"Deflation has become inevitable"

I’m reproducing the bulk of a very good (and possibly final) post by London Banker, a former central banker and securities regulator, that takes issue with some of the conventional wisdom surrounding the efforts to remedy our economic crisis via liberal applications of monetary easing and fiscal stimulus.

I happen in general to be sympathetic to minority views (conventional wisdom is generally wrong). And in this case, as I discuss below, I am worried that conventional wisdom rests on a thin and dubious set of data and assumptions.

London Banker’s arguments are two-fold: first, deflation is more likely than inflation because the underlying messes have not been cleaned up. Therefore investors will be leery of putting funds into risky investments. Note this differs from the commonly-held view that deflation can be cured without addressing institutional arrangements. Second, he argues that punitively low yields will lead foreign investors eventually to retreat even from government debt. He argues that they will tire at throwing good money after bad, and will prefer to seek returns closer to home.

This claim is hard to prove (one can argue that the high risk spreads are due to deleveraging, not distrust) but it is a serious issue if true. One of the things that worked for years in favor of the US is that it had the most liquid, deepest capital markets, That was due not just to the size of its economy, but also the fact that it had high standards for financial disclosure and generally strong investor protection. If investors come to doubt the fairness of the markets, or think that the rot in its economy is not being cleared out and will undermine growth, that will hold investment back. As Brad Setser has pointed out, foreign capital flows have consisted almost entirely of central bank purchases of Treasuries and Agencies for quite some time, hardly a vote of confidence.

We also have the question of how long the high dollar/low Treasury interest game can go on. Bernanke wants rates low to try to stimulate economic activity and has even broached the idea of long bond purchases to keep yields on the long end of the curve down. But the poster child of deflation and low interest rates is Japan, which due to its high savings rate, was not dependent on external funding. The US should want the dollar cheaper to boost exports, but that risks the ire of our creditors, who would take big losses on their FX reserves (many economists argue this idea is specious, but try explaining the loss in paper wealth to a populace not schooled in such niceties. FX losses, when the dollar was weakening earlier in the year, produced a lot of ire in China, including among bureaucrats). Similarly, even if you subscribe to the deflation outlook, 3%ish 30 year bonds is a pretty risky bet independent of the currency risk. So it looks like our friendly funding sources are likely to get burned one way or another, perhaps both. There is a real risk of a disorderly fall of the dollar, and it is hard to tell what the collateral damage would be.

Now to my doubts about the proposed remedies, namely monster stimulus and monetary easing. First, as mentioned before, the analogy is to the US in the Depression, which we have said repeatedly before is questionable. The US in the 1920s was the world’s biggest creditor, exporter, and manufacturer. Our position then is analogous to China’s now. Indeed, Keynes in the 1930s urged America to take even more aggressive measures, and argued that it was not reasonable for the US to expect over-consuming, debt-burdened countries like the UK and France to take up the demand slack. So even though most economists are invoking Keynes, it isn’t clear he’s prescribe such aggressive stimulus for the US and UK now.

Second, the argument is that the US in the 1930s and Japan in its post bubble era failed to engage in sufficiently large stimulus. That is mere conjecture; there is no way to prove that argument (we cannot go back in a time machine and test different remedies in both economies).

In the US, the claim generally made is that the US did not emerge conclusively from the Depression until it engaged in massive wartime spending starting in 1939-40, and therefore a stimulus of perhaps that large a magnitude is required. However, quite a lot happened between 1930 and 1939, including going off the gold standard, the securities law reforms of 1933 and 1934, the creation of the FDIC, refinancing homeowner debt to longer-term mortgages via the Homeowner’s Loan Corporation, and the closure of a lot of business, some of which were probably victims of circumstance, but others probably deserved to be put out of their misery.

There is another huge extenuating circumstance with the war spending that observers choose to forget. The US’s problem in 1929, like China’s appeared to be (at least in part) overproduction, that there might be too much global capacity relative to consumer demand (that is certainly true for the auto industry now, which had managed to forestall the day of reckoning by converting consumers to leases that had them trading in cars after 3 years, when buyers generally keep them longer, Decreasing the effective life of cars was tantamount to increasing demand). In addition, the US suffered a fall in GDP of 11% in 1946 and 1% in 1947 in transitioning off a wartime economy.

But perhaps more important, at the end of WWII, productive capacity in the next two biggest industrialized nations, Germany and Japan, had been destroyed. The US had effectively no competition for its bulked up industrial capacity.

Had the US in 1930 tried monster stimulus, without the painful adjustments of the 1930s, would it have worked? Probably narrowly, in keeping unemployment from rising to horrific levels and containing the fall in GDP. But I question whether it would have been a panacea. The New Deal, contrary to popular opinion, did produce a lot of good results with its workfare, such as the building of parks and roads, the electrification of rural America. if the US had attempted something at twice that scale, would it have been productive? Some argue that it didn’t matter, the important thing is to get money into the economy, but I wonder. Japan did engage in pretty heavy infrastructure spending (a lot of bridges to nowhere) and it does not seem to have done them much good.

Note my sophisticated investor buddies disagree, saying this is backwards looking, confident that a US budget deficit of 10% of GDP next year will do the trick, and think inflation/hyperinflation is the bigger risk (note some consider hyperinflation to be operative at 20% per annum; you do not need to get to Weimar scenarios for inflation to start distorting economic decisions in a very serious way).

From London Banker:

For a while now I have been on the fence on the inflation/deflation issue …. I’m now coming down on the side of deflation for a very simple reason: there is no longer any incentive to save or invest, and so debt and investment cannot increase much beyond current bloated levels.

In Lombard Street, Bagehot’s seminal tome on fractional reserve central banking, Bagehot advises any central bank facing a simultaneous credit crisis and currency crisis to raise interest rates. By raising rates they will ensure that foreign creditors remain incentivised to maintain the general level of credit available while the central bank resolves the local liquidity crisis through liquidation of failed banks and temporary liquidity support of stressed banks.

Yves here. For the UK, the currency crisis issue is a real concern. Recall that the pound has taken a huge dive in recent months, and Willem Buiter has taken to comparing Britain to Iceland. Back to the post:

The very opposite policies have been pursued by central banks in the US, Europe and UK …They have cut policy rates drastically, and as the crisis escalated and spread, the yield on government debt has dropped to negative territory. Meanwhile they have shielded those responsible for the creation of record levels of bad debt from any regulatory accountability, relaxed transparency of accounts, and provided massive taxpayer-funded financial infusions to prevent failure and liquidation.

While in the short term these policies have expediency and the maintenance of market “confidence” on their side, in the longer term these policies must undermine any confidence a rational and objective saver or investor might have that savings or investment in the US, EU or UK will be fairly remunerated at an above-inflation rate, or that savings and investments will be protected by effective oversight and regulation from the sorts of executive debasement and outright misappropriation and fraud that are beginning to colour our perceptions of the past decade…

If US, EU and UK had substantial domestic savings to fund their banks (as in Japan in 1990), then perhaps the consequences would not be so imminently disastrous. Lacking sufficient domestic savings, however, their actions will likely make foreign creditors in Japan, China, the Gulf and elsewhere question whether it is worthwhile to keep pumping scarce savings into such flawed and reckless economies…

The determination to avoid any accountability for failed banks, failed business models, failed regulatory systems and failed academic rationales for all the above invites anyone with spare cash – an increasingly select crowd – to withhold it from further depredations. It is this instinct, more than confidence in the government, which is driving so many to seek the temporary safety of short-dated government securities.

