Grantham: Deflation has won on points

Well, I, for one, am more or less willing to throw in the towel on behalf of Inflation. For the near future at least, his adversary in the blue trunks, Deflation, has won on points. Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. Even three months ago, I was studiously trying to stay neutral on the “flation” issue, as my colleague Ben Inker calls it. I, like many, was mesmerized by the potential for money supply to increase dramatically, given the floods of government debt used in the bailout. But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or flat prices are the prospect for the immediate future.

-Jeremy Grantham

Yep, that’s exactly it, isn’t it? Deflation is winning. This passage is how Jeremy Grantham begins his latest Quarterly Letter.  In describing this Battle Royale between inflation and deflation, in June of 2009 I said Central banks will face a Scylla and Charybdis flation challenge for years. My thinking was the deflationary forces of deleveraging would be counteracted by the inflationary forces of monetary and fiscal stimulus for years to come.

However, as 2009 progressed, I started to see the macro picture differently. I certainly developed "bailout fatigue" myself. However, as I expressed it in November, so had everyone else. The money printing, liquidity programs, bailouts, the record bonuses, the lack of credit availability combined with the unemployment, foreclosures,  and the acrimony over health care to discredit stimulus.

[P]eople were swayed toward Big Government because of a deep downturn and financial crisis but crony capitalism and bailout fatigue have discredited Big Government. And now we are witnessing a war about the proper role of government. Perceptions of recent policy decisions remain top of mind in the process.

A few thoughts about the limitations of government, Nov 2009

Here we are two-and-a-half years after the recession began with underemployment in the high teens, record foreclosures, contracting credit, a slowing economy and fears of a double dip. Yet, a lot of people are talking about austerity – as if that wouldn’t tank the economy. Some people forget, even Obama was talking this way in November. It was right then I knew that deflation was going to win.

So why do we see the sudden switch to austerity mode and the attendant slowing it will induce? The deflationary forces are winning because people have had their fill of the policy choices that have led us to where we are today. I agree with Krugman that Clive Crook’s comments on this are misguided. Obama has overpromised and undelivered. It’s as simple as that.

You have what I would call crony capitalism on the one side with bailouts and record bonuses all around for bankers. Juxtaposed are massive budget deficits and a still weak economy and employment outlook. No one is going to double down on that strategy. It’s a failure – and I would argue that it is because there was insufficient stimulus. All of this was predictable from the word go.

Where do I stand on these issues now? The euro zone is bound by the euro gold-standard strictures which force a deflationary economic policy onto the euro nations. So austerity-lite is a minimum requirement all around. And while the Germans claim they have the least austere budget in the euro zone for 2010, they too should be afraid of running budget deficits of 5% of GDP given their near 80% government debt to GDP.

In the UK and the US, government has more leeway. I don’t support austerity. I would like to see more stimulus but I can’t support a lot more stimulus if the goal is to maintain high levels of resource allocation in financial services. Where are the new jobs going to come from if the government is propping up the housing sector? Where are new jobs going to come from if credit availability is weak as the government aides and abets banks in hiding losses? Trying to prop up malinvestment only lengthens the downturn.

Picture this: Ben Bernanke announces a plan to buy up $2 trillion more in mortgage-backed securities. Maybe he buys some municipal bonds as well. We extend unemployment benefits, keep interest rates low and the yield curve steep. Meanwhile the Obama administration gets trillions of dollars in new money for shovel ready projects?  Now, fast forward to early 2012: what do house prices look like?  How about bank balance sheets? How about private sector debt loads? 

There would still be a too many people employed in the financial sector. House prices would be above median levels on long-term price to income charts. And I guarantee you there would be little household sector deleveraging. How is early 2012 then any better than mid-2010 on any of the longer term metrics we care about?

I’ll answer that. Unemployment would come down I bet and bank balance sheets would be marginally better. But household debt levels would still be large and bank balance sheets would be relatively weak on a mark-to-market basis. The demand for and availability of credit would therefore be weak. This is a muddle through scenario at best. Would we be closer to our goal of reduced private sector leverage? Yes. The cost of that deleveraging would be much greater government debt. In essence, we would have socialized the losses which would accrue to debtors and their creditors in a more deflationary scenario. Deficits might ease with recovery but they would still be large. And this would continue for a number of years more.

