Monday, November 03, 2008

Deflation: A new threat

Does the rate cut matter? We know that 1% fed funds isn't making mortgage rates lower, or spurring banks to lend. So what's the point? Is the Fed pushing on a string? Are they out of bullets?

I think too much of the commentary has been focused on the impact of fed funds on the stock market and/or the lending markets near term. There has also been way too much debate on whether the Fed's actions will "work" or "not work" in terms of averting a recession. The Fed isn't trying to revive the stock market nor is it trying to avert a recession. Those that continue to think in these terms will continue to misunderstand the market for the next two years.

The Fed is currently focused on deflation. They may not have made direct mention of this in their recent post-meeting press release, but deflation is the Fed's ultimate concern. Right now we have a weak economy which is headed for a recession. Nothing can stop that now. The tail risk here is another Great Depression. And what would bring about another Depression?

Here's what Milton Friedman has to say. "I think there is universal agreement within the economics profession that the decline - the sharp decline in the quantity of money played a very major role in producing the Great Depression."

Friedman believed very strongly that a proper reaction by the Fed in 1930 would have prevented the Depression. The deleveraging of our economy will result in a contraction in the money supply, all else being equal. In the recent past, the rapid expansion of credit has created huge amounts of spending power. This spending power is now being removed much faster than it was created. On top of that, the massive loss of consumer wealth, both from housing and from equity markets, will force individuals to increase their savings rate to fund large ticket purchases and long-term financial needs. A contraction in the money supply will result in deflation.

So what does Ben Bernanke think of the Fed's culpability in causing the Depression? At Milton Friedman's 90th birthday, Bernanke said, "Regarding the Great Depression. You're right, we [the Fed] did it. We're very sorry. But thanks to you, we won't do it again." That's all you need to know when thinking about the Fed's playbook for the next year or two. Bernanke will fight deflation with everything he's got. The only lower bound on fed funds will be zero. Here is a quote from Bernanke in 2002. "As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken."

He goes on to say that currency only has value because it has a limited supply. If the problem is that the currency is overvalued (i.e., the currency buys too many goods), the solution is simple: increase the supply. From the same speech: "But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

We may have a long way to go before we are literally printing money. But the fact that Bernanke would even mention such a thing shos the kind of resolve the Fed has in fighting deflation.

So what's the trade? First, you need to revise your thinking about the impact of ballooning government debt on the economy. Normally deficit spending results is both inflationary and negative for the dollar. In this case, the government debt is mostly going to offset a rapid decline in private leverage. Thus the increase in debt will not necessarily cause inflation or a devaluation of the dollar, but rather alleviate the deflationary impact of deleveraging.

Second, forget the idea that there is some natural lower bound on interest rates. It is easy to look at 2-year Treasury notes at 1.5% and scoff that rates simply can't go lower. But depending on how effective the Fed is in fighting deflation, rates could keep falling from here.

Finally, the odds are good that the Fed will succeed in preventing sustained deflation, simply because they have such powerful tools at their disposal. But the more unconventional means they employ to fight deflation, the more difficult it will be to control the outcome. In other words, an aggressive fight against deflation may eventually result in more volatile prices in the future.


Vijay said...

Friedman was wrong. There is NOT universal agreement in the economics profession. Read this, this, and .

We are now witnessing essentially the moneterist's playbook on how to approach a Depression like scenario. It was also tried in Japan and failed there. It will fail here too. The Austrian school of economics explained why these deflations come about first in Mises' opus The Theory of Money and Credit, yet this text is hardly known among mainstream economists, who continue to peddle their astrological theories.

Vijay said...

this is the third link I meant to post

Accrued Interest said...


I'll admit that there are economists that disagree about the Depression. But I completely disagree that we're following the same path as Japan. Japan refused to admit deflation was their problem until the mid 90's. Read Krugman's work on this subject. You know, before he became a political hack.

viking said...

treasuries next year: a lot more supply, a lot less demand

Bernanke's printing press comments assume dollar hegemony

That's no longer a sure thing

Friedman is wrong

No free lunch

lineup32 said...

