Forget Inflation, debt deflation is the real threat

It has been my assertion for some time that writedowns and the attendant unraveling of the financial system is the most troubling problem during this credit crisis. This process is deflationary by its very nature because credit contracts. Ambrose Evans-Pritchard at the Telegraph has written a great article highlighting just this fact. His post, entitled “Federal Reserve and ECB are in no mood to save us from the consequences of our debt,” shows that the ECB, the Fed, the BoE and all the other central banks won’t be able to bail us out of this one.

However, commenting on recent hawkishness by ECB chief Jean-Claude Truchet, Evans-Pritchard says:

The ECB demarche is ominous for the rest of us as well. We may be watching a replay of the Bundesbank’s ill-judged rate rise in October 1987, which sent the dollar into a tailspin and triggered the Black Monday crash.

Any tilt to monetary tightening is a dangerous gamble at this delicate juncture. The world is facing an almighty clash between two opposing storm systems.

The West is in the full grip of a debt deflation as years of credit abuse come back to haunt it. The East – loosely speaking – is in the blow-off phase of an inflationary boom. Russia, Ukraine, Vietnam and the Gulf are out of control. China has dithered beyond the point of no return. It is they who have repeated the errors of the 1970s, not the West.

The two camps face radically different problems at this point.

It will take central banking skills of great subtlety to pilot these seas. Slavish adherence to “inflation-targeting” and other such totemism and pseudo-science will ruin us all.
–The Telegraph 9 June 2008

Evans-Pritchard is well known in the British financial community, amongst gold bugs, and in the Austrian economics scene. I recommend his reading highly. However, while I agree with him that deflation is the ultimate concern here, I disagree about interest rates and inflation vigilance.

There is a bubble in commodities right now that is inflationary — but only for the short-term. Long-term, it creates greater downside risk of a deflationary spiral when it pops. We better put the inflation genie back in the bottle or a deflationary spiral is surely more likely.