Inflation or deflation? We live in interesting times

(noon – promoted by ek hornbeck)

The western financial system is caught in a trap. On the one hand, there is an urgent need for clearing prices to be established for impaired assets to restore confidence; on the other hand, if this is done in a mark-to-market world, there is a risk that some banks will run out of capital.

(Gillian Tett, Financial Times)

Bank bankruptcies are a realistic prospect in the coming months. And yet, this is not even the worst…

The global economy is facing twin shocks. Natural resource markets are delivering a supply shock of 1970s dimensions, while the financial system is delivering a shock comparable to the bank and thrift crises of the 1988-1993 period.

(Tim Bonds, Barclays Capital, in the Financial Times)

One of the most extraordinary things today is that we are facing two simultaneous major crises at the same time (not even including Iraq). To some extent, they are linked, as the growth in China or elsewhere that pushes commodity prices up by making obvious the resource constraints we are beginning to face was to a large extent fuelled by the financial capitalism-driven globalisation. But they are now having completely opposed consequences, as far as inflation is concerned, with emerging markets demand continuing to push prices up, while the credit crunch is savagely cutting into economic activity and causing across the board asset price drops.

What we are really seeing is a quite brutal change in the relative values of goods and assets. For years, we had debt-bubble-fuelled increase in asset prices (mostly real estate and financial assets) and stagnation in goods prices, caused by the downwards pressure from China and the wage stagnation engineered by financial capitalism’s requirements.

Now that process is partly going into reverse. Oil and commodity prices are feeding into goods price inflation, while the credit crunch signals the end of the the dizzying valuations of assets. One category is inflating, and another is deflating. And wages and pensions (ie living standards for most people) are caught in the middle.

But, making things even more complicated, the dollar, ie the unit of money that is supposedly neutrally providing the information on these relative valuations, is itself caught in the middle. The debt bubble was really a massive devaluation of the dollar versus financial assets. It was also a devaluation of wages, which was made tolerable to the general population by the parallel devaluation of consumer goods. Now, both the commodity price increases and the credit crunch are a reversal of that whole process, but as it is inflicting pain on rich Americans, ie the politically powerful, they are not about to let that happen if they can avoid it, and they are trying very hard to ensure that their assets do not lose their relative value. The way for them to do that is to continue to weaken the dollar, in the expectation that they can manage inflation better than others, and that their asset values will keep up with the price of goods and wages, thus entrenching the current (favorable) wealth sharing arrangements.

But the twist for them is twofold: first there are now other players in the asset game, with different priorities (oil producers want to protect the purchasing power of oil as well as that of financial assets; the Chinese want to protect their growth prospects and thus the stability of the system. Second is the fact that there is another anchor of value available today, the euro, which is untainted by either bubbly policies or lax central bank. Attempts to devalue the dollar will be visible immediately in its exchange rate against a credible alternative for all monetary functions (as opposed to, for instance, gold, which is a viable store of value in inflationary times, but is not practical for trade or accounting).

Beyond the battering to American pride of no longer being the dominant economy around, a fall of the dollar has political consequences in that the economy of the US is, right now, heavily dependent on borrowing from abroad to keep running. It could suddenly become dependent on what the lenders in stronger economies elsewhere want.

Which brings us back to our first crisis – the consequences of global growth, and the fact that the lenders are a combination of, on one side, the owners of the commodities that have fuelled the global boom, and on the other hand, the producers of the cheap goods that kept that Western population sated – and also the largest new consumers of those commodities. What both groups share are huge financial claims on the US economy – expressed in dollars. But they are also large consumers of goods – expressed in euros, and of oil and commodities.

Right now, the financial markets, mostly based in New York and London, areoblivious to these complexities, and are in full panic mode, with very unpredictable consequences for everybody:

The markets have become “utterly unhinged,” William O’Donnell, a UBS AG government bond strategist in Stamford, Connecticut, wrote in a note to clients today. A lack of liquidity has “led to stunning air-pockets in price levels.”


“Everything is telling you the financial system is broken,” Simon, whose Newport Beach, California-based unit of Allianz SE manages the world’s largest bond fund, said in a telephone interview today. “Everybody’s in de-levering mode.”


Basically the gears of capitalism are pretty much grinding to a halt,” said Mirko Mikelic, portfolio manager for Fifth Third Asset Management in Grand Rapids, Michigan. “What started as a little subprime problem has kind of morphed into a bigger problem for the bigger economy.”


