument which Prof. Roubini is presenting.
2) Is the recoupling/decoupling issue not simply one about survival of one's economy? Forced to choose between reducing the linkages with the US to save one's economy, and keeping the linkages, for geopolitical reasons, as they currently are, so that one's economy goes down with the US, what do you think the various governments of the world would choose, besides the G7 umbilical countries?
3) Is Professor Roubini only referring to the Western developed economies when he mentions a slack in labour markets? Surely, that factor on it's own in a China that is growing at a reduced rate of 9% from the previous 12%, is a slack that isn't classified as a negative rate of growth? Is 9% growth deflation? I don't think so.
4) The reduction in commodity prices, is surely rooted in the supply of money in an economy. However, one must realise that there is a time lag between actions to effect the money supply, and when that is felt in the economy. This time lag can be anywhere between 1-4 years, depending on the particular market.
I like TMS as the measure of money supply, rather than MZM, M3, M2 or M1, although I also look at those other indicators to corroborate TMS.
Using Year On Year Percentage Change in TMS (Murray Rothbard's True Money Supply) (see this link: http://www.321gold.com/editorials/saville/saville100708.html ),
coupled with corroborations in M2 & and the Monetary Base figures from the St. Louis Fed (see this link: http://news.goldseek.com/SpeculativeInvestor/1225198456.php ),
one can see that the period from around July 2005, til Jan 2007, was a period of the lowest TMS YoY percentage rate in the past 10 years, and that M2 was also at quite a low point at this time as well.
This would suggest that the timeframe of July 2007 til Jan 2009, would be marked as a low point in the money supply within the real economy, allowing for this time lag effect. If we take 2 years as the time lag.
However, if one looked at TMS for the period after Jan 2007, one can see that it went from around 1% in Jan 2007 to 7% as of now
If this money flows through the economy, and that's a big if, since the banks are now hoarding the cash that they have been given by these various government bailouts, then we can expect an upward revision in commodity prices based on this 6% rise in TMS. We can expect a rise on commodity prices between Jan 2009 & Oct 2011 or a year or so later, depending on the time lag used, and on when the current global deleveraging finishes, as that would signify the low point in prices. I don't think anyone will know when the deleveraging will cease.
One should realise that what we are witnessing is an old central bank scam, evident in various central bank actions for the past 100 years or more.
The scam is a process, first started by cheap money, and then followed by tight money, and then followed by cheap money. There may be a war in between or a recession/depression. The Austrian School of Economics calls this the Business Cycle, if memory serves me well?
However, the timing control of the release of money is also part of the scam. The first cheap money is usually released quite easily to cover up the bust of a previous bubble, then when the new bubble is well entrenched by this first cheap money, tightening occurs. One must not forget that the Fed was tightening money well into 2007.
This tightening of the money supply has the effect that we are now living through ie. a fall in asset prices across most markets, albeit this fall is enhanced by the massive leverage by various market participants: banks, hedge funds, mututal funds, etc... which forces these participants to deleverage when asset prices fall.
Then the reflation occurs, as it is happening now and for the past year, however, this reflation is only initially done for the banks, and the banks usually aren't lending at this time for various reasons, insolvency being one of them, and they won't lend until asset prices are lowered, as lending into an economy about to enter a recession/depression is certainly bad for the lending business.
When asset prices are close to bottom, especially their competition: gold & silver; tangibles, crude, gass & energy and any other alternative store of wealth, and the various companies that produce these tangibles.
It is at this point that the banks buy up these tangibles & their related business, and once they have had their fill, then the money that has been reflated into the banks, is allowed out to the wider economy, to bubble-ise another sector in the economy. This scam, and variations of it, has been going on a very long time.
It is essentially the arbitrage of the first use of inflated money in a fractional reserve system. In that, those who get to use the newly created money first, has best use of it, and the banks are first users.
I think that shopping for some solid resources, energy, precious metals, & alt. energy businesses between now & december, could be a very good example of value investing.
Believe me, if TMS had not bounced from its bottom when it did and by a 6% margin in 2 years, then I would probably be on Roubini's side, but in light of this evidence, I would have to expect the scenario to be a little different at this stage.
Comment by christina on 1 November 2008:
Nostradamus was right about a lot of things too. But he was also wrong about a lot of things
Comment by Dave on 3 November 2008:
The last few years has seen the central banks trying to avoid a reccession at any cost by keeping interest rates low. This has only served to inflate the various "bubbles" further and intensifying the unavoidable crash.
Given their track record so far I think the next move will be to monetize the debt. If that happens it will result in the next generation of taxpayers being thrown into a form of monetary serfdom.
Comment by Very Interested on 4 November 2008:
The "Prophet of Doom" business is booming! How can I get some of that action?