How Fed ‘Stimulus’ Strengthens Deflation

4 comments
Stimulus has inflated

[The following was posted in the Rick’s Picks forum on Wednesday by a regular contributor who goes by the handle ‘None’.  I am republishing it below because it deserves a wider audience.  RA]

While doubts are rising about central banks actions, there is still residual complacency, lack of awareness of the potential dangers of the current policy path and, more importantly, not enough efforts to articulate a more promising alternative. Central banks purchases of public and private debt titles were certainly justified as an emergency measure to backstop the imploding global credit system at the depth of the panic end 2008 – early 2009, the culmination of 35 years of consistently rising debt loads.

The mistake was to pursue these credit easing policies once the emergency had passed to make them structural and still lasting eight years later. At the Fed, Bernanke took the opportunity to demonstrate the validity of his theory expressed in his famous November 2002 speech “deflation, making sure it doesn’t happen here”. All the measures outlined in the speech have been put into practice. Most of his counterparts around the world followed. And we saw the results of this large-scale real life experiment: after a brief boost in 2010-2011 as newly created money flowed into commodities, inflation quickly fell back to 0% pretty much everywhere. No deleveraging occurred. Instead, global relative debt is higher than in 2007. The theory had been empirically tested … and proven wrong.

Debt Growing into a ‘Killer Wave’

Worse still, monetary creation by central banks (or by commercial banks under policymakers instructions like in China) have only ensured the next deflationary wave. Indeed, by distorting price signals in commodities markets and asset values, and by inciting agents with still strong balance sheet to leverage up, liquidity injections triggered a massive debt-financed investment cycle. Offshore dollar-denominated debt surged by $9.5 Tr since 2009 according to the BIS. China debt has been expanding at nearly +20%, nearly twice as fast as nominal economic activity. Many countries have been experiencing massive credit-driven real estate bubble (Australia, Canada, China, Norway, Sweden, etc.). In the US, the shale oil sector saw a credit-financed gold rush. Seven years later, developed markets have not deleveraged while many emerging markets have materially leveraged up. Global relative debt is higher than in 2007. Confronted to falling commodity prices and/or to rising dollar or dollar-pegged debts, these borrowers are now under financial stress. Rising credit risks triggered the beginning of a worldwide credit contraction during 2015, defeating previous central banks actions and forcing them to renew and increase their interventions. The snake is biting its tail, going nowhere.

The actual outcome is the opposite of what was predicted: “deflation, making sure it happens everywhere”. Central banks across the world are now locked in an headlong flight with no exit and in a conflictual dynamic of competitive devaluations to try to export deflationary forces they themselves exacerbated to trading partners. While several trillions of debt securities are yielding negative interest rates and exchange rates are jumping all over the place, global trade has barely grown since 2012, global PMIs have been lackluster and under-employment has barely receded from socially destabilizing levels. Currently, the global punching ball is the US as dollar strength means the US is shouldering most of the rest of the world excess debt despite being the main current account deficit country. At the time when the Fed would like to normalize monetary policy, the fundamental contradiction between the use of the USD as domestic currency of the US and as main international reserve instrument is plainly visible, though nobody has apparently much to say about that.

‘A Delicate Situation’

All this delicate situation for having refused to consider – for whatever reasons – the root causes of the problem, which is the imbalanced international trade and monetary system, whereby cross exchange rates are far from levels consistent with cross trade balances equilibrium, thereby enabling salary arbitrage eroding global demand and enabling duplication of credit between deficit and surplus countries feeding the global debt snowball, the two combining into a growing deflationary force weakening the real economic growth trend and increasing the debt load.

Those who “saved the world” in 2008 have been unable, for lack of a correct diagnostic, to formulate a structural policy agenda to deal with the root causes of the problem beyond emergency measures. The G20 has proven itself useless, ruling out any change to the global trade and monetary system on its very first meeting. As a result, policymakers are now leading the world into a dangerous impasse where the same unsolved problem is defeating their increasingly destabilizing policies. All that in a rather strange atmosphere of falling credibility, residual complacency, and increasing rejection of established political parties.

Restoring the Old System

A much more promising path would be to restore balance in the international trade and monetary system so as to make international free trade mutually beneficial and so as to avoid duplication of credit between debtor and creditor countries arising from large and persistent current account imbalances. This was the secret of the “Thirty Glorious” after WWII, incorporating the lessons from the mistakes made post WWI which led to the unbalanced growth of the 1920’s onto the Great Depression. The diagnostic is easy to establish, though rarely acknowledged. It is only a matter of willingness to restore and improve such a balanced system. This is of course what is expected from policymakers : to design and maintain a functional economic and financial system. To do “whatever it takes” to perpetuate a dysfunctional system can only lead to a loss of credibility. This is where we are now. Which means time is running short.