The result of discouraging domestic and foreign creditors and investors must be inevitable deflation as debt levels become increasingly hard to finance and ultimately contract. Irresponsible central banks and governments can try to bail out the failed banks, businesses and municipalities at the centre of every popped bubble, but the bubble economies are ever more certain to deflate with each bailout. Each bailout further undermines the market discipline which is bedrock to a saver or investor’s decision to part with hard-earned cash by trusting it to the intermediation of the management of a bank or business.

It’s this simple: I won’t invest in a country that bails out failure and punishes savers. I won’t invest in the US or UK until they change course and protect savers and investors, ensuring a reasonably predictable positive return. In the EU, I will be very selective, preferring those conservative states like Germany that never embraced the worst excesses, although sadly still have fall out from individual banks’ stupidity in buying into foreign excess. I will know when it is safe to reinvest when policy interest rates, bank/intermediary oversight and accounting standards give me confidence I am better protected than the corporate or financial elite.

While it may take the Asian and the Gulf State investors longer to embrace my analysis, I have no doubt that they too will eventually conclude that parting with their savings under the terms now on offer will only deepen their losses. They would be better off keeping the money at home, investing locally under local laws and vigilance, and letting the US and UK implode.

The argument against this has always been that with trillions already invested in the US during the deficit years, the Chinese and Gulf States would suffer even more horrible losses from a collapse of the western economies. This is accurate, but not complete, as it ignores the relative value of cash investment at the top and bottom of a bursting bubble. Once the collapse has bottomed out, so long as a globalised economy survives, there will be even better opportunities for those with savings to invest selectively in businesses with clearer prospects and more certain profitability under regulatory frameworks which have been restored to a proper balance of investor protection and intermediary oversight.

Right now survival of businesses in the West depends largely on political pull and access to regulatory forbearance and central bank or treasury finance. The market has failed, and officialdom is collaborating in perpetuating that failure…

I think it took me so long to feel confident about predicting deflation because the floating currency system under dollar hegemony and Bretton Woods II distorts the workings of both inflation and deflation. Despite the US being the epicentre of all the failed debts, failed securitisations, failed credit derivatives, failed rating agencies, failed banking businesses, failed corporate governance, failed accounting standards, failed capital adequacy models, and failed regulatory forbearance, the US dollar has recently strengthened as deflation globalised. The US exported inflation in the boom years, and now exports deflation in the bust years.

Since spring 2008, as US investment banks sold off assets, imposed margin calls, and used access to unsegregated wholesale assets in custody in the rest of the world to upstream liquidity to their US-based parents and affiliates, the dollar has strengthened relative to other currencies. The media reports this as a “flight to quality”, but it is more like a last looting of the surrounding countryside before dangerous brigands hole up in their hilltop fortress. The brigands appear temporarily wealthy compared to the peons left stripped and penniless and facing winter. When the brigands have eaten all the stolen grain and livestock, however, they will have no means to replenish except to use force to raid the countryside again. The peons can always hunt, forage, farm and carefully husband a surplus to gradually increase their wealth. If the brigands raid too thoroughly or too regularly, the peons have no incentive to grow crops or keep herds (negative savings returns) and everyone starves (deflation).

In the meanwhile, the peons just might wise up, hide any surplus more securely and organise mutual defense against further attacks to ensure that their peon children prosper and the brigands die off. That would be the end of Bretton Woods II, and the rise of China, India, the Gulf and other productive and/or resource rich states which invest surplus in domestic productivity and regional growth…

Only when that deflation has played out and rational policies that reward market-based management and returns are restored will it be worthwhile to invest again. In the meanwhile, any wealth saved securely from state seizure will “swell” to buy more assets in future – a key aspect of deflation and a key means of restoring the control of the economy into the hands of more farsighted savers and investors.

I have quoted Mr John Mill before, but it bears repeating: ““Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.” The extent to which capital has been betrayed in the past quarter century under Bretton Woods II, bank deregulation and the Basle Capital Adequacy Accords is unrivalled in the history of fiat banking. The bankers, lawmakers, regulators and academics who collaborated in the betrayal still hold power, like the well-armed brigands in the fortress, and their continued collaboration to prevent accountability must inevitably discourage honest savers from risking further loss. Even so, it is the savers/peons who hold the ultimate power as they can starve the brigands.

Some day soon savers will revolt at financing further depredations. They will refuse to buy even government securities, gagging at the quantities of issue forced upon them under terms of only negative return. When that final massive bubble bursts, deflation will follow its harsh corrective course and clean out deficit-financed “unproductive works”.

When that happens, if reason is restored in markets with effective oversight, I might consider investing again, very selectively, in whatever productive works might then be on offer and only when secure in realising – and retaining – a positive yield.

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64 comments

  1. Lune

    Interesting analysis. However, I’m not sure I like Germany’s chances all that much either. Regardless of their national character of financial conservativism, I suspect they will be forced as the anchor of the EU to spend most of their money bailing out the rest of the EU.

    As the saying goes, democracy only works until the people realize they can vote themselves money from the nation’s treasury. In this case, the EU only works until the people realize they can vote themselves money from Germany’s coffers. Once that happens (and it is happening now), Germany will be sucked into the same failed policies that London Banker criticizes the US and UK of pursuing. It might not come willingly, but that hardly matters.

    So in the final analysis, what country out there is pursuing the type of policies that would make an investor like London Banker confident enough to part with his savings?

  2. Anonymous

    There is a moralizing tone to LB’s post. Moral judgments in economics are often exercises in wish fulfillment and are distorting.

    “…the rise of China, India, the Gulf and other productive and/or resource rich states which invest surplus in domestic productivity and regional growth.”

    By contrast to the UK and USA and their vampiric relation to surplus states?

    Or, not so much. As wages have fallen in China relative to GDP, investment in productive capacity has been in a bubble. The crash will be horrific. That model is at least as unsustainable as the American model.

    Yes there will be deflation. It is a consequence of world-wide unwinding of leverage. But that doesn’t mean the ‘Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate’ policy is what we need.
    Rescuing productive and financial capacities from the forces of collapse is the only way right now towards any sort of climate for investment at all.

  3. bg

    As a deflationista, I thank you for posting this minority opinion. I know you are not sold on all the points. Deflation is about destruction of unproductive ventures. There is global overcapacity in every area, and a concentration of wealth from unproductive industries (yes, Wall street). Keynes and the Monetarists have created a mindset that acts of money can overcome acts of stupidity.

    You can’t throw enough money at this to compensate for the rapid extraction of capital from folly. We should be putting all our energy into getting money into self sustaining productive enterprises. There are plenty. Detroit is not one of them.

  4. Jesse

    Money Supply (deflation and inflation) are always and everywhere a policy decision in a purely fiat regime. What the Fed and Treasury cannot manipulate as easily is the velocity of money, aka the aggregate demand component.

    The mind rebels at the fact, and invents reasons ‘why the Fed cannot do this, and why private borrowing must do that.’

    If anything the last six month ought to have put some real meat on the bones of Bernanke’s assertion about the Fed’s printing press. The only reason we have not yet reaped the benefits of his handiwork in inflation is because they are trying to drain as they liquify, a noble pursuit.

    But wait until the Keynesian and Monetarist cocktail party gets seriously underway next year. And when foreign money starts tiring of subsidizing the US as LB suggests, the artficial underpinnings of the US dollar will vaporize.

