Sunday, August 28, 2011

On Managed Deflation (aka "Screwflation")

In the past week, both Steve Keen and Stoneleigh have independently posted up some interesting observations that support and reinforce each other.

First up is Stoneleigh's Et tu, Commodities? 

Our most consistent theme here at The Automatic Earth has been the developing deflationary environment and the knock-on effects that will follow as a result. Now that the rally from March 2009 appears to be well and truly over, it is time to revisit aspects of the bigger picture, in order for people to prepare for a full-blown liquidity crunch. October 2007-March 2009 was merely a taster.

As we have explained before, inflation and deflation are monetary phenomena - respectively an increase and decrease in the supply of money plus credit relative to available goods and services - and are major drivers of price movements. They are not the only price drivers, to be sure, but they are usually the most significant. People generally focus on nominal prices, when understanding price drivers is far more important. A focus merely on nominal price also obscures what is happening to affordability - the comparison between price and purchasing power.

* * *

While credit expansion (inflation) is a powerful driver of increasing prices, credit contraction (deflation) is a far more powerful driver of decreasing prices. Credit, having no substance, is subject to abrupt fear-driven disappearance. Confidence and liquidity are synonymous, and confidence is once again evaporating quickly, as it did in phase one of the credit crunch (October 2007-March 2009). As contraction picks up momentum, the loss of credit will rapidly lead to liquidity crunch, drastically undermining price support for almost everything. With purchasing power in sharp retreat, however, lower prices will not lead to greater affordability. Purchasing power typically falls faster than price under such circumstances, so that almost everything becomes less affordable even as prices fall.

Credit expansion reversed in 2008, and this is deflation by definition. Despite the talked-up attempts to monetize debt through quantitative easing - a deliberate attempt to stoke inflation fears in order to counteract the psychology of deflation - money plus credit has been in net contraction. Talk of monetary growth based on only the money fraction misses the elephant in the room, since the vast majority of the effective money supply is credit, and the tightening of credit is by far the dominant factor.

* * *

We stand on the verge of a precipice. The effects of the first real liquidity crunch for decades will be profound. We are going to see prices fall across the board, but far fewer will be able to afford goods or assets at those lower prices than can currently afford them at today's lofty levels. The social effects of this will be enormous, and will spread to many more countries. The collapse of our credit pyramid will be the driving factor and it will sweep all before it like a hurricane for at least the next several years. Beware.
Next up is Steve Keen's developing "Credit Accelerators," which seek empirically to measure the phenomenon Stoneleigh mentions above, i.e., that credit expansion (contraction) drives price increases (decreases).

If we go back to the week before last, Stoneleigh's colleague, Illargi, had his own interesting post, in which he quoted from a piece by Larry Kudlow that argued that the recent explosive growth in the U.S.'s M2 monetary aggregate.  Kudlow's piece is entitled The Deflationary M2 Explosion:

This is a very disconcerting development. Normally, big M2 growth would signal a faster economy, and maybe even higher inflation. But as economist Michael Darda points out, the velocity, or turnover, of money seems to be plunging.

“The recent pickup in broad money in the U.S. looks like a dash for risk-free cash assets,” writes Darda. He also notes that widening corporate-credit risk spreads and shrinking government-bond rates signal a recession risk, not a coming boom.

So contrary to monetarist theory, the M2 explosion seems more closely related to a deflation/recession risk. Economist-blogger Scott Grannis writes, “The recent growth of M2 surpasses even the explosive safe-haven demand for money that accompanied 9/11 and the financial crisis of late 2008. Something big is going on, and it can only be the financial panic that is sweeping Europe as money flees a banking system that is loaded to the gills with PIIGS debt.”

Grannis concludes, “In short, it looks like there is a run on the European banks and the U.S. banking system is the safe-haven of choice.”
When Jesse looked at that same M2 growth, he mockingly asked "Dude, where's my deflation?"  The answer, of course, is "right in front of you, but you are too blind to see it."  Indeed, it's almost as if he had himself in mind when he said the following:

There is certainly no lack of people who remain obstinate in their errors and illusions. I have a little more respect for those who try to maintain their theories while at least accepting the obvious. But unless they can create a whole of it, their theory is found to be lacking.
Jesse's error/illusion is twofold.  First, like most everyone else, he is ignoring credit's role in the inflation/deflation equation.  Second, he mistakenly believes that M2 is driven entirely by Fed policy and fails to understand that it is the banking customer who determines the vast majority of how much wealth is held in banking deposits instead of in equities and bonds.  He cannot be blamed for this, however, as Milton Friedman was the first to employ this kind of sleight of hand with monetary aggregates, when he argued that a contractionary M1 during the Great Depression implied a contractionary Fed policy when, in fact, M0 showed an expansionary Fed policy.  It was simply overwhelmed by depositors' lack of trust in banks to hold their uninsured deposits (there was no FDIC, back in the day).