Hindsight is 20/20 except with the GD seems to be plenty of disagreement on the cause/cure.
In the here and now I like your analysis given the level of debt/credit/wealth destruction but our models don't account for many of the economic forces at work such as manufacturing automation, generational spending/lifestyle and of course a workable economic wage based on productive work rather then financial illusion.
While we are not Japan our RE market and other inflated financial assets that suddenly cannot mark to market bear a striking similiarity to many of the problems faced by Japan.
For better or worse we have kicked the ball to the Fed and expect them to understand the problem and use their powers to right the ship, which as you suggest may lead to a positive outcome but they havn't shared their economic models with us nor any data to support their view, would be nice to know what the plan is all about considering the impact on all our lives.

Daniel Newby said...

While Vijay is correct about the improved steady state stability of Austrian maturity-matched banking, that does not address the immediate task of unwinding the large overhang of bad debt. Simply deleveraging to the 15:1 level overnight would probably precipitate the Great Depression II.

So in that sense Bernanke is doing the right thing. My worry is that I see no serious reform of the regulatory faults that blew the credit bubble. If the Fed continues to trustingly hand out cash, the bankrupt companies will eventually realize that they have nothing to lose by leveraging back up.

qadi said...

The economy needs risk-free returns for lending to begin anew.

This would be large-cap P3 projects, etc, backstopped by the Treasury. Obama said he'll do this.

Risk-free returns will induce inflation, not swaps etc.

Accrued Interest said...

I think flooding the system with dollars is the right thing to do, but it doesn't "solve" the problem. Merely prevent bigger problems.

Daniel: I'm worried that we've essentially put the government in charge of selecting "good" from "bad" banks, and I have zero confidence the government can effectively make that differentiation.

We're making capital injections into "good" banks. But what exactly constitutes a good bank? Alright, Wells Fargo is good and WaMu was bad. But not all the differentiations are going to be so stark.

When I say that I think flooding the system with dollars and bailing out banks is the right thing, let me be clear... I'm really angry that its come to this. It completely sucks. But this is where we are and the world we're dealing with.

TimingLogic said...

I have to giggle at all of the hypotheses regarding deflation. How can economists get this so wrong for so long. It's like a lie that continues to growth in girth as it circles with world re Mark Twain. Deflationary views are all taken from the view of an economist. That is mistake number one. Monetarists are completely wrong about the GD. And, current Austrians are wrong that Monetarists are completely wrong about money & debt.

The reality is deflation is not a monetary phenomenon. The monetary phenomenon is a symptom of deflation not the cause. And, Krugman is wrong about Japan. I have studied Japan extensively and anyone who believes the BOJ did not act until it is too late or failed on some level is highly erroneous in their conclusions.

Those who understand deflation know that Japan's deflation was signaling a future deflation in the US. It's coming and there is nothing anyone can do to stop it. That includes printing money. The Fed is not going to print money in the sense that they completely disregard sterilization so we could never see some type of Weimar outcome like so many clowns who know nothing about deflation espouse.

Deflation doesn't mean we are going to have a depression but we are likely to come too close to the edge to determine what this will be in hindsight. And, as a result of this cycle, Monetarists will need to find a new theory. The dismal science clearly will become even more dismal as a result of their faith in inductivism/observationalism.

Salmo Trutta said...

During the Great Depression, the FED’s structural problems caused the commercial banking system's excess reserves to be quickly wiped out by massive “runs” on the banks (caused the contraction in the money supply).

If failing to make the Federal Reserve a universal system was not enough of a handicap to effective monetary management, the Congress created twelve Federal Reserve Banks. It was not until 1933 that legislation was passed enabling the open market operations of the various banks to be coordinated.

I.e., before 1933 one FRB could be expanding credit, creating bank reserves and laying the foundation for a multiple expansion of money, while another FRB was doing the opposite. Since 1933, all open market operations of the twelve FRBs are executed through the manager of the open market account in the FRB of New York (our Central Bank).