    The bogeyman is Japan. But people ignore the several hundred other examples of the inflationary impact of credit and monetary manipulation. Japan’s trouble was a pure policy decision made in combination with their desire to maintain a high export driven low consumption economy, combined with a stable and aging popupulation because of a bias against immigration.

    so, we’ll see which way this goes, but there was not a lot of new material in LB’s essay.

    I have a strong feeling that what does result will be as shocking as the stagflation we had in the 1970’s that had every economimist’s jaw dropping and mouth agape.

  5. Balmain Bear

    I greatly admired LB’s parting shot, however felt his analysis made sense only in the pure crucible of economics. In the real world I think political economy will determine our fate…

    “In the meanwhile, the peons just might wise up, hide any surplus more securely and organise mutual defense against further attacks to ensure that their peon children prosper and the brigands die off. That would be the end of Bretton Woods II, and the rise of China, India, the Gulf and other productive and/or resource rich states which invest surplus in domestic productivity and regional growth”

    LBs analogy is posing a false dichotomy. There are no peons in the current world economy.

    A better analogy is that we have competing feudal fiefdoms. At the top of which sit corrupt elites that are complicit in a vast cross-border covenant designed to perpetuate their own power and wealth.

    In the Chinese fiefdom, savings are controlled by a landed technocracy. That clic deploys those savings in such a way that its peasants invest in production destined for the neighbouring fiefdom. Its does not invest in domestic productivity nor in services that support its local citizenry. It invests in neighburing demand. This system has created vast over-capacity in the local economy.

    The ruling technocrats know that without the demand of the neighbouring fiefdom this over-capacity will collapse and its power will be threatened by peasant riots. The elite also understand that its immature capital markets, no reserve currency and lack of legal clarity mean it is unable to finance its own economy. Moreover, its default politics depends largely on political pull and access to regulatory forbearance and central bank or treasury finance. Just the way they like it.

    They will therefore continue to finance the neighbours ad nauseum.

    Deflation may have its way but not through a collapse of foreign flows into the US.

  6. Blissex

    «high standards for financial disclosure and generally strong investor protection. If investors come to doubt the fairness of the markets, or think that the rot in its economy is not being cleared out and will undermine growth, that will hold investment back.»

    The one reason why investor put their money in the USA is simply political risk: the USA has been run by rentier/business elites for its entire history and there is no political risk unlike in China, India, or even the UK.

    Only Switzerland comes close in investors’ minds, for the same reason, and indeed capital flight money goes either to Geneve/Zurich (from Europe, Middle East and Africa) or to NYC (from Latin America and Asia).

    Since political risk is about the risk of losing part or all of the principal, not the returns, 0% USA or Swiss returns don’t discourage capital-flight investors. Indeed for quite a while Switzerland had negative interest rates (via a tax on foreign capital) and this did not much to stop the action.

    Apart from returns mattering a lot less than political risk protection, everybody knows that the USA capital markets are rigged and unfair, and the USA was still the target of capital flight when insider trading was legal. That is considered a minor risk by capital flight investors, and anyhow there are treasuries and minus.

  7. Blissex

    «Money Supply (deflation and inflation) are always and everywhere a policy decision in a purely fiat regime. What the Fed and Treasury cannot manipulate as easily is the velocity of money, aka the aggregate demand component.»

    The terminology here is not quite right: “Money Supply” is the combined product of quantity and velocity, and both of these are ill-defined, never mind the product.

    Not only it is difficult to define what the quantity of money is, but whatever it is the authorities can only control part of it, as a lot of that is just credit, and since the USA government effectively abolished fractional reserves in 1995 and the Japanese government lending Yen at 0%, the availability of credit (money? quasi-money?) has been in the hands of bank boards.

  8. Anonymous

    Deflation until late 2010 followed by the collapse of the Treasury market bubble and the dollar. Too much debt is the problem and adding more debt will onlly make it worse.

  9. Anonymous

    Agree with LB on his analysis of rewards for investing in US markets. This should result in an deflationary environment for ASSETS. Who would want to invest in US assets / treasuries / dollars with the current state of the economy, massive money printing, and rigged financial markets.

    However, its also clear that the Fed will print money until the press collapses from overuse. After all, the voter will have to be supported somehow. This will likely play out in inflation in the US but also for those countries that maintain the dollar peg. In other words, if you want to export to the US at current exchange rates, you will have to sterilise dollars and lots of them. If the Chinese want to maintain their peg and are willing to accept dollars for their hard work and manufactured goods for the benefit of the US consumer, well, lets drown them in dollars.
    The US dollar is going to drop and drop hard in 2009.

    My vote for
    Asset deflation
    Consumer inflation

  10. DownSouth

    Jesse said…

    “Money Supply (deflation and inflation) are always and everywhere a policy decision in a purely fiat regime.”

    That is the most accurate thing that has been said here.

    While I am certainly sympathetic to much of what London Banker has to say, I believe his analysis to be more transformative than descriptive. There is absolutely no logic to his argument that we require the aid of foreign investors in order to massively inflate the number of dollars in circulation. Some constituencies will benefit from inflation. Others will benefit from deflation. London Banker is advocating for those constituencies that will benefit from deflation. But politics, and the resultant policy decisions, will ultimately determine whether it’s inflation or deflation.

    I’m intrigued by attempts like this to pass policy prescriptions (and again, don’t get me wrong, I’m not necessarily adverse to London Banker’s policy prescriptions) off as if they were some sort of inevitable outcome. Robert L. Heilbroner in Behind the Veil of Economics does a wonderful job of ilucidating how these games are played. As Heilbroner concludes, by “screening out all aspects of domination and acquiescence, as well as those of affect and trust, it [the discipline of economics] encourages us to understand capitalism as fundamentally ‘economic’–not social or political–in nature.”

    For me a bigger question is why there is such a drive to create the impression that there is some “invisible hand” that makes all this happen, when in reality there is a Wizard of Oz that has his hands firmly on the levers. The only thing I can figure out is that it gives the Wizard plausible deniability. It’s like extrordinary rendition: the government can always claim it is someone else or something else that is causing the pain.

  11. Duck Diversified

    We should be mindful that politicians and their financial cronies have an interest in maintaining a floor, hence all the bailout action. I accept London Banker’s thesis or prediction that the end is nigh. The Wizard of Oz was smoke and mirrors, unable to work real miracles.

    Yves, thank you very sincerely for helping us think this through and unique timely coverage.

  12. patrick neid

    The banker finally gets it and Bagehot has always been right. The reason they are not listened to is because it is too simple. We like our stuff complicated.

    Even a casual study of previous bubbles going back several hundred years leaves the reader with only two major observations–there’s absolutely nothing you can do to put Humpty Dumpty back together and/but they will still try. That’s where we are today.

    Another major mistake that activist market historians make, Bernanke is getting his chance now, is mistaking hindsight for clairvoyance going forward. It is easy to forget that the mistakes made by the New Dealers were mistakes made by folks who were considered the best and brightest of their times. Each succeeding generation of the best and brightest always make the mistake of thinking that they are, today, the best ever. Never does it enter their minds that, whereas every past group of interventionists failed that maybe post bubble traumas are not open to intervention. This is what the Austrians and Bagehot understand.

    Furthermore the lack of this understanding makes the situation worse. The simple fact of intervening postpones the curative powers of the market itself. Bagehot has always been right, make money available but at rates above the current freight. Then stand aside and leave the market alone. Only time can remedy the “splat” effects of a bubble. Meanwhile protect your currency and reward prior savers.