I don’t think you can add huge amounts of stimulus to an economy without significant malinvestment which would retard longer-term growth rates. This is what I said about eastern Germany. I still think having a 200% debt to GDP ratio like Japan is a bad thing. And I don’t think we can close the output gap without increasing the debt to GDP ratio to Greek levels. I also don’t think the potential growth rate in an ageing society will be sufficient to ever reduce the debt to GDP ratio without inflation boosting nominal growth rates. Where does that leave us then?

I think it leaves us in a situation where deflationary forces prevail for the medium-term. Grantham says deflation has won on points. Radio Raheem would say "Left hand inflation KO’ed by deflation."

And I think they will continue to win until the output gap closes, when the left hand will be back.

 

Source: Summer Essays (registration required) – GMO Quarterly Letter, July 2010, Jeremy Grantham

20 Comments
  1. Rich says

    I expect that all that austerity talk will disappear if we get actual price deflation or if markets go down enough.

    The problem with predicting deflation over a longer timeframe is that deflation sows the seeds of its own demise by panicking the authorities into massively (if not immediately) inflationary policy. Under our current system, deflation can’t possibly “win” for long. But on a scale of months you may well be right.

  2. JB McMunn, MD says

    July 17: “So the problem for deficits is not national solvency but inflation and currency depreciation. That makes me worried about deficits. If that makes me an inflation hawk and anti-deficit, then so be it.”

    July 19: “I don’t support austerity.”

    I don’t get it. How can you be “anti-deficit” but not “support austerity”?

    1. Edward Harrison says

      JB, I am anti-deficit in that I see it as a problem to tackle. I wouldn’t make the statement “deficits are not a problem” nor would I say “Japan’s 200% of debt to GDP is not a problem.” That doesn’t mean I reject short-term stimulus except to the degree it is used to maintain malinvestment (which is where we are right now). So I wouldn’t say “let’s cut the US budget deficit right now because we need austerity to focus on the deficit.” I would say that there is a structural deficit due to military spending and entitlement programs that needs to be addressed.

      Where I think Krugman is objecting to Jamie Galbraith is regarding the sense that focusing only on govt’s public purpose (to ensure full employment and the deployment of real resources) means that you can entirely ignore the deficit. I don’t think you can entirely ignore the deficit either.

      I think what Galbraith was saying in the Krugman/Galbraith debate is (Marshall can correct me here):

      1. In the short-run, deficits are an ex-post accounting identity that result from economic performance. We should concentrate on the true inputs which drive performance: i.e. deploying real resources and closing the output gap rather than on the deficits themselves.

      2. In the long-run, if we do so, the deficit issue is far off. Don’t use the short-term deficit as an excuse to raid entitlement spending. Keep your hands off social security.

      The first part seems right. The second part seems too dovish – at least regarding health care and military spending. I know that liberals are more concerned with cuts to social security less concerned with medicare and not at all concerned with military spending. The reverse is probably true for conservatives.

      But, I don’t see how you get from here to there without recognizing that a lot of resources are being used to cover entitlement spending and military spending. This may not be an issue for now, but at least recognizing it as an issue would make the short-term deficit issues of less concern. It’s when Galbraith says short-term deficits are no problem and we shouldn’t worry about the adjustments needed for 2030 and beyond because they are a long way off – it’s then when people reject the ideas. It’s simply too dovish.

      Marshall, if you have comments, please add them.

      1. Marshall Auerback says

        I think you’ve characterised Jamie’s position correctly, but I would add
        that MMTers do have concerns about the deficit, but what Krugman was
        initially suggesting that MMTers don’t concern themselves with deficits at all,
        which is patently wrong (as you know). MMT’ers have to concern themselves
        with sustainability, too, as it’s fundamentally about the inflation constraint
        and debt service. And perverse effects of high debt service don’t stop the
        CB from using other tactics–which would be better from our view
        anyway–such as credit controls, procyclically manipulating capital requirements,
        margin requirements on different types of lending (which would be a more
        direct way to affect rates on loans made by the pvt sector to the pvt sector),
        and so forth.

