In the world of finance (besides guessing where the stock market will end up this year), a topic that dominates front page news is the issue of inflation or deflation. The financial world is divided over this issue with the deflationist dominating the debate.
The Deflation Argument
The deflationists cite the historical levels of debt overhanging the economy and the enormous asset bubbles in stocks, bonds, mortgages and real estate. In a levered economy and financial market any increase in interest rates would cause the whole debt bubble to implode. This would lead to a deflationary spiral as debts are liquidated contracting the supply of money.
In an economy and financial world, this leveraged rise in interest rates would devastate the financial markets and the economy leading us back into a recession. Rising interest rates would also usher in the next leg of the secular bear market which has yet to begin. Collapsing asset prices, debt defaults, and bankruptcies would surely contract the money supply and this would be deflationary.
Another argument made on the deflationary side of the debate is the world is awash in excess capacity. Global competition is keeping a lid on prices, so therefore we live in an environment whereby prices continue to decline. Here again the same mistake regarding prices as a symptom rather than a root cause obscures the deflation debate as it does the debate over inflation.
Defining Deflation
I refer to Webster’s definition of deflation: a lessening of the amount of money in circulation, resulting in a relatively sharp and sudden rise in its value and a fall in prices. As mentioned in a previous essay, inflation and deflation are both sides of the same coin. They are both a monetary phenomenon. A rise or fall in price is more of a symptom than it is a cause. Once again we have confusion here regarding monetary terms with deflation usually thought to be synonymous with falling prices. Historical evidence points to falling prices as a consequence of productivity and economic progress that result from increasing production and the supply of goods and services which lead to lower prices.
If a given good or widget can be produced in greater quantity resulting in lower prices, this is a perfect example of economic progress and productivity that results in goods being manufactured at a lower cost. What needs to be distinguished here is that there are two primary drivers of lower prices. The first driver is an increase in production and the supply of goods that result in lower prices as a result of efficiencies achieved in manufacturing. This is economic progress not deflation. The other driver of lower prices is a decrease in the quantity of money and/or volume of spending in the economic system. The commonality that both drivers share is falling prices; one is economic progress, while the other is deflation.
What Brings Deflation?
What brings about deflation is a contraction in the money supply. This reduction in the amount of money in circulation or the volume of spending in the economic system causes prices to fall. With less money circulating within the economy there is less money that can be earned, and thus there is less money available for the repayment of debt. This leads to monetary contraction and is the only real form of deflation that exists. Falling prices by themselves aren’t deflationary. As the supply of money contracts, falling prices become the cure. The drop in prices is what enables an economic system to be able to buy the same amount of goods and services as before the collapse in the supply of money. Therefore falling prices are always positive as they enable a reduced quantity of money and volume of spending to buy the same amount of goods as when the supply of money and spending was much larger. It is not the general level of prices that makes debt liquidation difficult, but the supply of money that is available to pay that debt.
There are a number of ways in which governments and their central banks can confront a collapsing money supply. The government can come in and monetize debts and take them over. Government spending can be substituted for consumer spending. There are other means which government can combat a shrinking money supply. Today’s financial system has also become more sophisticated by offering numerous ways in which the supply of money and credit can enter the system. Government sponsored entities (GSEs), the securitization of debt and the expansion and of money market funds are just a few of the ways that money and credit can be expanded outside the purview of the Fed or the nation's banking system. The Euro-dollar market is another.
Deflationary Storm Front Closing In
Within the next 12-18 months I fully expect a deflationary storm front to hit the financial system and the economy. The debt overhang will begin to implode with rising interest rates causing financial asset prices and real estate prices to fall. This will be deflationary. What the Fed and the government will do to counteract this deflationary storm front will be to expand the supply of money and credit within the system and the amount of money spent within the economy. This will bring about inflationary forces that will counteract the prevailing deflationary headwinds of a collapsing financial system.
As the financial markets begin to crater with an accompanying rise in bankruptcies and defaults, the government and the Federal Reserve will move with a use of force with every tool at its disposal. The result is that monetary and fiscal stimulus will accelerate. Listed below are seven inflationary headwinds that will confront a deflationary headwind in the financial markets and the economy.
1) Lax Monetary Policy
The first headwind is that monetary policy will remain lax. The Fed will keep interest rates low and may even drive rates lower if the economy doesn’t improve or the employment picture weakens. There is simply too much debt in the system now for the Fed to tighten interest rates unless it is forced to do so by the currency markets. If rates rise, the Fed brings about the very deflationary forces it has been trying to combat. A sharp rise in rates would lead to a reversal of the “carry trade” which would cause the bank and hedge fund community to unwind their long bond positions causing rates to rise even further.....
2) Expanding Budget Deficits & 3) Expanding Government Spending
Today the majority of the government’s budget is made up of non-discretionary spending. Entitlements such as Social Security, Medicare, the Department of Health & Human Services, and interest on the debt make up the bulk of the government's budget aside from defense spending. We are a nation at war, so I don’t expect the defense budget to decrease as I will show in just a moment. The point here is that the majority of the government’s budget is untouchable. It will continue to rise at a rate faster than the economy and there are very few politicians in Washington who have the courage to tell voters that we are issuing checks that we don’t have the means to pay for. In recent testimony on the budget last week, Alan Greenspan warned congressmen of the coming Social Security problem. One congressman responded honestly by stating that there wasn’t a single congressman on the committee from either party who would attempt to cut any of today’s popular entitlements. Entitlements are simply untouchable.
Shortly, in the year 2008, the first batch of baby boomers will enter into retirement. They will begin collecting Social Security benefits putting further strains on the government’s budget. The problem for the government is there is no trust fund to use to pay these benefits. The money has all been spent...................
