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The Case for Deflation

10/08/2009 10:03 am EST


Gary Shilling

Columnist, Forbes

Gary Shilling, editor of INSIGHT, explains why inflation is very remote and why deflation is the economy’s biggest problem.

The US economy is now in deflation, as measured by year-over-year declines in the consumer and producer price indices, [and] it’s difficult to see anything but deflation in coming quarters because of the huge excess of aggregate supply over demand.

These substantial deflationary forces are at work even in the face of gigantic monetary and fiscal stimuli. Many, of course, believe it’s only a matter of time until these stimuli promote serious inflation. [However,] before the bank reserves provided by the Federal Reserve can promote excess demand, they’ve got to get into circulation as money. But scared lenders and creditworthy borrowers are unlikely to convert massive bank reserves into money until rapid economic growth resumes. And that, we believe, is unlikely for many years.

Moreover, the continuing decline in bank loan demand suggests there isn’t much demand for money by creditworthy borrowers. Indeed, money supply as measured by M2 and the broader MZM measure [has been] declining recently.

In addition, the recent nosedive in money velocity, the ratio of GDP to the money supply, indicates that money could expand sharply to restore normal relations, and far more would be needed to create excess funds and inflation.

Furthermore, if economic growth and loans mushroom, contrary to our forecast, major central bankers, with their congenital fear of inflation, will no doubt withdraw much of that liquidity.

The Fed is in the classic liquidity trap where ample bank reserves and near-zero interest rates don’t spur money creation and lending. The Fed is pushing on the proverbial string.

With conventional monetary policy impotent, the Fed has resorted to quantitative easing. But with all this money, the economy remains weak except for inventory gyrations. What will happen to the economy and deflation after the Fed stops paying out all this money?

Furthermore, any liquidity created through central banks is tiny compared to what’s being destroyed by the world’s deleveraging financial sectors. Securitizations are only one segment of the previously exploding, now collapsing shadow banking system. Off-balance sheet vehicles of banks are being eliminated or written down substantially. Major governments are in the process of increasing capital requirements of financial institutions, which will slash their profitability and lending.

In the post-World War II era, commercial bank loans and leases have grown rapidly and only paused in recessions. Now they are turning down decisively.

Financial asset deflation in stocks in the 2000-2002 years and again more recently as well as the tangible asset deflation in houses, has sired a consumer saving spree along with other forces that are generating CPI-style general deflation.

Protectionism resulting from the deflationary, high unemployment global economy may spur competitive devaluations—currency deflation that leads to retaliation and slows worldwide growth. That would enhance other forms of deflation.

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