The Slowdown Is For Real; Is Deflation Next?

What can we say about today’s GDP report? Not much that hasn’t already ben said: the economy is slowing down quite quickly. Growth in the second quarter fell to 2.4%, compared with 5.0% in the last quarter of 2009, and 3.7% in the first quarter 2010. That’s fairly dramatic and a much more rapid slow down than is normal. There is no way that this cycle can be characterized as being normal. The track we are following is truly one of a kind and so we lack precedence to give us comfort as we try to forecast the next few quarters.

What we do know is that history tells us that recessions and recoveries following crises caused by banking and financial implosions are always difficult. Evidently that is the one precedent seemingly being played out again.

It is becoming tiresome to repeat the obvious: we face a massive shortfall in demand which is causing an equally massive shortfall in resource usage to linger on. Jobs. Jobs. Jobs.

Interestingly a sharp debate about the nature of unemployment has now broken out in the ranks of analysts.

One camp argues that the downturn is healthy in that it is forcing inefficient sectors such as construction, where we had vastly over-invested, to shed jobs and thus – eventually – allow those workers to be re-trained for more useful and productive purposes. This analysis relies on the traditional, classical, view of economic cycles as being purges to be welcomed, rather than as crises to be avoided. Joseph Schumpeter, he of the “creative destruction” theory of capitalism is the leading architect of this viewpoint.

Others, myself included, regard this as nonsense.

We hold that ever since Keynes pointed out that capitalism can be saved from its own excesses through a combination of monetary and fiscal policy, society has no need of Schumpeterian purges. Indeed such purges are counter-productive and consign large numbers of people to horrible lives unnecessarily. Given that we know how to avoid such cycles, we believe that society owes it to itself actually to avoid them.

Which camp is correct?

The clues are all within the nature of current unemployment. Were this a ‘purgative’ cycle we would expect unemployment to be focused on those industries and sectors where inefficiencies had built up. Other industries should be less affected. But we don’t find such a pattern. Unemployment is both deep and widespread across the entire economy. For the Schumpeterian view to hold we would have to argue that the entire economy is rotten and not one sector. In which case there seems to be no informative or predictive content to the theory. Empty theories aren’t worth much.

In contrast the Keynesian view is holding up well to empirical testing.

This is, indeed, a cycle we could have dampened or ameliorated if we had employed the right counter measures in the right strength early enough.

Meanwhile, that the economy is now headed for more slowdown is a certitude.

Worse for all of us, all the characteristics of a depression are lingering near the surface. Sufficiently close that we are still under threat of a true calamity.

One example: this week has seen the auction of large amounts of bank debt at record low interest rates. US Bancorp was able to sell five year paper at the lowest interest rate ever paid by a bank. Think about that for a moment. The lowest rate ever paid by a bank. What leaps out from that is that we have absolutely no threat of inflation at present. None. In fact the real and present danger is deflation. So clear is this threat that, for the first time I can recall, members of the Fed are talking out loud about what they would have to do were deflation to set in. This is an incredible turn of events. Especially in light of the fact that the Fed officials making all the noise include some of the inflation hawks who were recently advocating hiking interest rates to stave off the inflationary threat of the massive build up in money supply engendered by the Fed’s bailout activities of 2008 through last year.

Textbook monetary theory says that such a huge build up will, inevitably, manifest itself as a surge in inflation. There will be too much money chasing too few goods. So prices will rise to bring about a balance between money supply and the goods being produced. That’s how we get inflation.

One of Keynes’ greatest insights was that, under certain circumstances, this traditional relationship will not hold. He argued, correctly, that if business expectations are severely limited, and if the prospect for profit from new investment is constrained by the lack of demand, businesses will not invest spare cash. They will hoard it instead. So the increase in money supply will simply sit in bank vaults and go unlent. This is exactly what we are seeing currently. The economy is awash with cash. Bank reserves are accumulating at rapid rates. But there is no, or little, demand for credit. Similarly households are sitting on what cash they have – debt pay downs and savings are taking a higher priority than consumption. We are saving too much, by which I mean we are saving more than we want to invest, and that is depressing demand. Our economy has fallen out of balance.

In other words the economy is frozen despite the plentiful money sloshing about. This is what is called a ‘liquidity trap’. The economy is flush with liquidity, but is trapped in a downward spiral because there are no profitable opportunities to invest at current interest rates and in the face of current demand.

Keynes’ solution to the trap was to inflate demand by whatever means possible.

Without such action he predicted that deflation would set in and the effort to break free would get progressively more difficult. Deflating wages makes it harder for households to pay off debts, so they have to save even more aggressively. This reduces demand further … and so on.

Are we there yet?

Not quite.

There are hints of inflation. But those hints are ebbing quickly. We have been in a ‘disinflationary’ mode for months now. And those bank debt auctions suggest that the credit markets think we are on the verge of deflation. If we strip out volatile items from the consumer price index it, too, has an ominous trajectory.

The danger is clearly there.

And it isn’t as if we don’t have plenty of recent experience of the trauma deflation can bring: Japan is still deep in its malaise twenty years after its real estate bubble collapsed. One anecdote from Japan tells it all: the story goes that the best selling consumer items during the 1990’s in Japan were safes for households to horde their cash. We do not want to fall into that particular hole.

What can we do?

The Fed can stop paying interest on bank deposits. That would make it more profitable for the banks to lend.

The Fed could also buy assets from the private sector in the hope that the money thus created is sufficient to put the economy past the critical level of money supply – we would be so inundated with cash we would have to do something with it!

Or: we could try to induce inflation. The Fed could raise its inflation target beyond the 2% ceiling it now has and attempt to get the private sector to adjust its inflationary expectations.

And, presumably, we could double down on the federal deficit in the hope that more stimulus would fill the demand gap sufficiently to encourage businesses to invest and re-hire.

Then there’s the Schumpeterian approach: let the devil take the hindmost.

This could get ugly.