4) A Falling Currency
As a result of America’s twin deficits (trade deficit and budget deficit) the dollar will head lower, much lower. The loss of 28% of its value since 2001 has done very little to address the nation's trade imbalance which is structural. The recent trade deficit figures indicate that we continue to import more capital goods into this country, while our exports of capital goods continue to decline despite a falling dollar. We are also importing more oil and paying a higher price for that oil. The trade deficit is structural and will continue to climb until the dollar loses half of its present value. When that happens, Americans will no longer be able to afford to buy foreign cars and electronics. But we will still be importing capital goods that we no longer manufacturer here and we will still be dependent on foreign oil to run our economy. That dependence will only deepen during the twilight of the oil era.
A falling currency translates into higher prices for the things we import into this country. While higher prices may eventually weaken demand for foreign made goods, it will not get rid of our need for basic necessities. If we burn more oil and natural gas, we will simply have to pay what the market dictates. We are no longer in control of our energy future. In fact we are looking head on at another energy crisis or series of energy crises this decade..................
5) War and an Expanding Military Budget
The next war has just begun. The era of peace and stability that we have come to know is over. We are entering an era in history, not of peaceful economic competition between nations, but a time of warfare between tribes, ethnic groups, religions, and economic systems. This war will be unlike other wars. There will be no major battlefields. Armies won’t line up to face each other and do battle. The 21st century war will be taken to the cities and suburbs as well as the skies. It will be fought with car bombs, small explosives, light armaments, and surveillance. It will be a war of men killing each other at close quarters. Battles will be replaced by skirmishes, bombings, massacres and genocide. It will be fought by regular armies against small groups known as terrorists, guerrillas, bandits and robbers. For the first time in the West, war will become personal. It won’t be watched from afar, but will be experienced first hand as immediate participants, victims or targets. In this new war, age and sex will be meaningless for many of its warriors will have little regard for life......
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Although I wrote these words over two years ago they are just as relevant today. We are a nation at war and our military budget reflects this war. The military budget will expand by 7% next year to $401.7 billion. It has risen from $$297 billion in 2001 to this years $375 billion. As shown in the table below, outlays for military spending will rise to $487.7 billion by the end of the decade. These outlays do not include emergency and non-emergency spending for the War in Iraq which will added another $72 billion to the military budget for 2003 and will add another $66 billion to the military budget this year.
Wars are inflationary. Why? The government spends more money which therefore does not contribute to productivity or expansion of the supply of goods and services within the economy. Wars also consume resources which means the price of tangible goods keep going up and will rise even further.
6) Soaring Oil and Commodity Prices
We are entering an era of energy scarcity, a time when the price of energy will rise relentlessly. There will be times or brief periods when the price of energy will recede, but only for brief moments of time. The western world whose economies run on oil will experience rising energy prices throughout this and the next decade as major oil fields go into decline globally. Falling oil discovery rates will result in further industry consolidation as companies rely more on new technology to harvest oil from existing fields. The energy markets will be characterized by the fact that we will be finding less and consuming more. The result will be even higher prices for the energy we consume. Western economies run on oil. We use it as fertilizer to grow our crops and power the tractors that plow the fields. We use it as a source of heat and to cool our homes as temperatures change. We use oil in all forms of transportation from the ships that carry crude across the oceans, to the trucks that transport goods to factories and stores, and a means of transportation to and from work or a leisurely drive in the country. Oil is used as fuel to carry passengers in planes around the world. Our modern world runs on oil.
The simple fact is that we are running out of cheap oil and there are no remedies to immediately replace it. All present projections for increasing demand assume that that increase in demand will be met by growing surpluses coming out of OPEC. Specifically, when the world refers to OPEC they really mean Saudi Arabia. Saudi oil has become the plug factor that makes up for supply deficits in the rest of the world. However, the assumptions of abundant Saudi oil have not been verified for a long, long time. Experts now believe that the kingdom’s oil fields are now in decline....
7) Protectionism
As each nation struggles to keep its economy afloat, its politicians are adopting protectionist's measures to gain an up-leg on its competitors. Not only are protectionist’s drums beating loudly in the halls of government, but also on the campaign trail. Calls for tariffs are being put into action here in the U.S. and overseas. Today the European Union imposed trade sanctions on U.S. exports in a dispute over export tax breaks. The European Union will impose a 5% duty on selected goods such as jewelry. The 5% duty will rise by 1% a month to reach $315 million by the end of this year.
Last year President Bush imposed tariffs on steel. On the campaign trail this year all of the candidates are talking about trade sanctions. Protectionism is back in vogue. Politicians aren’t just talking about it--they are acting. Tariffs, trade sanctions or currency debasements are being enacted or carried out as official policy with governments around the globe. Each nation is resorting to a “beggar thy neighbor policy” reminiscent of the trade wars of the 1930s. The European statesman Fredrick Bastiat once remarked, "when goods don’t cross borders, armies do.”
Trade wars, currency debasement, tariffs and protectionists measures are inflationary. That seems to be the direction the world is heading. Like the 1930s, these trade conflicts will lead to general conflicts, which left unresolved will lead to war. War by its very nature is inflationary.
In his book “The Great Wave”, historian David Hackett Fischer concluded that the world was living in the late stages of a very long price-revolution. The author felt we had now arrived at a critical stage, a time when these processes accelerate becoming part of a global process. Hackett acknowledges that in time a free market will correct all price distortions. But in between this time, historical equilibriums are more common. Throughout the passages of history, equilibrium has been the exception rather than the rule.
O artigo como já devem ter percebido, é um bocado longo :-) e vem acompannhado de gráficos e ilustrações que ajudam à compreensão do texto, a leitura deste excertos não substitui, nem por sombras :-), a leitura integral deste artigo em: Collision Course, The Perfect Financial Storm, por Jim Puplava.
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