    I have said from day one that the “plans” would all fail. Not because I have some great insight or a brilliant economic mind in sifting through academic data points but a simple market historian’s approach—there has never been successful post bubble interventions. When bubbles burst everything returns to the original point of departure. Interventions only slow or speed up that process. The other fact, they are all deflationary.

    We don’t even have to discuss the absolute insanity of the idea that a small group of people anywhere has the knowledge and foresight to manipulate seven billion peoples economic transactions on a daily basis to effect a certain outcome and resolve problems that they never saw coming in the first place. Wow, the absurdity of it all.

    And finally the constant screaming of fire in the theater is not helpful. They are not messengers they are arsonists. Wagner and cohorts being the last example.

  13. DownSouth

    Blissex said…

    “The one reason why investor put their money in the USA is simply political risk: the USA has been run by rentier/business elites for its entire history and there is no political risk unlike in China, India, or even the UK.”

    Blissex, even though there is much truth to this, it is not the whole truth.

    Kevin Phillips in Wealth and Democracy does a stellar job of describing the political ebb and flow in the United States as it relates to wealth. There were indeed eras–the Gilded Age, the Roaring Twenties and the period from about 1980 to present–when the rentier/business elites you describe did “run” things. But there were other eras, such as those under the administrations of Jefferson, the two Roosevelts, Washington, Jackson and Lincoln, where the power and influence of bankers, financiers and corporate elites was greatly rolled back and kept in check by a more populist–and democratic–polity. It is during these more populist periods that the “high standards for financial disclosure and generally strong investor protection” came into being.

    Your highly bowlderized and revisionist recounting of history, especially when it comes to the past performance of economic elites, seems to be in keeping with all libertarian ideologues, whether they be of the Aurstrian or Chicago varieties. Since history doesn’t fit well within their doctrines, they find it necessary to distort the historical record so that it does.

  14. Chris

    Lune
    On the UK and BRD. There most likely will be some kind of agreement between the two. But it will be a negotiated one. The final result most probably will involve some arrangement for Britain to join the Euro which would free Germany to join a Euro-wide stimulus package. France would approve this. It will include some settlement of the eastern EC members issues. How that result is brought about, and over what time frame will be interesting. The key issue of course will be the UK’s future relationship to the dollar. There were also currency issues at play in the 20’s and 30’s. I would imagine, given how serious the whole situation is, that the UK would be quite capable of doing something generally unexpected and emulating Churchill’s decision to go off the gold standard. I doubt there would be much upside at this point to tighter integration with the US. Mandelson’s return and the deal with the Russians over their oligarchs’ foreign investments kind of point to UK participation in the European discussion with the Russians. Otherwise, time will no doubt tell, but things will not continue on their present path for with the present choice of policies the continuing mess remains unsustainable.

  15. mab

    LB,

    You are a big hypocrite. It’s clear you are a rent seeker, rather than a wealth creator. You whine about the failings of government yet want the protection of a government. You ARE the problem. With wealth comes responsibility. Somehow you fail to see this. You expect wealth from wealth without work. Something for nothing always leads to nothing for something.

    There are NO guaranteed real returns. That’s life. Grow up you spoiled brat. Nobody owes you savings a living let alone a real return. You want a guaranteed victory in order to “compete.” What a seriously warped view of capitalism.

    Take your “savings” and hide them in a mattress. I seriously doubt you would ever directly invest in a competitive endeavor.

  16. DownSouth

    patrick neid,

    Again, yours is a highly revisionist view of history, the historical revisions being necessary for hitory to fit neatly within your economic dognma.

    As Phillips sets out in Wealth and Democracy, all “Capitalist Heyday” periods–the Gilded Age, the Roaring Twenties, the Great Bull Market of the 1980s and 1990s (and the Great Housing Bull Market of 2000 to 2007)–share certain characteristics. These include conservative politics and ideology; skepticism of government–laissez-faire and deregulation–and emphais on market and the private sector; the exaltation of business, entrepreneurialism, and the achievements of free enterprise; aspects of survival-of-the-fittest thinking; reduction and elimination of taxes, especially on corporations, personal incomes or inheritance; and rising levels of inequality.

    But it was Reinhold Neibuhr, in The Irony of American History, who rendered what was probably the most devastating critique of the entire libertarian enterprise:


    “The ironic contrast between Jeffersonian hopes and fears for Americans and the actual realities is increased by the exchange of ideological weapons between the early and the later Jeffersonians. The early Jeffersonians sought to keep political power weak, discouraging both the growth of federal power in relation to the States and confining political control over economic life to the States. They feared that such power would be compounded with the economic power of the privileged and used against the less favored. Subsequently the wielders of great economic power adopted the Jeffersonian maxim that the best possible government is the least possible government. The American democracy, as every other healthy democracy, had learned to use the more equal distribution of political power, inherent in universal suffrage, as leverage against the tendency toward concentration of power in economic life. Culminating in the “New Deal,” national governments, based upon an alliance of farmers, workers and middle classes, have used the power of the state to establish minimal standards of ‘welfare’ in housing, social security, health services, etc. Naturally, the higher income groups benefited less from these minimal standards of justice, and paid a proportionately higher cost for these than the proponents of the measures of a ‘welfare state.’ The former, therefore, used the ideology of Jeffersonianism to counter these tendencies; while the classes in society which had Jefferson’s original interest in equality discarded his ideology because they were less certain than he that complete freedom in economic relations would inevitably make for equlity.”

    “In this development the less privileged classes developed a realistic appreciation of the factor of power in social life, while the privileged classes tried to preserve the illusion of classical liberalism that power is not an important element in man’s social life. They recognize the force of interst; but they continue to assume that the competition of interests will make for justice without political or moral regulation. This would be possible only if the various powers which support interest were fairly equally divided, which they never are.

    “Since America developed as a bourgeois society, with only remnants of the older feudal culture to inform its ethos, it naturally inclined toward the bourgeois ideology which neglects the factor of power in the human community and equates interest with rationality.

    “Such a society regards all social relations as essentially innoncent because it believes self-interest to be inherently harmless. It is, in common with Marxism, blind to the lust for power in the motives of men; but also to the injustices which flow from the disbalances of power in the community.”

    Your talk of the “mistakes made by the New Dealers” also betrays your ideological predelection. As Phillips points out:


    “Politics…often lends itself to moneymaking, but its higher levels of popular respect–generally missing in the late twentieth century–are reserved for those who have fought the forces of avarice.”

  17. Independent Accountant

    YS:
    I read the LB and Buiter posts; I regularly read both. I think LB is all wet here. So wet, I wonder if he wrote this post “tongue in cheek”. Is LB serious? Jesse’s got this right. Our “money supply” is misnamed because supply is a flow number, a schedule of quantities at prices over time. What we have is a “stock” number, a balance sheet number. Consider, if M2 is say $8 trillion, it’s $8 trillion right now! There is no time dimension, hence it’s a balance sheet number. That said, what we call “money” is the monetary base multiplied by the “money multiplier”, which currently is decreasing. When it gets going again, measured “inflation” will soar. Study the German 1918-1923 experience. With fiat money worldwide, I can’t credit the defaltion case.

  18. purple

    Asia and the ME won’t have any savings when this over with. They’ll be too busy propping up their economies.

    The weakness in countries with reserves is already apparent in Russia. It’s quite likely that China will go from 12 % GDP growth to 0% in less than a year.

    A lot of people are acting like this is the 9th inning, when it’s still the 3rd, or even warm ups.

