The inflation-deflation debate

My last two posts may leave the impression that I believe inflation to be the greatest concern facing the global economy. I certainly believe it is a problem but not the primary one. Deflation is the looming concern and much more problematic.

For more than a decade, the global economy had become too dependent on an over-extended U.S. consumer to do the heavy lifting of global demand growth. After the Tech Wreck in 2000, this game should have come to an end. The U.S. fiscal position was decent and banks and other financial institutions’ credit-making capacity was largely unaffected by the stock market bubble. Yes, the current account deficit in the U.S. was large, U.S. households were indebted, and U.S. companies were as well. But, overall, the U.S. was in the best macro-economic position it had been in for decades. The time was ripe for a retrenchment.

But, Alan Greenspan decided to double down on the U.S. consumer, especially after 9/11. The result was the largest housing bubble and the largest credit bubble the world has ever seen. The Bush Administration did their part to keep the gravy train going by turning a fiscal surplus into a massive fiscal deficit.

So, here we are in 2008 with many of the same problems, and more. The U.S. consumer is more indebted than ever. The U.S. current account deficit is near 6% of GDP. On the plus side, corporate balance sheets look much better today than in 2000-2001. However, add to the problems, a large federal deficit, an impending shortfall in state and local tax revenue, an impending deficit in Social Security receipts as baby boomers retire and the mother of all credit crunches and things are much worse today than in 2000. Obviously, doubling down was a bad idea.

All of this says the U.S. economy is fragile and needs life support to avoid a deflationary spiral. I disagree vigorously with the Fed policy remedy to address this concern, but, at a minimum, I understand they are at least on the case. The problem is inflation. The Fed would have a free hand to do what’s necessary to battle deflation. The U.S. Government would as well. But, with consumer price inflation at 5%, the Fed is constrained and this makes their job tougher.

I certainly feel inflation needs to be dealt with immediately before consumer price expectations become unanchored. But, let’s not lose perspective of where we are. The global financial system is at risk as credit is now contracting, sucking the life blood out of the global economy. This credit deflation is the risk that must be foremost in policymakers’ minds. It is the deflation risk that is the one to be reckoned with down the line.