        In a message dated 7/20/2010 05:58:29 Mountain Daylight Time,
        writes:

        Edward Harrison wrote, in response to JB McMunn, MD (unregistered):

        JB, I am anti-deficit in that I see it as a problem to tackle. I wouldn’t
        make the statement “deficits are not a problem” nor would I say “Japan’s
        200% of debt to GDP is not a problem.” That doesn’t mean I reject short-term
        stimulus except to the degree it is used to maintain malinvestment (which
        is where we are right now). So I wouldn’t say “let’s cut the US budget
        deficit right now because we need austerity to focus on the deficit.” I would
        say that there is a structural deficit due to military spending and
        entitlement programs that needs to be addressed.

        Where I think Krugman is objecting to Jamie Galbraith is regarding the
        sense that focusing only on govt’s public purpose (to ensure full employment
        and the deployment of real resources) means that you can entirely ignore the
        deficit. I don’t think you can entirely ignore the deficit either.

        I think what Galbraith was saying in the Krugman/Galbraith debate is
        (Marshall can correct me here):

        1. In the short-run, deficits are an ex-post accounting identity that
        result from economic performance. We should concentrate on the true inputs
        which drive performance: i.e. deploying real resources and closing the output
        gap rather than on the deficits themselves.

        2. In the long-run, if we do so, the deficit issue is far off. Don’t use
        the short-term deficit as an excuse to raid entitlement spending. Keep your
        hands off social security.

        The first part seems right. The second part seems too dovish – at least
        regarding health care and military spending. I know that liberals are more
        concerned with cuts to social security less concerned with medicare and not
        at all concerned with military spending. The reverse is probably true for
        conservatives.

        But, I don’t see how you get from here to there without recognizing that a
        lot of resources are being used to cover entitlement spending and military
        spending. This may not be an issue for now, but at least recognizing it as
        an issue would make the short-term deficit issues of less concern. It’s
        when Galbraith says short-term deficits are no problem and we shouldn’t worry
        about the adjustments needed for 2030 and beyond because they are a long
        way off – it’s then when people reject the ideas. It’s simply too dovish.

        Marshall, if you have comments, please add them.

        Link to comment: http://disq.us/hlqyk

    2. Edward Harrison says

      Marshall recently wrote:

      “Deficit cutting, whether now or in the future, is not a legitimate goal of public policy for a sovereign nation. Deficits are (mostly) endogenously determined by the performance of the economy.”

      This is where Marshall and I differ. Marshall is saying that government should concentrate on the real resources ONLY. I would say, politically, you can’t get around the deficit issue. People want to know that government debt levels are stable. Just because we are not in a gold standard world doesn’t mean that governments can run deficits at will. It just means there is no operational constraint.

      What if potential long-run nominal GDP growth is 4.5% with a 2% inflation rate but the structural deficit from non-discretionary spending is 7%? Then you have to allow debt to gdp to rise, re-allocate resources to target that deficit or get inflation up. I think this is where comments by Marshall will help. Most people (including me would rather see resource-reallocation in this scenario). Few people want to see higher inflation rates or higher debt to gdp.

      One other issue is the Japan issue. Should Japan reduce dept to GDP or can they go on forever with debt-to-gdp of 200%? If they should reduce it, then over what time period? By what means?

      1. Marshall Auerback says

        The reason we differ, Ed, is because I am not saying REDUCE the debt to GDP
        ratio. As my critique of Summers makes clear, I don’t think that is a
        legitimate objective of policy. In fact, I think the Chick/Pettis paper
        shows that this is a flawed objective because (as they empirically demonstrate),
        an ex ante attempt to reduce the debt to GDP ratio leads to an ex post
        increase, all other factors being equal.

        My point is that the debt to GDP ratio will be reduced AS AN EFFECT of
        properly targeted fiscal policy, which the paper also illustrates.

        In a message dated 7/20/2010 06:10:55 Mountain Daylight Time,
        writes:

        Edward Harrison wrote, in response to JB McMunn, MD (unregistered):

  3. Michael Jung says

    So you still think USA can outgrow this starting 2012/14, when GDP growth is >2.5%?

    But will the USA have the same qualities like a Germany or Japan (export, conservative) till 2012/14.