  19. DailyVus

    from

    In the same way, I am disgusted by the central banks preserving the privileges of the financial elite in preference to the jobs, incomes and businesses powering the real economy

    Where was the disgust when the term “downsizing” was invented to disguise the appalling (to anyone not Wall Street brain dead) “firing” thousands to the applause of instantly higher share prices. Greed is too mild a term.

    I’ll save ithat for another post.

  20. DailyVus

    Apologies

    the previous quote is from London’s Friday, 28 November 2008

    “What We Value Is What We Save In a Crisis”

  21. Gentlemutt

    Fascinating arguments, all this, thanks to all for the education.

    In trying to sift through contending historical interpretations, it is unclear whether there is substantive disagreement on the matter of policy prescriptions, say for the USA, nowadays.

    For example, does DownSouth disagree with Mr. Neid on the matter of Bagehot’s preference for rewarding savers in the aftermath of a bubble? Does Mr. Neid disagree with DownSouth’s apparent preference for imposing stronger and more clear regulatory oversight in pursuit of widespread confidence in the rules of the game? I feel like the grandpa in Moonstruck, where this is all very confusing, so a clarification on what this thoughtful panel recommends govt should do now would be much appreciated. Grazie.

  22. fresno dan

    Yves “Now to my doubts about the proposed remedies, namely monster stimulus and monetary easing”
    and
    “In the US, the claim generally made is that the US did not emerge conclusively from the Depression until it engaged in massive wartime spending starting in 1939-40, and therefore a stimulus of perhaps that large a magnitude is required. However, quite a lot happened between 1930 and 1939, including going off the gold standard, the securities law reforms of 1933 and 1934, the creation of the FDIC, refinancing homeowner debt to longer-term mortgages via the Homeowner’s Loan Corporation, and the closure of a lot of business, some of which were probably victims of circumstance, but others probably deserved to be put out of their misery.”

    Agreed.
    Debt held by the government is no worse, AND no better than privately held debt. The question I always have (and cannot be definitively answered – I’ve read various suppositions) is how much debt can the US amass before bondholders come to the conclusion that it is an uneconomic proposition? If it happens, I expect it will be sudden.

  23. Anonymous

    Yves said, “Some argue that it didn’t matter, the important thing is to get money into the economy, but I wonder. Japan did engage in pretty heavy infrastructure spending (a lot of bridges to nowhere) and it does not seem to have done them much good.”

    At a minimum Japan got infrastructure. I would call that, “good.”

    In the US we have an atrociously immobile workforce. We need to make workers/citizens secure and truly mobile. That way, business can have the labor it needs, where and when it wants it.

    We need a true safety net, and real transportation options for people. Only then will we (business) really be able to exploit the potential of our workers…to the benefit of everyone.

    I’m much less concerned about what a bunch of central bankers have to say about marginal decimal point movement of indices. This is about humans having decent and secure lives.

  24. Carlosjii

    This note from a German friend of mine
    I do not understand the market but I do understand that money is an illusion, something we have agreed to use as exchange for goods and services. My grandmother lost her fortune twice and in the end would only invest in gold. She also had a cache of miniature bottles of champagne under her bed. Another good investment.
    Gisela

  25. Anonymous

    Jesse says:
    “If anything the last six month ought to have put some real meat on the bones of Bernanke’s assertion about the Fed’s printing press.”
    I see it differently. I think the last six months have proven Bernanke dead wrong and made him look like a fool. There come a point in any science where the facts rule. Theory that does not work is wrong – there is no optional choice for belief.

  26. Anonymous

    From all the fine comments two points stay with me:
    1.patrick neid

    “I have said from day one that the “plans” would all fail. Not because I have some great insight or a brilliant economic mind in sifting through academic data points but a simple market historian’s approach—there has never been successful post bubble interventions. When bubbles burst everything returns to the original point of departure. Interventions only slow or speed up that process. The other fact, they are all deflationary.”

    @.Reinhold Neibuhr via Down South
    “Since America developed as a bourgeois society, with only remnants of the older feudal culture to inform its ethos, it naturally inclined toward the bourgeois ideology which neglects the factor of power in the human community and equates interest with rationality.

    “Such a society regards all social relations as essentially innoncent because it believes self-interest to be inherently harmless. It is, in common with Marxism, blind to the lust for power in the motives of men; but also to the injustices which flow from the disbalances of power in the community.”

    For the first: that is just an example of the notion from systems biology that the system will bring temporary dislocations back to the equilibrium state.
    Of course there may be oscillations around the equilibrium state before it reaches a resting state. They may be dampen-able by intervention.

    For the second: all the recent work arising out of an examination of the Prisoners Dilemma only reinforces this. This is equally true for the Gordon Gekko’s and the
    UAW.
    Foolonthehill

  27. Anonymous

    “in favor of the US is that it had the most liquid, deepest capital markets, That was due not just to the size of its economy, but also the fact that it had high standards for financial disclosure and generally strong investor protection”

    Thus far, the remedy has not included the restoration of this corner stone. Things will not improve until the fascists are gone and transparency and regulation are reinstated. They killed the golden goose.

  28. London Banker

    @ Yves
    Many thanks. I’m gratified you found yesterday’s post worth highlighting. If some of it is inadequately expressed, as many here indicate, it’s because I’m still unhappy with my conclusion that there is no good place for savings today. I’ve never been a gold bug, but I’m tempted lately just because I fear the banks, the markets and the states of all being corrupt and grasping beyond historic norms. Hiding cash in a matress was popular with our grandmothers in just such circumstances.

    Over on Brad Setser’s Follow the Money blog, he notes that Korea raised $50 billion in dollar swaps from China and Japan – an historic cooperation for this three with their bitter history. This is the sort of cooperation among the looted “peons” I was rather hoping would emerge when I wrote my piece yesterday, and substantiates to me that patience with US deficit excess and dollar hegemony will be limited by the willingness of the “peons” to organise and collaborate to protect any accrued wealth.

  29. killben

    “It is easy to forget that the mistakes made by the New Dealers were mistakes made by folks who were considered the best and brightest of their times. Each succeeding generation of the best and brightest always make the mistake of thinking that they are, today, the best ever”… patrick ned comments

    Exactly, I totally agree … I also expect that the best and brightest would have done their best at that time.

    “We don’t even have to discuss the absolute insanity of the idea that a small group of people anywhere has the knowledge and foresight to manipulate seven billion peoples economic transactions on a daily basis to effect a certain outcome and resolve problems that they never saw coming in the first place. Wow, the absurdity of it all”
    …. patrick ned comments

    Exactly .. what is Bernanke trying to do … play god… he simply doesnot understand he does not have the intelligence, capability, humility or wisdom for such a big role … better desist … but scholar prefers to experiment …

    Bernanke thinks because he is a scholar of great depression he knows best … that is not being a learned man in my books … a learned man is humble and wise … which obviously Bernanke would not understand given that he intends to play god … control deflation, control markets, control which company should die and which should live, distort market mechanism, control tax payers money …

    oh my.. he controls quite of bit … when are the taxpayers going to revolt…or have americans got used to eating crap.