  • John Jay March 18, 2016, 11:12 am

    Rick,

    Yes, imagine all the missed opportunities for a Untited States of Europe, even starting after the Franco/Prussian War of 1870.

    Even if that wasn’t possible, the Royal Cousins could have agreed to divide the planet into spheres of influence, instead of launching a new 100 Years War that killed off the best and the brightest until now, finally, it will “End not with a bang, but a whimper”.

    As for comparing Trump, the 1%, and you and I to movie characters, it just fits, doesn’t it?

    Let me close with another wonderful piece of dialog from “Deliverance”.

    Drew: “It is a matter of the Law.”

    Lewis: “The Law!!! What Law? Where’s the Law Drew?”

    Where’s the Law Drew?

    That’s a very good question, isn’t it!

  • John Jay March 17, 2016, 11:28 pm

    Well, taking a global view, I see the entire world political, social, and financial order imploding.
    Every day, more and more.

    My arguments:

    Europe is finished, and the Muslim invasion is the final nail in the coffin.
    WWI destroyed half of Europes Alpha Males.
    WWII destroyed the other half.
    Western Europe is in its’ death throes.
    But some how, Eastern Europe, in spite of WWI and WWII, still has Common Sense.
    Go figure!

    Central and South America are almost, but not quite as bad off as Europe.
    Brazil, Venezuela, et al.
    Res ipsa loquitur.

    Asia?
    Who the hell knows for sure, but it does not look stable to me.

    Ah, and now, the good old USA!
    I will revisit my Port Royal view.
    Southern California has seen an enormous flood of Chinese people and money fleeing China.
    Florida has the same deal, only with the wealthy from South America.
    As Europe faces 415 AD for a second time, I expect to see wealthy Europeans fleeing here en masse.
    For the average American that leaves two choices:
    Greenwich, or the Ghetto!

    Finally, a quick explanation of the Trump popularity amongst the US masses, and his hatred amongst the 1%.

    The masses, after being told to “Squeal like a pig” for the last 50 years, see Trump as Lewis with his bow and arrow coming to the rescue!

    And the 1% see Trump as Colonel Kurtz and his Montagnard Army, who can’t be allowed to upset their elaborate plans!

    I rest my case!

    &&&&&&

    Great post, JJ! Thanks. Your point ascribing Europe’s spinelessness to the loss of alpha males during WWI & II is the first time I’ve ever heard this, but it seems logical. RA

  • Vashishta54 March 17, 2016, 10:46 pm

    The “Thirty Glorious” refers to the Bretton Woods agreements during the post WW2 era, the IMF and The General Agreement on Tariffs and Trade which when combined together created a functional international framework for economic activity and international trade. Studies have shown that between 1953 and 1973 world trade and world GNP grew on average 7.5% and 4.7% annually. “None” is an astute observer with a long range vision. Many thanks.

    &&&&&&

    There is no refuting the law of comparative advantage, which holds that we all benefit economically when we allow the lowest-cost provider to supply any good or service. But Government, in sundry ways, either directly or indirectly, has turned this benefit on its head. Tariffs and currency manipulation are an obvious source of dysfunction. But tax policies have played an even larger role. If Americans had invested more in manufacturing instead of pissing away most of their would-be savings on consumption, and in getting ‘rich’ off inflated home values, we would be producing steel and automobiles at prices competitive with Korea and China.

    Even then, however, we would need to have had fiscal policies in place — i.e. no taxes on capital gains or on corporate income — that would have incentivized investment to flow more naturally toward innovations in energy, healthcare and information technology that we could sell to the rest of the world. We do lead in these areas, but not as strongly as we might had there been more tax incentives to favor capital investment over consumption.

    Unfortunately, it is probably too late to recover, since our best and brightest companies have been giving away their most valuable secrets to, or have allowed them to be stolen by, the likes of China and Russia. RA

  • Colinvest March 17, 2016, 10:01 pm

    Excellent article by “none”, although the language used could have come from the Fed itself! The monthly chart says it all, and indicates a first move to support around the 2007/08 highs around 14,000. Once that happens, collateral will have been eroded, with corresponding gearing imploding as one financial institution after another vies for the title of “New Lehman” under the duress of Third Party contagion of negative returns. His last sentence sums it all up — “Which means time is running short” — indicating that short positions will ensure secure returns in the months ahead. The destabilising “X-Factor” hasn’t even entered the equation, and remains ‘classified’ lest global panic expose the current charade. We are living on borrowed time, so we must savour every moment of our excesses, before bunkering-down.