Submitted by Edward Harrison of the site Credit Writedowns.
Nearly a month ago, back on May 5th, I highlighted some testimony by Federal Reserve Chairman Ben Bernanke before congress in a post labelled, “Bernanke expects recovery later this year". In his testimony, Bernanke used the phrase ‘Scylla and Charybdis’ to describe the Federal Reserve’s policy challenge regarding deflationary and inflationary forces. I would like to highlight this characterization because I believe it goes to the core of the debate as to how the global economy and asset markets will fare over the next 5-10 years. In my view (and apparently in Bernanke’s), both inflationary forces and deflationary forces will be at work for some time to come. This will present policy makers with a problem as the reflation trade comes good, and the resulting policy responses will have serious implications on the medium term outlook for the economy and asset markets.
Deflationary forces
The problem is this: we have just witnessed one of the most serious asset bubbles in history. In fact, I would call the great housing bubble an ‘echo bubble’ that was merely a continuation of the bubble forces that created the technology bubble of the late 1990s. So, the world saw asset price inflation of the most severe kind for over a decade – from the mid 1990s when Alan Greenspan first voiced concern about ‘irrational exuberance"’ to 2007 when the housing bubble imploded. What results from the implosion of such a significant bubble is deflation.
Actually, more crisply put, what results is ‘the D-process,’ an outcome highlighted by Ray Dalio of Bridgewater Associates (see my post "A conversation with Bridgewater Associates’ Ray Dalio" for more detail). This process involves the three D’s of deleveraging, deflation and depression (outlined in my post “We are in depression").
Richard Koo goes further in his book “The Holy Grail of Macro Economics.” Here, he argues that the unwind of great bubbles suffers from what he labels a ‘balance sheet recession.’ In essence, companies go from maximizing profits, as they had done in normal times, to a post-bubble concern of reducing debt. Regardless of how much priming of the pump monetary authorities do, the psychology of debt reduction will limit the effectiveness of monetary policy as a policy tool.
In my view, the catalyst for this change of psychology is the ‘debt revulsion’ that ushers in the panic phase of an asset bubble collapse. (Charles Kindleberger highlights the various stages of a bubble and its implosion in his seminal book “Manias, Panics and Crashes”). In this particular bubble, debt revulsion began post-Lehman Brothers. What we have seen, therefore, is a reduction in leverage and debt as the most leveraged players have gone to the wall. But, more than that, the household sector has gotten religion about debt reduction as the savings rate has increased dramatically since Lehman. In fact, I would argue that companies learned their lesson about debt from the aftermath of the tech bubble. It is the household sector in the U.S. (and the U.K.) which is heavily indebted. Therefore, if the psychology of a balance sheet recession does take form, it will be the household sector leading the charge.
In sum, the psychology after a major bubble is very different than the psychology before its collapse. The post-bubble emphasis becomes debt reduction and savings, making monetary policy ineffective, not because financial institutions are unwilling lenders but because companies and individuals are unwilling borrowers. These are forces to be reckoned with for some to come.
Inflationary forces
Meanwhile, inflation is going to be a problem too. Why? Two principle reasons come to mind: commodity prices and money supply. Now, just yesterday in my most recent post “Kasriel: ‘greater risk for the global economy…is inflation’,” I highlighted Paul Kasriel’s view that there are several inflationary forces, both secular and cyclical which will impinge upon the economy. I want to bear down on just the two forces of commodity prices and money supply.
First, let’s look at money supply. The Federal Reserve and other central banks have been pumping a lot of money into the financial system in an attempt to add reserves to the system and to take on the intermediation role the wider banking system normally serves. Nevertheless, this money is not being lent out and excess reserves are piling up at the Federal Reserve. Last April, there were only $1.8 billion in excess reserves i.e. reserves against which loans were not being made. According to figures just released by the Fed on May 28th, this April that figure has soared to $824.4 billion, a surge of 447 times in one year. If you want to know what is wrong with the American economy, you should start here.
But, what happens when the economy returns to an environment in which those excess reserves start to be lent out? Inflation. And this is an inflation that will not be so easy to control because the Federal Reserve has embarked on a policy of ‘qualitative easing’ by buying up non-treasury assets, transforming its balance sheet from one dominated by treasury assets to one in which Treasury assets are in the minority. So, as the Fed has intervened and bloated its balance sheet, an increasing amount of the assets it has with which to withdraw the excess liquidity in the system is hard to sell.
So, you have a huge amount of excess reserves, hard to sell assets on the Fed’s balance sheet. Add in the fact that the Federal Reserve is going to be loathe to choke off an incipient recovery and you have the makings of inflation when recovery takes hold.