Any optimism that the market might escape further violent swings has become increasingly rare. BNP Paribas said: “While deleveraging has taken an accelerated path since the beginning of the year, we believe that this is only the beginning of a trend which will look to unwind the excesses of the last few years.”

In recent days new horrors surfaced from the hedge fund world. As credit spread have risen, highly-geared funds have come under increasing pressure from uneasy investors who want their money back, and brokers terrified on counterparty risk.

Willem Sels at Dresdner Kleinwort said: “Price changes, multiplied by leverage, leads to redemption risk and margin risk, which ultimately also leads to unwind risk. This creates a technical sell-off as the unwinds happen in a bearish market.”

(FT Alphaville Blog)

For the oil producers and the emerging economies, the financial crisis is not a major issue, because they have not been exposed much to the supposedly sophisticated bits of the financial world, having parked most of their money in so-far-safe US Treasuries, and they have not lost their shirts there. But they do worry about attempts to inflate away the crisis.

And they are in a strong position to impose their views, as therelative importance of the two crises has yet to sink in:

The financial markets require a recapitalisation of the banking system, with estimates ranging from $300bn to $1,000bn.


The broad story [in commodity markets] is of depletion. Most of the easily obtainable resource deposits have already been exploited and most usable agricultural land is already in production. Natural resource discoveries, where they continue to occur, tend to be of a lower quality and are more costly to extract. Meanwhile, the dwindling supply of unutilised land faces competing demands from biodiversity, biofuels and food production.

Predictably, the scale of response to each of these crises is in inverse proportion to their respective magnitude. In the US, the credit crunch has elicited an instantaneous fiscal package to the tune of $168bn, or 1.2 per cent of nominal GDP. In contrast, the latest annual budget appropriation for renewable energy spending is just $1.72bn – 0.01 per cent of GDP.

(Tim Bonds, Barclays Capital, in the Financial Times)

In effect, the current credit crunch, while likely to be horribly painful and hugely destructive, is not the biggest crisis we face!

The growing scarcity of oil and commodities, and the increasingly strained fight for these between the big economies of the planet, is driving a parallel, and even more momentous reallocation of resources and value.

Both the money printing policies of the Fed to fight the deflation in the financial world, and the inflationary effect of commodity scarcity threaten to squeeze the middle classes.

:: ::

The only good news, so to speak, is that there is a common solution to both problems, and it is one we can choose. That solution is to focus economic policy towards energy efficiency and moving away from oil. This will have the simultaneous advantage of weaning the economy off an increasingly rare resource, to provide a timely keynesian economic boost to the economy, and to re-industrialise the same economy. A massive energy efficiency programme for homes will help slow down the real estate collaspse while providing jobs to a sector (construction) in full retreat right now ; massive investment in reneawable energies, the grid, and public transportation will help put in place the infrastructure needed for the coming decades and create non-offshoreable jobs.


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  1. I need to post stuff over here more often, dammit!

    I’m off to bed, but will be around tomorrow morning to reply to comments.

    This is crossposted from European Tribune

  2. The only good news, so to speak, is that there is a common solution to both problems, and it is one we can choose. That solution is to focus economic policy towards energy efficiency and moving away from oil.

    This assumes some kind of control over the money system.  Do we actually have that control?  The big financiers buy our politicians, and in exchange they get policies which support their investment portfolios.

    As long as oil is profitable, “alternative energy” will be marginalized.  You might try getting off of the capitalist plan, Jerome, your mentor Thorstein Veblen would think as much…

    • robodd on March 9, 2008 at 2:10 am

    the problem is the deficit which has led and is leading to the deflation of the dollar.

    The solution is getting out of foreign entanglements that are bankrupting the country and taxing those who have unjustifiably profited thru them over the last seven years.

    What are gas prices doing in Europe?

  3. But I have been watching the other elephant in the room, people.

    The Marine puppy video and other youtubes of abuses in Iraq once again are reinforcing a global “get rid of the US” theme.  911 truth worldwide is gaining recognition even if it is still a blacklisted topic here.

    Again all of this serves the planned resource reallocation from the US and back into “the world”.  It is all so on schedule.

  4. I was reading somewhere about how the Fed’s cutting of short term rates is helping to feed inflation above and beyond the norm by encouraging speculators into the commodities market.

    Basically, the theory goes that Bernacke is attempting to inflate a bubble in commodities to offset the bursting of the housing bubble – similar to Greenspan’s inflating of the housing bubble in beginning of the decade to offset the bursting of the tech bubble.

