28 November 2008

the case for deflation - why stimulus spending won't help

At first blush, it would appear as if all the government bailouts and stimulus (to address the financial crisis) will wind up massively increasing inflation. After all, with government putting trillions of new dollars into the economy, how can this do anything other than to cause prices to rise and the US dollar to drop in value?

Unfortunately, this seemingly logically interpretation of government spending is flawed. Rather the causing inflation, government spending will contribute to the exact opposite result. An increase in national debt is DEFLATIONARY. It sucks money out of the rest of the economy, causing asset prices to decline even more (i.e. “deflation”).

The key thing to keep in mind is that debt is deflationary, and is not the same thing as printing money. At some point debt has to be repaid. Sure, increasing debt can also increase the money supply, but it also will lead to a contraction as well (i.e. when the debt is repaid). If the government was actually just “printing” money, instead of borrowing it, then I would agree we might be headed to a period of high inflation. But this is not what is happening.

Also, it is important to keep in mind that all this increased government spending (and the debt to back it) is a drop in the bucket when compared to the amount of debt creation which has VANISHED from the private sector. The global credit markets have been operating in the tens of trillions of dollars range for years ($40 to $60 trillion per annum), and this spigot of debt creation has virtually ceased to exist over the last 10 months. All the increased stimulus/spending of the world’s governments doesn’t come close to making the difference.
Consequently, this leads us towards deflation, since the velocity of money is contracting at a furious rate.

Even the people who are railing on banks to start lending more completely miss the point. As a matter of fact, the world’s banks have INCREASED their lending dramatically this year. The problem, however, is that it just doesn’t make up for the loss of the private credit markets. But this phenomenon is very opaque, and difficult for people to understand.

A given bank may actually be initiating a lower total volume of loans this year, but a FAR higher percentage of those loans are staying on the bank’s books. Over the last 20 years banks have begun to HEAVILY rely on the private credit markets to goose their lending capacity. A bank may lend $10 million to a company wanting to expand it’s manufacturing capacity, and then turn right around and re-sell that loan to mutual funds on the private market. In this way the bank becomes little more than a retailer, making a commission for the initial under-writing and on-going servicing of the loan. The actual loan itself, however, is owned by a 3rd party, and isn’t on the bank’s books at all.

Many companies became reliant on going directly to the private credit markets themselves, and side-stepping banks altogether, to get credit. Many firms became reliant on constantly selling their receivables as asset backed securities, and continuously rolling over that debt with new receivables every month. Unfortunately, this has almost completely ceased to happen over the last year, driving borrowing costs for these firms up enormously as they now have to go directly through banks (which always charged higher rates than the private markets).

In the last year, however, banks have had to place almost all the loans they write on their own books. The total loans the banks have on their books area increasing dramatically, but the actual value of the loans that they issue is down.

This is why we are facing deflation. The global credit markets are MASSIVE, and the virtual disappearance of them is a problem that no amount of stimulus or government spending can replace. The US government could undertake another $5 trillion in stimulus spending and it still won’t help. The Japanese government attempted to spur inflation with massive stimulus during the '90s, but that clearly didn't work either.

It’s possible the world’s governments could “print” money to stoke inflationary fires again, but doing so would pretty much destroy a national currency overnight. The days when governments can print money for months, or years, before the negative impacts are felt are over. Technology ensures that the markets will know when governments start printing and act swiftly.

The printing press (and electronic equivalent) is similar to having an arsenal of nuclear missiles during the cold war. In theory these missiles could be launched in a war, but the reality is that no leader will ever be willing to press the button on global thermonuclear war.