    This academician does not seem to realise that:

    1. He was not able to guage the extent of the problem as it was developing … as far as I know … no noise from him during 2006/07 when the time bomb started ticking

    2. He did not understand the extent of the problem even after the first hedge fund blow up (BNP or Bear Stearns .. I do not remember) in mid 2007

    3. He did not guage the extent of problems in the housing or the CDO and CDS market during 2007-08

    4. He did not understand the extent of problems this implosion will present due to global interlinkages today

    5. Above all despite being a scholar of great depression he never saw this coming…. now tell me what kind of a scholar is that

    With all the above you need to be a great optimist to expect this man to lead us out of it … I personally feel he is simply trying to put to work his Phd thesis with American Tax payers as the guinea pigs for his experimentation. Infact my view would be he should be sacked and someone like Volcker should be brought in in his place.

    I feel that regulators were sleeping at the wheel when the bubble was gathering storm and should be rightfully sacked for the same..

    While prciking the bubble at the time it was gathering storm would have been the right solution, having allowed it to happen the only way out is to allow deflation to reprice the asset and mark it to its true value (it may go down further than the true value … but it will revert) so that people with money and enterprise at that stage will start working towards recovery … and that is the best way .. LEAVE IT TO THE MARKET .. IT WILL FIND A WAY OUT..

  30. Don

    From my untutored perspective, is it possible to have both? Is sharp deflation possible in the short run followed by sharp inflation?
    It seems there has been a precipitous deflation of commodity prices in the last few months. Will other assets follow suit in 2009 and then have reflation soon after? I think the tug-of-war going on in gold might be indicative of this.

  31. River

    Killben said…

    ‘Leave it to the market..It will find a way out’.

    Maybe Mr Market is already finding a way out. Lots of people that could still be spending money have stopped. Are they voting with their wallets? Mr Market continues to surprise.

  32. Anonymous

    There’s no deflation when $50 billion on paper disappears because it was never there to begin with (fraud, scam, Ponzi bookkeeping). The original investment money is still circulating in the monetary system.

    There is a shortage of dollars because everyone is hoarding and/or trying to go to cash, doesn’t mean dollars are evaporating.

    Treasury in collusion with Federal Reserve has $700 billion to unload in one hand and in the other hand, at the same time, injected over $8 trillion, that we know of.

    I expect most cash or savings to go towards higher taxes because over spending by local, State and Congress continues, not to mention price inflation for survival items.

    Debt on an international level is just not forgiven, they want their money back and they don’t care how that transpires.

  33. David Pearson

    Seems to me that LB is arguing for deflation and inflation. Just goes to show you that the two are not far apart — two sides of the same coin,really.

    LB says creditors will get sick of financing our spending. He argues many will choose not to hold dollars. This will lead to a classic emerging markets-style inflation/deflation crisis.

    Emerging markets that face default on their debt go through the following:

    -a maxi devaluation
    -a step-down in hard asset prices; followed by inflation of the same once the debt is wiped out.
    -inflation in imported goods and assets
    -drastic decline in real wages

    The above encompasses some inflation, some deflation, and a lot of pain and decline in standard of living. It is not far off from what London Banker envisions for the U.S., and also not far off from what I saw living in Argentina during their recent crisis.

  34. FairEconomist

    From my untutored perspective, is it possible to have both? Is sharp deflation possible in the short run followed by sharp inflation?

    Oh, absolutely. That’s the expected response to a large monetary response to an unexpected deflation. Increases in the money supply take time to produce inflation – about 18 months in the US IIRC. So initially you see little effect and the deflation continues. But if the money dump was large enough to help any at the time, then when the inflation really starts kicking in in a year you swing to inflation.

  35. Anonymous

    I can't understand why some found a moralizing tone in the post. Is fear of getting screwed again and again a moral perspective?
    Frankly, I am tried of all the crap I been reading to say it's a good idea to bail losers out using taxpayers' money because it keep the economy going & we should just stop "moralizing." Wouldn't it be better to let the losers perish & save the money for the ordinary guys who may be affected?

  36. wunsacon

    Sorry to say. But, this endless Ben-bashing is tiresome.

    >> Bernanke thinks because he is a scholar of great depression he knows best

    He probably knows better than people who spent less time studying the great depression. No?

    >> … that is not being a learned man in my books… a learned man is humble

    Do you see Ben strutting around like Mick Jagger? What is it that makes you villify him?

    >> … and wise

    And, he's not? Why not? Because he hasn't chosen your policy prescriptions or because many generally prescient investors pan him? Not all generally prescient investors pan him.

    >> … which obviously Bernanke would not understand given that he intends to play god

    Ben-bashing is a worn-out conversation. Quit it. Please.

    Q: You want to know what's even less humble and even less wise than studying the Great Depression and using your education to help you set policy for the present conditions?
    A: Not studying the Great Depression in depth and then casting aspersions on people who did.

  37. Andrew Teasdale

    It is interesting to note that population growth in the US surged from the middle of the 30s to the early 50s and collapsed from the late 1920s to the mid 1930s. We should be watching population growth as well.

    Andrew Teasdale

  38. Reader Dean

    Yves,

    Keep in mind the polarity between creditor-borrower. Our creditors wish deflation, our borrowing propensities as a nation point to inflation as the end result.

    IMHO we will end up with a grey area slightly favoring inflation over time.

  39. mmckinl

    “Deflation has become inevitable” for at least two reasons. They are both leveraged by the fractional reserve banking of fiat money.

    The first is that debt will have to be destroyed. The U.S. cannot support 50 trillion of aggregate debt. Money and credit are only created through debt. When the debt is destroyed roughly ten times the credit is withdrawn, destroying that amount of money, ten fold. Less money and credit in the system means all goods are monetized by fewer dollars and less credit – deflation.

    The second is the zombie banks. This has to do with velocity. Since there is no trust in the financial system banks are loath to extend credit to other banks and credit markets such as student loans, AR financing, Inventory financing, Commercial Paper. As these and other markets freeze up the dependent businesses are literally starved to death of cash, whether they be viable businesses going forward or not.

    Once the cycle of currency and credit destruction infects the business sector it feeds on itself. Less money leads to less credit leads to dropping economic activity. Rinse and repeat.

    Until there is an FDR Bank Holiday or Swedish Plan to clean up the toxic debt in the banks trust will not be restored between banks and to the credit markets and the deflationary cycle of less currency and credit and further carnage in the economy will continue unabated eventually creating insolvency for a vast swath of our economy and, through the tax base, government local, state and federal as well.

  40. Anonymous

    “A: Not studying the Great Depression in depth and then casting aspersions on people who did.”

    Let’s take a little quiz.

    What did Ben say about the subprime problem in 2006?

    What did Ben say about housing in 2007?

    What predictions has Ben been right about?

  41. Yves Smith

    The reason I believe that so many engage in Bernanke bashing despite his generally modest personal style (in contrast to Paulson) is not only his incorrect reading fo the situation (per Anon of 4:58) but more generally, the Treasury’s and Fed’s going into high gear on the remedy front (after the second acute phase, November-December 2007, when the TAF was created) without doing a proper diagnosis.

    In the wake of the 1987 crash, which was a vastly simpler to assess crisis (one market, more or less, all the transaction data available since the meltdown was on exchanges), President Reagan established the Brady Commission within a mere 10 days to study the causes of the crash and come up with remedies. He got his report in two months and a few days.

    Here we have a vastly more complex phenomenon, spanning multiple opaque, inter-related markets and multiple economies. We should have had a coordinated international effort among central banks, the BIS, and others with good analytical staffs (perhaps the IMF and World Bank) to gather data (at a minimum, if you knocked heads at the 16 or so major international debt intermediaries, they could have gotten a good deal of insight in a fairly short amount of time). They probably could not have gotten insight in a Brady Commission two month timeframe, but in four to six months, they would have had a vastly better grasp of the lay of the land.