From 1933-1942 the centralization of the open market power was of little consequence. So pervasive was the trauma of the Great Depression, and the lack of what the banks considered “bankable loans”, expansion of reserve bank credit typically led to more excess reserves rather than more loans and money.

At the onset of the Great Depression, Federal Reserve Notes had to have a MINIMUM backing of 40percent “eligible paper” and a MAXIMUM backing of 60 percent “eligible paper”

In 1933 the Federal Reserve Note had to be collateralized by a least 40 percent in GOLD BULLION or COIN, and the remaining collateral had to consist of "eligible" commercial paper, principally TRADE and BANKER's ACCEPTANCES.

The FED neither had sufficient gold nor the banks sufficient discountable “eligible paper” to meet the panic-inspired massive demands of the public for currency.

Hence, bank failures were more than numerous; they would have been virtually universal if Roosevelt had not declared a “bank holiday” in March, 1933.

It was not until 1933 that we began to unshackle our paper money from the numerous and unnecessary restrictions pertaining to its issuance. With the numerous types of paper money in circulation at the time, this would seem to have been a nonproblem.

Here is the list: Gold Certificates, Silver Certificates, National Bank notes, United States notes, Treasury notes of 1980, Federal Reserve Bank notes, and Federal Reserve notes.

With that array of paper money there should have been plenty to meet the liquidity demands placed on the banks by the public. But the volume of each type that could be issued was so circumscribed by restrictions that even the aggregate group could not begin to meet the panic demands of the public.

The first tentative step was to reduce the gold requirement to 25 percent and allow U.S. government obligations to provide the remaining collateral. The framers of the Federal Reserve Act did not believe that the credit of the U.S. government was inferior to that of the Federal Reserve Banks and the short-term commercial paper of business.

One of the pre-conditions the U.S. needed in 1929, was a much larger NATIONAL DEBT, and a willingness on the part of the Congress, the Administration, and the business community to tolerate an adequate expansion of the national debt.

In 1929, the national debt was less than $17 billion, and the banks held only a SMALL proportion of that amount. We needed a LARGER debt and a much more rapidly expanding debt in the 1930's, not only to "prime-the-pump", but to meet the monetary management needs of the FED.

The open market operations of the FED require a depth of market that will enable the FED to buy or sell billions of dollars worth of treasury bills on any given day without deeply disturbing the bill rates.

It seems more than a coincidence, that during the Great Depression, which engulfed the country after 1929, and which remained with us for over a decade, that throughout this entire period there was no overall expansion in total net debt.

At the end of the 30's net debt was actually less than it had been in 1929. Estimates of the Department of Commerce put the net debt figure as of the end of 1939 at $183.2 billion compared with a figure of $190.9 billion as of the end of 1929.

During the 1940-1945 period total real debt expanded by approximately $193.5 billion. Thus in the short space of five years the total cumulative net debt in existence at the end of 1940 was more than doubled. Practically all of this expansion, or $185 billion, was accounted for by the expansion of the Federal Debt.

After 1933, after we had central bank and a coordinated FED credit policy, the FED pumped billions of dollars of reserves into the banks; and nothing happened. There were years during this period when the excess legal reserves held by the member banks were larger than the volume of required reserves.

The exercise of FED policy was likened "to pushing on a string". It was true, as the Keynesians insisted, that monetary policy didn't matter; fiscal policy was everything.

Today the Federal Reserve Note has no legal reserve requirements, and the capacity of the FED to create IBDDs (interbank demand deposits) has no legal limit.

There is only one restriction placed upon its issuance. No Federal Reserve Note can be put into circulation unless there is a prior transaction involving the relinquishing by the public of an equal volume of bank deposits, and an equal diminution of holdings of IBDDs (legal reserves) on deposit with the Federal Reserve District banks.

In other words, the issuance of our paper money contains no inflationary bias. Its issuance does not increase the volume of money. It merely substitutes one form of money for another form.