Moreover, there is a rise in commodity prices which is adding inflation to the pipeline. Much of the recent decrease in headline inflation numbers is due to the collapse in commodity prices. But, Copper is near a seven-month high. Oil is near a seven-month high. And all of the agricultural and industrial commodities are taking off again. As China ramps up its economic stimulus, the recent increases in the ISM manufacturing data in the U.S. and elsewhere point to an increasing demand for industrial commodities, and this is inflationary.
In sum, any pickup in the economy is going to be met by a host of inflationary forces. This is one reason that bond yields have been increasing and the spread between the two-year and 10-year U.S. government bond is near a record.
Scylla and Charybdis
So, how do I see this push and pull of deflationary and inflationary forces playing out? There are two outcomes I am looking for.
Outcome Number One
- No policy traction. This is a sluggish muddle-through Japanese scenario where the Richard Koo thesis of the balance sheet recession comes into play. You would see an output gap and below-trend growth for an extended period. Most pundits would say it is the lack of lending that is creating the problem. However, what if it is the lack of borrowing which is at fault? Then, we are going to see no traction from monetary policy.
Outcome Number Two
- Start-Stop economy. I believe Bernanke would prefer this outcome. This is one in which the Federal Reserve allows the economy to recover by keeping interest rates low. The result is a rise in inflation. We could see inflation rising to 3 percent inflation and then to 5 to 7 and 10 percent. An example would be animal spirits coming back in 2010. And leading to 3 percent inflation followed by 7 percent including $100 oil and then interest rate hikes and another recession at which point the deleveraging begins again in earnest. Followed by more easing and on it goes. But, of course, the problem with outcome two is it is unstable and that it invites an aggressive policy response which risks situation one as an ultimate outcome.
Neither of these scenarios is one in which asset markets are likely to benefit, one reason I see the latest uptick in share prices as nothing more than a bear market rally.
Sources
H.3 Aggregate Reserves of Depository Institutions and the Monetary Base, current release – U.S. Federal Reserve website
H.4.1 Factors Affecting Reserve Balances, current release – U.S. Federal Reserve website
Copper Falls From 7-Month High on Speculation Gains Too Rapid – Bloomberg.com
Soybeans Advances to 8-Month High, Corn Gains to 7-Month Peak – Bloomberg.com
Oil Falls From Seven-Month High on Signs OPEC Output Climbing – Bloomberg.com
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I take issue with your analysis on two points.
► First, there is no indication of any deleveraging, at least of any significant degree, going on. We can see this in a graph from a Brad Setser post from yesterday’s NC links:
http://blogs.cfr.org/setser/2009/05/31/more-government-borrowing-doesnt-necessarily-mean-more-total-borrowing/
Business and household borrowing have approached zero, but they have not gone negative. Meanwhile, federal government borrowing has exploded. The combined result is a very slight decrease in overall borrowing. Outstanding debt has decreased only ever so slightly. There has been almost no deleveraging:
(see Fed spreadsheed d3)
C:\Documents and Settings\Owner\Local Settings\Temporary Internet Files\Content.IE5\7DJKP3NO\z1r-2[1].zip
► Second, what if the uptick in commodities is not due to underlying supply and demand fundamentals as you seem to indicate in this statement: “As China ramps up its economic stimulus, the recent increases in the ISM manufacturing data in the U.S. and elsewhere point to an increasing demand for industrial commodities, and this is inflationary.” What if, as I think poster Hugh keeps hammering away at, the recent increase in commodity prices is due to speculation?
I’m not so sure the “change of psychology–the “debt revulsion”–that you speak of has really taken hold. I believe there’s a rather good possibility that the nation is still in speculation mode. Therefore I’m not sure that the bubble has even began to collapse.
DownSouth, fair points. Let me see if I have your interpretation of events right: “animal spirits never died – they are now being re-channeled into commodities again. And deleveraging has not occurred in any meaningful way yet.”
This would support outcome number two, which I see as the likely outcome. Again, outcomenumber two is inherently unstable because it risks hyper-inflation, the Faber thesis. I suspect an aggressive policy response i.e. interest rate hikes will be the likely result. This response would risk a double-dip in which both deleveraging would begin and animal spirits would dissipate.
Where do wages fit in this discussion? I see little to no possibility for wage-inflation kicking into gear.
It seems to me that this is a significant factor in the deflation/inflation debate and the possibility that there could be both. Inflation in commodities but deflation in other consumer space as the wage income simply isn’t there to support the debt needed to make the purchase.
Can you address this in a post?
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Edward,
On the psychological spectrum, with “debt revulsion” on one end and “speculative infection” (this is what you call “animal spirits,” no?) on the other, I’m not sure where we are right now.