    That does not mean they necessarily should have done nothing in the interim, BTW, but what has happened so far is that they have been tackling symptoms. One credit market is stuck, they devise a remedy for that, it often creates dislocations elsewhere or fails to work, and then they are off to another remedy. This is not very encouraging to spectators.

    And I in general, I question “remedy by analogy” to the Great Depression when there are many ways that our current circumstances differ.

  42. Anonymous

    I do NOT want to see a bank holiday plan. Those all involve the same people meeting behind closed doors. I want to see insolvent banks liquidate. They can put all their toxic assets on Ebay. Just explain away in the product description. Then everyone can bid on the assets, and the public can be involved.

  43. mmckinl

    “I do NOT want to see a bank holiday plan. Those all involve the same people meeting behind closed doors. I want to see insolvent banks liquidate.”

    I share your anger …

    But there is a little matter of guaranteed deposits. Under a true Swedish or FDR Bank Holiday Plan the shareholders, bond holders and indeed the top management would be liquidated, the structure of the bank would be saved with cash infusion and run by the FDIC. I would propose that we keep the banks under this plan and run them as public utilities for the profit and benefit of the U.S. taxpayer. If the public takes the risk then the public should enjoy the benefit.

  44. Duck Diversified

    Yves, an addendum to your remarks about staff work a la the Brady Commission in 87. The telling lie is the fact that Paulson and Bernanke went to Congress asking for $700B to purchase Tier 3 junk, then pumped capital to a favored few. Similarly, letting Lehman fail while rescuing Goldman vis a vis AIG was worse. Kudos again for highlighting the abuse of poewr. But I’ve seen ordinary citizens do the math and come to the obvious conclusion that $2 trillion handed directly to peons ($10,000 per US household) would have saved Main Street and Wall Street both. It was never considered by Paulson or Bernanke. They don’t care what happens to demand.

    Lastly, I’m awed by the discourse on this comment board. Something grand is happening here.

  45. Anonymous

    Yves,

    I cannot thank you enough for your postings. Also I want to thank the commenters that add further depth to my attempt at understanding.

    What I want to ask is why aren’t we going to have both massive deflation and inflation at the same time? I think we can and will. The deflation is well described here and I think that the inflation is an obvious result of the trillions going out the Federal door in the past few months and who knows how far into the future.

    I agree that until and unless we stop reinforcing bad fiscal behavior the patient will continue to die.

  46. Abbott_Of_Iona

    What's the difference between Mad(e)off with $50Bn and Paulson disposing of $1T (or $8T depending on your view of how Government uses its ability to print and dispose of (future)liabilities as it sees fit).

    Are thy not both Ponzi schemes.

    Do you think China is blind?

    Is Korea bilnd?

    Is Europe blind?

    Is Russia blind?

    Still,

    At least GM, Ford & Christler are making cars that (in the word of Sharia Palin) "AMERICANS" are willing to buy.

    What a pitty that AMERICANS don't have the money (Credit?) to buy their own production.

    Deflation?

    This is beyond deflaton.

    The United States of America had better become united.

    The tap has been turned off and the debt has been written off.

    Maybe it's time for the USA to go back to its roots.

    Cut out the cancer that is "Globalization" ~ Who sold this Poniz scheme to the Citezens of the USA.

    Kissneger, Clinton, Bush (I orII).

    Who are these people.

    Why are they destroying the USA?

    However,

    Nevermind, If Mad(e)off with $50Bn is a crime, what does that say about the Ponzi scheme that is the CDS market?

  47. Zeke

    Down South:

    “high standards for financial disclosure and generally strong investor protection” came into being.”

    Oh, yeah, that’s FDR alright. Except for that little incident where he ordered everyone to turn in their gold and then devalued the dollar. That was pretty hard on a lot of people.

    And of course FDR saddled us with the poorly thought out Social Security system which is the bubble pop that will make all previous ones seem wrong.

    His head of the SEC was a drunken whore-monger. Even Chris Cox looks good by comparison.

    So I guess it’s not just libertarians who twist history to suit ideology.

  48. John

    Oh, Mr. London Banker is right, BUT he is forgetting about American patriotism AND the fact that American peasants know – without doubt – that god loves America best. Like all geeks, Mr. Banker is omitting THE most important factor that makes America successful. That being: American peasantry loves its nobility with ALL its heart. The peasants know that as god loves America best, such a god would never allow a totally corrupt nobility (and MOST of all this nobility bashing is just the liberal media anyway). And, with a good and righteous nobility leading America, the peasants have no need to worry their tiny little brains with “details” (like: “who are loot-ees and who are the loot-ors” or “what am I getting out of the citizenship deal?”). Remember, America FIRST! (You bet-cha!). Ask NOT what the country can do for the peasant; ask what the peasant can do for the country (and, of course, his righteous nobility leadership)!

    America wins in the end. It’ll be a glorious battle between the xenophobic Chinese peasants, American Christian peasants, with a few Muslim peasants providing a half-time show, occasionally.

  49. Bob

    Brilliant discussion. So when in 2009 will the dollar begin its collapse? ballpark? Will the inevitable FED intervention be able to stop the dollar collapse? Thanks!

  50. MikeW

    “I will know when it is safe to reinvest when policy interest rates, bank/intermediary oversight and accounting standards give me confidence I am better protected than the corporate or financial elite.”
    You will never invest, then. The absolute best you can hope for is
    “as well” not “better”.

  51. Gentlemutt

    Hello Yves, Mr. Neid's comments, informed by Walter Bagehot, still stand out amidst this puzzle now under discussion by so many capable contributors. To wit:

    "When bubbles burst everything returns to the original point of departure. Interventions only slow or speed up that process. The other fact, they are all deflationary."

    Others have since posed a similar question; here is mine, with a preface:

    Deflation after a bubble sure makes sense. What else could one expect? And Mr. Bernanke's attempt, presumably with all the goodwill and humility we can ask of our public servants, to avoid a binary event (i.e., to smooth the process for everyone's sake) is also understandable, particularly in light of the pain experienced during our 1930s Depression.

    So, if there must be deflation, and Mr. Bernanke is intent on printing money in various ways, what is the likelihood that historians 25 years hence will conclude that the world experienced deflation AND the US simultaneously experienced relative inflation? Such a result might manifest itself as flat-ish price changes here, with enormous simultaneous price decreases elsewhere, all measured in nominal dollars?

    Perhaps stated more bluntly ala Jim Rogers, maybe Mr. Bernanke can keep nominal dollar prices from sinking post-bubble, but he cannot at the same time keep the dollar from sinking.

    So those of us in America may not see much nominal deflation, while Mr. Bagehot's observations about other bubbles remain flawless and our foreign friends can at least feel like everyday is half-price day at the Short Hills Mall.

    Is this where we are headed? Is Mr. Bernanke attempting to supply enough dollars to create a kind of 'positive air pressure' locally while the inevitable global deflation both wreaks havoc elsewhere and makes US assets astoundingly cheap for all sorts of new friends we never knew we had?

    PS At least for this knucklehead it would be most educational to learn whether Messrs. DownSouth & Neid can agree on policy prescriptions going forward, or not, given their historical and political views appear to differ.

