Grantham: Deflation has won on points
Well, I, for one, am more or less willing to throw in the towel on behalf of Inflation. For the near future at least, his adversary in the blue trunks, Deflation, has won on points. Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. Even three months ago, I was studiously trying to stay neutral on the “flation” issue, as my colleague Ben Inker calls it. I, like many, was mesmerized by the potential for money supply to increase dramatically, given the floods of government debt used in the bailout. But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or flat prices are the prospect for the immediate future.
Yep, that’s exactly it, isn’t it? Deflation is winning. This passage is how Jeremy Grantham begins his latest Quarterly Letter. In describing this Battle Royale between inflation and deflation, in June of 2009 I said Central banks will face a Scylla and Charybdis flation challenge for years. My thinking was the deflationary forces of deleveraging would be counteracted by the inflationary forces of monetary and fiscal stimulus for years to come.
However, as 2009 progressed, I started to see the macro picture differently. I certainly developed "bailout fatigue" myself. However, as I expressed it in November, so had everyone else. The money printing, liquidity programs, bailouts, the record bonuses, the lack of credit availability combined with the unemployment, foreclosures, and the acrimony over health care to discredit stimulus.
[P]eople were swayed toward Big Government because of a deep downturn and financial crisis but crony capitalism and bailout fatigue have discredited Big Government. And now we are witnessing a war about the proper role of government. Perceptions of recent policy decisions remain top of mind in the process.
Here we are two-and-a-half years after the recession began with underemployment in the high teens, record foreclosures, contracting credit, a slowing economy and fears of a double dip. Yet, a lot of people are talking about austerity – as if that wouldn’t tank the economy. Some people forget, even Obama was talking this way in November. It was right then I knew that deflation was going to win.
So why do we see the sudden switch to austerity mode and the attendant slowing it will induce? The deflationary forces are winning because people have had their fill of the policy choices that have led us to where we are today. I agree with Krugman that Clive Crook’s comments on this are misguided. Obama has overpromised and undelivered. It’s as simple as that.
You have what I would call crony capitalism on the one side with bailouts and record bonuses all around for bankers. Juxtaposed are massive budget deficits and a still weak economy and employment outlook. No one is going to double down on that strategy. It’s a failure – and I would argue that it is because there was insufficient stimulus. All of this was predictable from the word go.
Where do I stand on these issues now? The euro zone is bound by the euro gold-standard strictures which force a deflationary economic policy onto the euro nations. So austerity-lite is a minimum requirement all around. And while the Germans claim they have the least austere budget in the euro zone for 2010, they too should be afraid of running budget deficits of 5% of GDP given their near 80% government debt to GDP.
In the UK and the US, government has more leeway. I don’t support austerity. I would like to see more stimulus but I can’t support a lot more stimulus if the goal is to maintain high levels of resource allocation in financial services. Where are the new jobs going to come from if the government is propping up the housing sector? Where are new jobs going to come from if credit availability is weak as the government aides and abets banks in hiding losses? Trying to prop up malinvestment only lengthens the downturn.
Picture this: Ben Bernanke announces a plan to buy up $2 trillion more in mortgage-backed securities. Maybe he buys some municipal bonds as well. We extend unemployment benefits, keep interest rates low and the yield curve steep. Meanwhile the Obama administration gets trillions of dollars in new money for shovel ready projects? Now, fast forward to early 2012: what do house prices look like? How about bank balance sheets? How about private sector debt loads?
There would still be a too many people employed in the financial sector. House prices would be above median levels on long-term price to income charts. And I guarantee you there would be little household sector deleveraging. How is early 2012 then any better than mid-2010 on any of the longer term metrics we care about?
I’ll answer that. Unemployment would come down I bet and bank balance sheets would be marginally better. But household debt levels would still be large and bank balance sheets would be relatively weak on a mark-to-market basis. The demand for and availability of credit would therefore be weak. This is a muddle through scenario at best. Would we be closer to our goal of reduced private sector leverage? Yes. The cost of that deleveraging would be much greater government debt. In essence, we would have socialized the losses which would accrue to debtors and their creditors in a more deflationary scenario. Deficits might ease with recovery but they would still be large. And this would continue for a number of years more.
I don’t think you can add huge amounts of stimulus to an economy without significant malinvestment which would retard longer-term growth rates. This is what I said about eastern Germany. I still think having a 200% debt to GDP ratio like Japan is a bad thing. And I don’t think we can close the output gap without increasing the debt to GDP ratio to Greek levels. I also don’t think the potential growth rate in an ageing society will be sufficient to ever reduce the debt to GDP ratio without inflation boosting nominal growth rates. Where does that leave us then?
I think it leaves us in a situation where deflationary forces prevail for the medium-term. Grantham says deflation has won on points. Radio Raheem would say "Left hand inflation KO’ed by deflation."
And I think they will continue to win until the output gap closes, when the left hand will be back.
Source: Summer Essays (registration required) – GMO Quarterly Letter, July 2010, Jeremy Grantham