Tuesday, 1 June 2010

Deflation first, then possibly inflation

The deflationary pressure in Europe and the USA is clearly increasing. Banks in Europe are becoming more reluctant to lend and $ libor is edging up too. The fear of inflation is still prevalent despite contrary evidence; why is this?

There is an assumption that monetising debt is de facto a route to inflation, but that is not necessarily the case. Referring to government orchestrated debt buying, Von Mises wrote in Human Action “The first stage of the Inflationary process may last for many years…..it is not too late for the government to abandon its inflationary policy”.

Monetising debt (or QE) is not an automatic route to the (hyper) inflation that many people fear. Firstly the banks need to use this new cash and be prepared to lend it out within the fractional banking system. They are not doing that. They prefer to hoard the money as reserve requirements are being raised and they are fearful of the current economic conditions (with good reason). Secondly, even if banks were prepared to lend the money, consumers must be prepared to borrow more and leverage their own balance sheets. That is equally not happening. In fact the saving rate in the US is increasing as people pay down their mortgages.
In short, the velocity of money has collapsed and money available for exchange is contracting (M3). The money created by recent QE is merely plugging holes in the banking system. This is unlikely to change until Real Estate starts increasing, consumers chose to leverage themselves and quickly increase borrowings.

In the medium term, debt pay- down will drive assets lower and the dollar higher. It may also even drag gold down, but gold will not fall nearly as hard as Real Estate or the Stock market. Interest rates are set to stay low as there is a drive to cash. The reason the dollar stays strong is because it’s the reserve currency. Borrowers who cannot raise money in their own currency usually chose the dollar instead. As assets decline quickly in a disinflationary environment, the need for cash increases and de facto the need for dollars to pay down debt.

The end game of this crisis may well be a reflationary nightmare. Don’t worry about that now. In fact when it comes, it will be so horrendous that central banks may be forced to expand their balance-sheets by 50 x not the current 3 x.

With over USD 500 trillion of outstanding derivatives a breakdown in the banking system in a few years might precipitate the need for a new currency but in the meantime deal with a declining real estate, declining wages and a declining stock market

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