2009-06-28

Deflationary Spiral?

I've seen mentions of the deflationary spiral cropping up. Phil of Phil's Stock World mentions it in this post, Just Stop the Madness Already (h/t: Zero Hedge). I recommend reading the whole thing, but I want to focus on one part.
I keep telling people but the market does not listen to me: Commodity hyperinflation is causing DEFLATION in the price of everything else, especially when neccessities like fuel are allowed to run out of control. This is sucking money out of the rest of the economy and causes a deflationary cycle that ends up snapping back and bursting the commodity bubble anyway. IT JUST HAPPENED LAST YEAR - WHY DOES NO ONE THINK IT WILL HAPPEN AGAIN?
First off, I've made the same point about high commodity prices. I believe inflation fears are having a deflationary impact because inflation fears are deflationary, or at least disinflationary. People associate high interest rates with high inflation, but high interest rates are the reaction and the cure to high inflation. Once high rates arrive and everyone prices inflation into their calculations, the end of the inflation is in sight—assuming the central bank doesn't choose economic suicide by fiat currency. "The Market" (the millions of individual investors, business, and governments) are already applying the cure before the disease shows any symptoms.

Back to the spiral. The deflationary spiral, in a nutshell, is that falling asset prices causes financial institutions to lose money and they must raise capital to shore up their balance sheets. Credit contracts and then more business and individuals are forced to sell, and then the process repeats and repeats until we hit bottom.

Your thinking on this spiral is where the rubber meets the road in the debate between "liquidationists" and Keynesians and Monetarists. The "liquidationist" argument, i.e. the classical and Austrian argument, is to let the deflation happen at once (do nothing to arrest it). There will be no deflationary spiral because prices fall to such a degree that they have nowhere to go but up. In psychological terms, I believe an overshooting to the downside is itself a part of the recovery process because it teaches the public that prices will only move higher. If you failed to buy at the bottom, you will never see it again. This is a powerful force for recovery because fear is blown out of the market, what remains is something like post-traumatic stress, where some people swear off investing. The criticism of this policy fits with this last part, that a massive deflaiton would create social disorder or cause catastrophic economic collapse—substantively the same argument used by Paulson to ram through the bailouts last fall.

The Keynesians and Monetarists want to halt the deflationary slide. They pursue policies to support home prices, bond prices and stock prices, prevent bankruptcies, bank failures, and foreclosures. This works if it succeeds in stopping the deflation and is the reason for the desperate attempt by Bernanke to create some positive inflation. It has great appeal because it prevents the sort of disaster witnessed in the one-fell swoop of a panic. The criticism is two fold. First, if it fails, it costs a lot of money and time and accomplishes nothing. More importantly, I believe, is the psychological impact. A failure of this policy creates the deflationary spiral because each attempt to arrest the decline is followed by another deflationary event. The public becomes accustomed to falling prices and mentally accepts this situation.Once people expect a cycle of lower prices, we can enter the deflationary spiral and the bottom will arrive much, much later, and possibly at a much lower bottom.

No comments:

Post a Comment