Frederick Lewis Allen in Only Yesterday recounts that in the 1920s, in spite of the popping of a nationwide real estate bubble, a “marked recession” and in February, 1928, unemployment “more serious than at any time since immediately after the war,” this did nothing to dampen the speculative fever and the Big Bull Market. (see my comment on todays Links for more detail)
Aaron L. Friedberg in The Weary Titan: Britain and the Experience of Relative Decline 1895-1905 points out a similar phenomenon. Great Britain, “from the 1860s at least,” experienced a negative trade balance and began “living off its capital.” Between 1872 and 1896 was the “Great Depression.” Friedberg concludes that “the beliefs of national leaders are slow to change.” Lord Bolingbroke wrote: “They who are in the sinking scale…do not easily come off from the habitual prejudices of superior wealth, or power, or skill, or courage, nor from the confidence that these prejudices inspire.”
Friedberg cites the work of Kenneth Boulding who speculated that the citizens of a country as a whole may come to share a historical “national image” that extends “backward into a supposedly recorded or perhaps mythological past and forward into an imagined future.” Boulding argues that adjustments to this national image occur “rarely, if at all,” while John Stoessinger asserts that change “is possible only as the consequence of some monumental disaster.” The process of change is “driven by gradual developments in the thinking of ‘change agents,’ middle- and upper-level officials whose views begin to deviate from the norm and who are abile to recive a wider hearing only at moments of intense crisis.”
In Great Britain, the “change agents,” the most promient and strident being colonial secretary Joseph Chamberlain, were not successful in the period 1895-1905 in altering the “national image” of the country. “The consensus (free-trade and laissez-faire dogmatism) that had grown up over the course of the preceding sixty years would not be easily shattered,” Friedberg writes. “Most people probably…believed their country was still the world’s industrial leader and that, under a policy of free trade, it would be able to continue in that role.” Chamberlain’s calls for reform therefore went unheeded.
To give an idea of the spirit of the debate here’s a quote from the reform-minded Chamberlain:
Granted that you are the clearing-house of the world, but are you entirely beyond anxiety as to the permanence of your great position?…Banking is not the creator of our prosperity, but is the creation of it. It is not the cause of our wealth, but it is the consequence of our wealth, and if the industrial energy and development which has been going on for so many years in this country were to be hindered or relaxed, then finance, and all that finance means, will follow to the countries which are more successful than ourselves.~
Charles Ritchie, president of the Board of Trade and later chancellor of the Exchequer, an adamant defender of the status quo and Chamberlain’s principle obstacle to reform, issued this statement:
The solution of the question of how best to develop and increase our competing power is one to which the State can only give limited assistance… What the Government can do is to facilitate the supply of accurate and carefully collected information and in the dischage of this duty…we are somewhat behand-hand.
Edward,
Deleveraging is in progess and attempts to demonstrate that this is not the case ignore the collapse of the shaddow banking system (e.g., Downsouth’s reference to Setser).
There is no sign or prospect of wage inflation.
Impact of commodity prices on medium term core inflation is not significant because supply/demand forces for commmidities act in the shorter term.
Recent increase in equities could well be due to speculation – or simply normalisation – but either way the movement is a short term one of no great significance to the macroeconomic reality.
The inflation risk from the excess reserves is negligible whilst deleverage continues – and that process has a long way to run.
So I expect your outcome 1 will endure for many months and potentially several years to come.
Which bit of this don’t you agree with?
Mr S and Jamie,
I don’t see wage inflation as a huge threat at this point. What I do see as the inflationary threat are the two things I identified: excess reserves being lent and commodity prices going through the roof/the dollar getting killed.
I just wrote a follow-up to this post in which I have pinpointed a statistic that I call the Consumption-to-Income Gap which should help gauge which outcome is likely to prevail.
I too am unsure about deleveraging. Banks still have found no definitive way to dump their crap assets on to the government, though they are trying. Sitting on large cash reserves is consistent with deflation since money increases in value relative to everything else. On the other hand, large reserves to some extent balance off the inability of banks to dump their toxic waste. Meanwhile where they can as in commodities, there is a return to speculation and leveraging. So overall a mixed picture. Nothing has been solved but government money is for the moment keeping the whole enterprise afloat or possibly sinking more slowly.
@Ed – "the household sector has gotten religion about debt reduction as the savings rate has increased dramatically since Lehman. In fact, I would argue that companies learned their lesson about debt from the aftermath of the tech bubble"
Well, there's one more institution that has to get religion about debt. It's the one that's leveraging up right now – government. In fact, aren't we in the middle of the "final" bubble – the government bubble – with t-bills as the inflated asset?