    Now combine the Fed’s interest rate moves with the Treasury’s giveaway auction of unsecured or barely secured loans to otherwise insolvent banks and you’ve got a toxic inflationary cocktail that is bound to clobber us.

    Not to mention that these moves only speed deflation in the housing market by driving up long term rates, which Bernacke has already admitted he can’t control, thus making it even more difficult for prospective buyers (if there are any left) to finance home purchases.

    Bottom line: I have a very bad feeling we are watching the implementation of monetary and fiscal policy which will make an already terrible situation much worse – so much worse, in fact, that Hoover’s tax raise at the start of the Great Depression may look good by comparison.

  5. Echoing TomP’s comment about the other place, I hardly ever find myself over there anymore. So to see you posting here is great as you probably do the best job (for me anyway) of explaining the labyrinth, seemingly inexplicable world of finance. Stick around.

    • documel on March 10, 2008 at 6:37 am

    Before anything positive can happen, the US will have to have significant inflation until house prices seem normal.  This will cause a lot of pain, but it is inevitable.  Twenty per cent inflation would get most home owners out of negative equity, and decrease the bank losses.  Of course the consumer loses, but this administration doesn’t care about those on the bottom.

    Greenspan kept interest rates too low for to long–and for that, we must bleed.  The wealthy will by euros, the middle classes will struggle to buy potatoes.  The poor will increase in number.

  6. It has gotten me into nothing but trouble lately.  I’m ready for this.  So many people that I know though are not.  It’s sort of really crazy how many people I know who are freaking out on some new tangent every day that they didn’t expect.  Like the savage energy and credit pigs that we have been doesn’t have a downside 😉  Everything was just going to keep coming up roses even though we weren’t growing any 😉

  7. economic reality at this point. I love, in a sick way, watching the candidates act like this can just be fixed by tinkering with the bad trade policies, offering ‘green’ industries, and vague references of tax incentives to keep work here. Free Market is still God. Regulation, trust busting, and a halt to privatization, seem off the table and the government is set to stay an ATM for the pirates disguised as Corporations.  

    Meanwhile in real world, If I call my bank and actually get a person on the line I get someone from India with no conception of my concerns. My groceries have just about doubled,  everything I try to buy is made in China, my electricity is controlled by a Scottish Co, and I’m told that being forced to pay the vig to insurance companies is Universal Health care. I sold my nasty inherited stocks and feel under the mattress is the most secure place for money these days.

    Your solutions are sane and make sense even to me a socialist, who has had come to grips with capitalism, but we are not even capitalists anymore, were owned outright by the Visigoths of profit who have no thought of what it leaves in it’s wake. Sorry to be so pessimistic. Thanks for your ongoing education of this former economic dummy. What I used to suspect was a con I now know is.      


    • ANKOSS on March 10, 2008 at 7:42 pm

    In all the policy discussion regarding current economic problems, US corruption is held constant, but is it? When the US government has been ethically crippled to the point that regulatory agencies can no longer function (FCC, SEC, FDA, EPA, etc.), what good will policy changes do?

    It is the collapse of honesty, a basic structural support of our mixed economy, that has enormously increased the difficulty of restoring America’s health. The notion that the BushCo malaise will soon lift like an evil fog is simplistic. Thousands of dysfunctional Bush-era appointees litter the agencies of the US government, and their malignant influence will be felt for many years. Hundreds of thousands of correspondingly corrupt managers, consultants, and PR people riddle the business sector with pockets of incompetence and deceit.

    Nobody in the academic community or the press wants to turn over the rock under which the ugliness of systemic corporate and governmental corruption of the US economy has hidden. But that is what is the root of the problem, not just a few bad decisions that can easily be reversed.  

  8. Just another note on the liquidity/asset conundrum:


    Financial Crisis: Sorting Through the Rubble in Post-Bubble America

    by Mike Whitney

    Global Research, March 8, 2008

    “Market conditions are the worst anyone in this industry can ever remember. I don’t think anyone has a recollection of a total disappearance in liquidity…There are billion of dollars worth of assets out there for which there is just no market.” Alain Grisay, chief executive officer of London-based F&C Asset Management Plc; BloombergNews.

    The hurricane that began with subprime mortgages, has swept through the credit markets wreaking havoc on municipal bonds, hedge funds, complex structured investments, and agency debt (Fannie Mae). Now the first gusts from the Force-5 gale are touching down in the real economy where the damage is expected to be widespread.

    Fasten your seat belts, folks.  This looks to be one-heck-of-a-ride!

  9. You forgot stagflation.

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