    Still, no other country could survive this -but bc they have THE DOLLAR. Japan survived it because of its exports (money coming in) and independent monetary policy (&fiscal). The Dollar still brings money in, but that’s it – the rest the American people have to do.

    Bleak it looks for EU peripheral countries who got slapped with austerity. Wonder when Greeks & Co. become tired of going on the street, if ever. And Spain with its own lost generation (40% youth unemployment).

    The end of sameness.

    And we have not yet looked at China and its overcapacity problem. Or the threat Australia / Canada and ITS own property bubble poses to Global Stability.

    1. Edward Harrison says

      I don’t think the US is outgrowing anything. “How is early 2012 then any better than mid-2010 on any of the longer term metrics we care about? I’ll answer that. Unemployment would come down I bet and bank balance sheets would be marginally better. But household debt levels would still be large and bank balance sheets would be relatively weak on a mark-to-market basis. The demand for and availability of credit would therefore be weak. This is a muddle through scenario at best. Would we be closer to our goal of reduced private sector leverage? Yes. The cost of that deleveraging would be much greater government debt. In essence, we would have socialized the losses which would accrue to debtors and their creditors in a more deflationary scenario. Deficits might ease with recovery but they would still be large. And this would continue for a number of years more.”

      That is the best case scenario. What is likely to happen is that by 2012 we fall into a double dip recession as Shiller and I have defined it.

      https://pro.creditwritedowns.com/2010/05/what-is-a-double-dip-recession.html

      Afterwards, we get another great recession similar to what the Japanese saw in 1997. And then we get more stimulus. Then we get another bounce and on it goes. Marshall calls this stop start and that’s my base case for what will happen politically.

  4. J. Powers says

    Interesting and educational economics discussion here, but it kind of feels like the wrong discussion. (I know, Ed, that you’re just responding to what people post.) Seems to me the real issue is the political one of ending malinvestment in and by the financial sector. Until we clear that hurdle, it’s hard to imagine what inflationary pressure (other than WWIII) could drive the US out of the current deflationary spiral. Stop and go until the reign of the TBTFs ends.

  5. steve_from_virginia says

    Hmmm … this and the Krugman- Galbraith discussion are interesting … and orbit around economic rather than fiscal issues.

    Let’s leave out the social stuff or (essential) energy conservation, without which there will be no recovery of any sort, guaranteed.

    I make a point repeatedly on my own humble blog that governments borrowing in their own currencies can run unlimited fiscal deficits; the act of creating the deficit creates the funding for it at the same time.

    At the same time, economic performance is dependent upon real output.. Fiscal stimulus aims at temporary liquidity shortages but not hoarding or ‘spenders’ boycotts’ where currency is held and output is devalued relative to currency by their doing so. attempting to end this state of affairs by force of ‘fooling’ strategy is absolutely counterproductive, adding greater incentives to hoard, even foment revolution against a government taking such action!

    This in turn illuminates the ‘solvency trap’ that preoccupies policy makers and economists. This is irrelevant compared to the destruction of capital that is the consequence of hoarding. Fiscal policy must aim at encouraging funds to circulate rather than restructuring. Hoarding is a social/political act as much as an economic act. Heedless restructuring creates currency traps increasing the relative value of it (scarcity premium) relative to (shrinking) commerce

    In theory deficits either encourage currency hoarders to spend (it never has) or it substitutes for final demand/spending (it doesn’t really as no new money is created.) Stimulus is irrelevant and eventually reflects poorly against the competence of the government attempting it (which it has and is.)

    Doing something effective would be employing people, I can look out the window and see tens of thousands of tasks that need doing; every city and town in America needs a streetcar system, our towns and cities need to be reconfigured away from auto use, all this using hand tools that would employ hundreds of thousands of people. Where is the 21st century version of the CCC? Where are our WPA artists, writers and photographers?! Where is the imagination?

    How about a million new farmers?

    Deficits would run from this but the economic effect would be multipliers in action which in turn would loosen coin from the cash boycotters’ mattresses.

    Right now any new deficits head right into the highway contactors’ pockets (and those of cronies) where it does little. It’s past time to leave the head of the pin to the angels and put people directly to work. If this is competition for (over- automated) private sector, so be it.

    They need the competition.

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