I’ve been asked frequently whether I view inflation or deflation to be the more likely outcome to the credit crisis. My view has been that deflation is more likely, but that circumstances could certainly change.
Left to its own devices, with no government intervention, we would collapse into a debt-deflation spiral. Why? Because as the economy turns and risk premia rise, highly-leveraged banks would be forced to sell assets in a scramble for cash to cover short-term loans, which would in turn drive down asset prices further, setting off further collateral calls from lenders and investors, forcing more asset sales and so on. In fact, this is what’s happening right now, and the government is intervening about as much as it can to stop it.
The debt deflation spiral turns into price deflation because the inability to borrow causes demand to collapse. Firms and consumers hoard cash to pay off debts instead of investing in their business or consuming. The value of cash rises and everything else falls. Eventually, things get so cheap and the potential returns so high, that “strong hands” step back in to the market, stopping the cycle.
We are particularly vulnerable a prolonged debt deflation now, because the US economy is more leveraged than it has ever been, particularly the financial system and US consumers.
Ironically, the US government is not that highly leveraged as a percent of GDP, at roughly 60% today vs. well over 100% during World War II, and businesses are not leveraged outside of the norm.
We got to this point because, after the Great Depression, we have set up our entire system to avoid deflation at all costs. We have used monetary, fiscal and currency policy to fight potential contractions in private credit. In other words, we have relentlessly fought off deflation with inflation, levering up our economy to the point where it can’t go any further. I would argue that we are not facing a shortage of demand, as much as we are retreating from artificially high demand fed by artificially abundant credit.
Consumers will be forced to deleverage, first as housing prices fall and then as baby boomers prepare for retirement. Additionally, we are likely to see a contraction in the GSE programs and new regulations that limit “subprime” lending in all forms. The financial system will also be forced to deleverage, first as asset prices fall and then as a new regulatory regime limiting the leverage of banks, hedge funds, and GSEs is implemented. The US government does have scope to leverage itself, which is what it is doing.
The fear among the inflation hawks is that the recent large government deficits and expansion of the Fed’s balance sheet will eventually result in high inflation. While this is possible, it would take a concerted effort by our government to let inflation spin out of control. Why? Because as the economy improves, the government will face political (and fiscal) pressure to sell its bank investments back into the private markets and the Fed will face pressure to shrink its balance sheet back down and to trade its recently-acquired risk assets for Treasuries. These sales will restrict growth in the monetary aggregates. While I don’t have a ton of confidence in the economic skills of our elected officials, I give them more credit than to think that they will purposely send us down the road of hyperinflation.
In addition, without a re-leveraging of the financial system or consumer balance sheets, we are unlikely to return to renewed credit inflation in the near-to-intermediate term. I therefore believe that we are more likely to see a period of price declines in the near term followed by a long period of subdued inflation and relatively low interest rates.