About #2 – if the Fed even hints that it might inflate, won't the Chinese pull the trigger on their SDR idea and/or require the US to write RMB paper instead of USD paper? And if that happens…
@Hugh – The banks' big mistake was to not unionize!
All of you have written very well. I would like to add two points. From some points of view, the US is moving towards a "global mean" wage. I don't see manufacturing returning until we're competitive. I just don't see any kind of upwards wage pressure.
The second point is that I don't believe that it is applicable to group oil in with the rest of commodities. Our second biggest supplier, Mexico is rapidly running out of oil. They expect to import in a few years.
Even Dick Chaney said that demand is more than supply. I believe that oil should be considered separately.
Dan
Agreed, great discussion. I'm trying to make sense of the huge growth of reserves at the Fed. Those are U.S. bank holdings? Is any of it toxic assets that the banks have "loaned" to the Fed? How much of that is a needed hedge against future losses?
So jobs and house prices are not much of a factor in either scenario?
I can't help but come back to fundamentals, and the fundamentals say we go back to a credit-fueled consumptive economy again any time soon.
I realize that is what the banks want, but unless they unveil a program to train everyone as a banker, and create an economy where everyone creates synthetic CDO's comprised of everyone else's synthetic CDO's, and declare us all systemmically important and elegible to borrow free money and receive bailouts, then I see nothing but trouble.
I see a financial system that put the theory to test, and won. The banks called all the shots for themselves in this. They created a risk tranch called public compulsory, and now the only thing to do is fine tune it.
There are people running around still talking about how stupid AIG was, and point to their being on the wrong side of all those bets.
They honestly don't see it for the nuclear option that is was. Why go out with a whimper, when you can strap up and threaten to take a bunch with you when you go?
I'm keeping one neighbor partly employed right now, and other than despair and feelings of worthlessness, he's doing fine.
It's my other unemployed neighbor that worries me. He lost his job of 21 years, and if he looses his house, he will snap.
I want someone to explain to me why the economy seems to tank when taxes are at their lowest, and why the outrageously high tax rates in the decades following WWII were coincident with an extremely stable economy and massive wealth creation.
I'm at the point where globalization can go to hell. I can't afford $8.00 workboots from China if I don't have a job. Slap a tarriff on imports, and open up a boot factory here. I know the banks don't want to hear that, but they have had their fill.
We are not buying anything these days anyway.
Eventually you all will come around to my thinking ;-)
@kackermann…bravo and well said!
Re where to hide currencywise, do take note of Wisdom Tree's relatively new ETF, symbol CYB, that amounts to a synthetic money-market investment in Chinese renminbi. (Morgan Stanley has a remninbi-tracking ETN also, symbol CNY, if tax complexities and counterparty risk don't frighten you.)
One hates to think of buying a currency with a decent chunk of one's savings only to have it crash and burn, but it really seems unlikely that the already too-cheap renminbi would be allowed by the Chinese government to become even more underpriced. To me that's the renminbi's big attraction.
I'll grant though that it's not crystal clear how the pressures on them to revalue upward might evolve in a dollar crisis. (I keep reading mpettis and bsetster and hoping enlightenment just comes.)
kackermann said, " I want someone to explain to me why the economy seems to tank when taxes are at their lowest, and why the outrageously high tax rates in the decades following WWII were coincident with an extremely stable economy and massive wealth creation." OK… I'll take an armchair-economist stab at that one. (Real economists please do weigh in an clear up the mud.)
High top-bracket tax rates sap the drive to rape and pillage, financially speaking, and so lead to greater income equality. Low top rates mean that the reward for bad behavior at the top is radically increased, and the incentive forces associated with the phrase "the scum floats to the top of the pond" are at their maximum. We get things like a mortgage industry riddled with fraud, as per William Black's recent comments, and we get enormous income inequality in that a decent fraction of all income is going to ultra-high-"earners".
But that's not all we get. Great income inequality means large amounts of income accrue to those who can't possibly consume it all, so consumption is weak and there are excess savings. All the stuff we've been reading about of late from the Neo-Keynesians. But great income equality, by contrast, means essentially all income is associated with consumption, so consumption is adequate to drive full employment. All this is another way of saying that collectively (!) speaking, the workers need to be paid enough to afford to buy what they are, as a group, producing.
We should not be motivating economic rape and pillage. There was a time when doing the CEO job responsibly had an other motivations besides financial gain. Some people simply want to make a mark on the world, do something great, build a great firm, etc. We should not be encouraging the low-morals charlatans to rush out in front of them to grab the jobs instead. We need high top tax rates again. There's no excuse for letting them drop below 50%.
There is no excuse for excusing capital gains and dividends either. Yes, double taxation is horrible, so just abolish the corporate income tax and admit that in the end, only people pay taxes.