November 15, 2009
Is the world heading for deflation or inflation? If you talk to serious investors and long-term followers of economic trends, this is the big question. As in the boom – when the major conundrum was whether we could continue borrowing and spending – the experts are divided again.
The mainstream view appears to be that the world will suffer from some – or a lot of – inflation in the coming years. This thinking stems from the fact that all the money printed by the world’s central banks in the past 12 months will find its way into the real economy, and be shunted on from stocks to property to general prices and, then, towages.
This is one of the reasons that the price of gold – a traditional hedge against inflation – is skyrocketing. Another compelling reason to fear inflation is that the world, or at least some of the world, wants it. Many suspect that inflation will rise in the years ahead because only via inflation will the US be able to inflate away its enormous debts. Consequently, investors believe that the dollar will continue to fall against most major currencies.
The general consensus is that, while prices won’t rise now or next year because economies are too weak, as economies recover afterwards inflation will return. But the general consensus has been wrong before. In fact, the consensus has been wide of the mark about practically everything in the past five years. So what if it is wrong again?
What if, rather than entering a world where prices rise all the time, we are about to enter a period where prices and wages fall for a long, long time?
The historical portents are disturbing. The world has experienced long bouts of deflation in the past. From 1876 to 1900 was one such period, and the resulting agricultural unemployment in Ireland led to a huge upswing in emigration to the US in the final three decades of the 19th century. We had another long period from 1929 to 1939,when deflation was again the norm. Japan had a dreadful experience with deflation in the 1990s.Could this happen again?
A crucial determining factor in whether we will get global deflation or inflation in the years ahead will be the banks. (In Ireland, deflation is highly likely, as is the nationalisation of the banks, but more on that later.) If banks lend out all the money they are getting from the central banks there will be inflation, if they don’t there will be deflation. It is really that simple.
In monetary economics, there is a thing called the ‘multiplier’. This measures how many times a single euro lent out by the banks is lent and lent again. Think about the boom. If house prices went up, your net worth also went up – and this made you feel wealthy.
Therefore, you felt comfortable borrowing against this new wealth, and the bank, because it had the security of your house, which were rising in value, felt comfortable lending against it.
As long as prices were rising, you didn’t care about savings, so you spent and borrowed more and the bank lent more.
This is the multiplier effect, where one upward movement in prices and borrowing reinforces the logic of the boom and begets more upward movements in prices and borrowings and so on.
This created the bubble which has now well and truly burst, leading to the total destruction of the banks’ balance sheets.
Then the state has a choice: either it can let the banks go and create new ones, or it can save the banks and inject enough new cash to allow the banks to lend again.
But what if the banks have a different objective to the government? Yes, the banks want the cash, but not necessarily to lend out to you and me (who might not want to borrow anyway). If the banks stopped lending out cash and used the cheap central bank money they were getting to invest somewhere else, then we would have a major problem.
Let’s say that the banks use the money they are getting at 1 per cent from the European Central Bank (ECB) to buy government bonds which are yielding 5.7 per cent in Ireland and 3 per cent elsewhere, in order to rebuild their balance sheets and give the money back to shareholders. Now all the new money is stuck and doesn’t leave the banks, there is no multiplier and, what’s worse, if the people see just how much debt is costing them, they will stop borrowing and start saving.
Already, we can see that people’s attitude to debt has changed. All around the world, debt and credit (which had been expanding progressively since the 1980s) has become, not only unfashionable, but reprehensible. People want to pay off debts when they can and save more.
This causes prices to fall. And people – seeing prices falling – then expect this to continue. If you think you are going to get a bargain by postponing spending today and waiting for prices to fall even more tomorrow, deflation takes hold. This trend will be reinforced if the banks use the cheap cash they have been given to buy risk-free, high-yielding government bonds, since they will not put money into the economy.
Therefore, the very act of saving the bad banks fuels deflation and leads to less, not more, credit in the system. We get zombie banks presiding over zombie economies.
This is a possibility around the world and, as such, suggests that the recent stock market rally – one of the most dramatic in history – as well as the surge in the price of gold, could well reverse themselves. Such a reversal would usher in stage two of the crisis.
In Ireland, things are unfortunately more clear-cut. Such an outcome is almost guaranteed. The National Asset management Agency (Nama) will not lead to any resumption of credit because the banks are traumatised and have better things to be doing with the ECB’s largesse than lending it out to a country where prices fell 6 per cent year-on-year in October; and the market expects Nama Mark Two.
Remember Nama covers â‚¬77 billion of a total Irish bank lending book of â‚¬400 billion. Already the valuations for Nama are coming in much lower than the government’s estimates (surprise, surprise).When bad debts and defaults spread to the rest of the crocked â‚¬400 billion loan book, the banks will be submerged – and will have to be taken into public ownership because no private investor will give them a cent. They will become zombie banks owned by a zombie government.
The only way we can get credit flowing again is through a new bank or a system of new banks in Ireland. With this now ruled out, because our government refuses to admit what a Leaving Cert economics student can see, the spectre of deflation stalks the land.