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Forecast: Continued Deflation

November 27, 2009

Listen to this episode
Plus Steve Keen and Hyman Minsky on debt deflation
nd a comment on the Fed’s fanciful independence.

Today’s forecast defends our call at Demand Side that the Great Recession has not ended.  Growth in Q3 and possibly Q4 is noise from record government subsidy, not a turn in the business cycle.

The Conference Board said Thursday that its index of leading economic indicators rose 0.3 percent last month. Economists polled by Thomson Reuters had expected an 0.5 percent gain.  The index of leading indicators has been a major positive for recovery fans, who remark on its seven months of positive showings, forgetting how poorly the index performed at the turn of 2007-08 and failed to predict the Great Recession, largely on the effect of stock prices then.  You’ll remember the peak.  October 2007.

Taking a look at the details of the leading indicators, we see that the vast majority of the upside push is provided by three items:  the interest rate spread, the money supply and stock prices.   Absent the continuing effects of these, the negative effects of supplier deliveries, building permits and consumer expectations would have pushed leading indicators negative.

Answer for yourself whether stocks and monetary aggregates are rebounding as a result of business cycle recovery or as a result of policy manipulation.

Elsewhere David Rosenberg cites sources saying the 3.5 percent 3rd quarter number is already being retracted to 2.5 percent.  Our oft-quoted Steve Keen has pointed out the absurdly high contribution of 1.66% of the growth was due to increased motor vehicle output, which was primarily driven by the government’s “Cash for Clunkers” program. Another 0.48% was due to the growth in government expenditure and investment rising an improbable 11.5%, due primarily to a whopping 23.4% in residential investment.  How likely is that?

Meredith Whitney, noted Wall Street analyst who called the collapse, in fact calls it her major worry that the entire housing market is being supported by the Fed, which holds 1.25 trillion dollars of decreasingly valuable mortgage-related paper on its balance sheet.  Who will buy it?  And who will step in when the Fed steps out?  Many analysts are predicting another ten percent leg down in housing. 

Demand Side asks you to consider what effect $1.25 trillion in direct aid to debtors would have had.  Next week’s forecast will estimate the impact of not following the Home Owners Loan Corporation model, but rather ratifying as much as possible the claims of the lenders and giving the borrowers more time.

Rosenberg notes also the consensus forecast believes that the unemployment rate will peak this quarter at 10.2%. That is remarkable, he says, because we know that in a garden-variety manufacturing recession, the jobless rate lags by 2-3 months. But in a credit and asset cycle, it lags by 12-18 months.


“As for Q4, it looks like restocking in the automotive sector is the big story and likely to underpin growth. We could see a 3.5% on headline GDP, but only 0.5% on real final sales, which is key.”

At Demand Side, we’re sticking with our claim that the recession has not ended.  We see twelve percent unemployment already baked in, and twenty percent in the all-in U-6 measure. 

Debt Deflation

We see that Minsky’s debt deflation is not well explained in tomorrow’s relay of a Steve Keen talk, as we promised, so we’ll borrow from Mr. Keen’s book Debunking Economics to outline what exactly debt deflation is.

After liability structures have gotten out of hand in a boom, and a reversal in the growth of asset values is visited on the Ponzi financiers and other actors, increasing debt to equity ratios affect the viability of business activities.  Cash flows cannot finance debt service.   Liquidity is suddenly much more highly prized, holders of illiquid assets attempt to sell them. The asset market becomes flooded and the euphoria becomes a panic, the boom becomes a slump.

Investment collapses, leaving only two forces that can bring asset prices and cash flows back into harmony: asset price deflation, or current price inflation. This dilemma is the foundation of Minsky’s iconoclastic perception of the role of inflation, and his explanation for the stagflation of the 1970s and early 1980s. Minsky argues that if the rate of inflation is high at the time of the crisis, then though the collapse of the boom causes investment to slump and economic growth to falter, rising cash flows rapidly enable the repayment of debt incurred during the boom.

The economy can thus emerge from the crisis with diminished growth and high inflation, but few bankruptcies and a sustained decrease in liquidity. Thus though this course involves the twin ‘bads’ of inflation and initially low growth, it is a self-correcting mechanism in that a prolonged slump is avoided. However, the conditions are soon re-established for the cycle to repeat itself.

If the rate of inflation is low at the time of the crisis, then cash flows will remain inadequate relative to the debt structures. Firms whose interest bills exceed their cash flows will be forced to undertake extreme measures: sell assets, increase their cash flows at the expense of their competitors, or go bankrupt. All three classes of action tend to further depress the current price level.

If assets are sold as going concerns, then those who buy them face a lower cost of capital, and can undercut their rivals in the current goods market. If firms attempt to increase cash flows by reducing their markups, they can instigate a race to the bottom.  If firms go bankrupt, their stocks and assets will be sold into depressed markets, thus further reducing current prices.

The asset price deflation route is therefore not self-correcting but rather self-reinforcing, and is Minsky’s explanation of a depression. Thus while Minsky still sees inflation as a problem during stable periods, he perceives it in quite a different light during a time of crisis. The fundamental problem during a financial crisis is the imbalance between the debts incurred to purchase assets, and the cash flows those assets generate. A high rate of inflation during a crisis enables debts that were based on unrealistic expectations to be nonetheless validated, albeit over a longer period than planned and with far less real gain to the investors. A low rate of inflation will mean that those debts cannot be met, with consequent domino effects even for investments that were not unrealistic.


Listening to Steve Keen reminds us that it was not just the Chicago School who missed the crisis, but the great swath of mainstream economists of all stripes.  We at Demand Side hit the call on the housing bubble, but we did not see the financial crisis until we were alerted by the likes of Nouriel Roubini in late 2007.  We are reminded again that it is not only conservative economists who need to revisit their assumptions and revise their views.

Today’s example is Alan Blinder and Mark Thoma who support the illusion of Fed independence.  This is even more fatuous than the belief in economic stability in the midst of the housing bubble.

Blinder recently wrote, and Thoma seconded:

“In academia and in the financial markets, the overwhelming attitude is: Hurrah, and thank goodness, for Ben Bernanke, who gets kudos for his boldness, creativity and smarts.”

Calling on the good sense of Academia and Wall Street is a bit strange.  I have a vision of somebody blindsided by a bus raising a broken hand and bleating “Good thing the driver is keeping the speed up.”  The Fed didn’t see it coming, when it came they couldn’t manage to avoid the worst, and after the fact they are now denying the obvious remedies, plus ignoring their residue of $1.25 trillion in rapidly devaluating mortgage backed securities on the Fed’s balance sheet. Great.  Clever.  Creative.

Bernanke’s “save the big banks first” strategy is increasingly flimsy, a “keep the bonuses flowing while one-quarter of children go hungry” strategy.  It shows how little he knew about the Great Depression and how much he was willing to risk on his unproven hypothesis.  Then as now it is income flows that have to be restarted, not balance sheet flows.

And who gave the Fed this independence? Was there a law or Constitutional amendment that created a fourth branch of government? After they bungled the Great Depression, there was little appetite in the country for giving them more power.  They waited until in the middle of the night in 1951 when Truman was preoccupied and politically impaired by the MacArthur in Korea fiasco.  Then they broke free to make interest rate policy on their own. The so-called “Treasury Accord.”

It wouldn’t be a problem if the Fed was independent like the SEC or FDA or every other “independent” government agency. But they are independent like they can spend trillions of dollars with no control. They are independent of everybody but their owner banks.  Whether Academia and Wall Street approve, history will not.


From → Misc.

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