  52. lineup32

    Assets and commodities decline while the liquidity that supported there pricing power goes pooooof combined with the race to T-bills, this looks like deflation given the widespread credit repricing impacting markets worldwide with the American consumer no longer able to provide the ever expanding market for the worlds luxury goods.
    Best to look closely are what is happening here and now which is massive layoffs which will impact the economic powerhouse called the two income household. The current banking system credit models havn’t yet reflected the changing employment landscape but given there access to large data pools it woun’t take them long to make the adjustments and credit will get even tighter, much tighter. The American consumer is not going to save China’s,Japan, Korea’s, Germany’s export economy nor be the growth behind American GDP for many years,its over, the mutli-national corporations and there political allies around the world need a new game plan.

  53. Anonymous

    If US, EU and UK had substantial domestic savings to fund their banks (as in Japan in 1990), then perhaps the consequences would not be so imminently disastrous. Lacking sufficient domestic savings, however, their actions will likely make foreign creditors in Japan, China, the Gulf and elsewhere question whether it is worthwhile to keep pumping scarce savings into such flawed and reckless economies…

    This sounds good but is actually hocus pocus.

    And in so many ways!

    First of all, the savings of our foreign creditors aren’t scarce. It has been a flood (or “glut”) and China for one has had to park it in Treasuries to keep their currency peg.

    Second of all, American savings are going up, even as we speak. That’s why international trade volume is off, duh!

    3rd of all, the reason our ‘flawed and reckless’ economy is going to do a surge in deficit spending is because… yes, savings are going up. That is exactly why a stimulus is needed. We will be importing LESS and spending tax dollars on domestic infrastructure. That means the copious savings of our creditors will be GOING DOWN.

    If they don’t want to come to the USA and invest, well who cares – they won’t have the money to invest! They’re losing money, duh!!

    4th of all, if you think that the problem is that they have these huge piles of reserves that won’t be attracted to investments, well hello: they’re already invested. Michael Pettis puts it this way, in a very good entry here:
    The $2 trillion in reserves that China has is already invested, so it cannot be used for additional investment. If the US really needs larges amounts of Chinese financing in the future, this is simply another way of saying that China must run significant trade surpluses with the US in order to accumulate the dollars necessary to lend to the US government (remember, China doesn’t finance the fiscal deficit, it finances the trade deficit).

    Basically what Zakaria is implicitly saying is that in order to boost the US economy – which means boosting US production of goods and surpluses – the US must run very large trade deficits with China so that fiscal deficits can be financed by the Chinese. But a trade deficit, by definition, is consumption supplied by foreign production, not domestic production, so insisting on a large trade deficit with China cannot be the way to boost US production. And of course if the US does not run a large trade deficit with China, then China simply cannot fund the US fiscal deficit.

  54. Anonymous

    The outcome is even less predictable than LB presents. The work-out will certainly be some few years-say through 2012 before the smoke clears. During that time there are other events that may derail the process enroute-a pandemic, an earthquake in California or Japan, war/nuclear war in the Middle East or India/Pakistan or N. Korea, political assasinations and such. The probabilities are low, but not zero. So, I can’t see past my nose into the future. I think we live day-to-day now and for a while into the future in a poor, unstable and dangerous world.

  55. Anonymous

    Great discussion.
    I agree with lot if what has been written, but I think it is worth mentionning a few points.
    It is wrong to frame the debate between the thrifty on one side and the profligate on the other. The bubble has lasted so long and was so entrenched into expectations that there was no way for anyone not to benefit from it. It is true between countries (china and Germany couldn’t have saved so much if there wasn’t a bubble) and inside countries (joe the plumber wouldn’t have had a job). Nobody is innocent.
    It is not only wrong, it is dangerous. Resentment is what creates conflict between countries and excessive distrust within the society. Such distrust is what creatsd the overshoot of the real economy on the downside. To avoid excessive resentment, the pain of bubble popping must be shared in a way that is seen as fair.
    If one accepts that fact that nobody is innocent, a decrease in the real value of the currency, associated with a bigger share of added value to labour, is probably the fairest way to pop the bubble. And I think this is what the central bankers of the world are doing (except Trichet because he has no political mandate for doing so That won’t last).

    My second point is that, in the inlation vs deflation debate, one has to be precise of what one is talking about. Nobody argues that we are not in deflation NOW. But the real question is to know what is the cumulative general price level change between now and the end of the crisis. Defining the latter has a big impact on the final answer. If the end of the crisis is when the economy starts to register significant growth, then lower level of prices is the answer. If it is when the economy is back on its historical, and supposingly sustainable, average of the ratio between aggregate assets and GDP, my bet is on significantly higher general price level. Note that, under the latter definition, the Japanese bubble has not popped yet, it has just been replaced by a bond bubble.

    A final point : when the central bank starts to do quantitative easing with risky assets (poor credits or long maturity bonds), it may put itself in the position of not being able to put the bloated monetary aggregate genie back in the bottle because of investment losses. The only way in this case is to get a tax funded recapitalization by the government. I don’t see this as likely, this is why I am weighted toward inflation.

  56. patrick neid

    Gentlemutt

    Does Mr. Neid disagree with DownSouth’s apparent preference for imposing stronger and more clear regulatory oversight in pursuit of widespread confidence in the rules of the game?

    ———————————————-

    To be honest I don’t even think about it. It’s coming, that’s a given. I just hope they do it well. As usual much will address things that will never happen again. Every bubble is different shaped by the times except for the low cost money. While much is made of the “confidence” factor the important players already have that. What they don’t have confidence in is the fiddlers. When the markets finally recover main street will tag along.

    What I will say going forward is that we will revisit these times again. That’s the nature of capitalism. If my analysis of the markets is currently right, it being the 2008 version of 1974–then its been 34 years. If the larger bears are right and most obvious indications suggest as much, then we are in something out of the 1930’s–so its been 75 years. My point being that bubbles are rare events and as such I tend to skip over the partisan snipping that looks to score political advantages about how the economy should be centrally managed going forward to prevent that which isn’t preventable if we are to have any personal freedoms. In fact even in the most oppressive “ism’s” are they not bubbles that go splat? Hello Moscow, is that you Havana?

    Not to pick on comrade DownSouth but he/she presents a perfect example. My piece was about bubbles and their aftermath it was not about how we got there or what we should do to prevent them. Tip of the day — they can’t be prevented or let’s say this, they will be when we stamp out human nature. The other grim detail in this whole mess is if you agree, as many do, that doing nothing is the actual remedy the bad news is, it will never be the course of action. You are then left, as so many market participants are, with the dreadful anxiety of how bad are they going to screw this thing up such that the cure is worse than the disease. The magnitude of that fear will tell how long the contraction will last.

    Given the times I would not revisit Bernanke’s famous helicopter speech from years ago. It is very disturbing in light of today’s events. But if you insist here it is:

    http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

    It’s a blueprint he has been following the last few months. The next steps are very scary indeed.

    Finally the deflation now vs inflation later debate is really a market timing conversation. First down then up? Ultimately if the prior bubble analysis is accurate deflation, despite any ups or downs, prevails. Why? Because they can’t print enough money to recreate the prior excess. Which is to say, the original players are exhausted. They are done. A great primer in modern times is the Florida land boom and collapse in the late 20’s which some would argue was a precusor to the 1929 crash.The beaches didn’t leave, the sunshine didn’t go away but the players did for almost 50 years. Lower prices couldn’t bring them back. South Beach went ghetto. No amount of regulations, tax breaks or favorable changes could put Humpty Dumpty back together except for TIME.

  57. mft

    I’ve been away for a while, so I’m trying to catch up with what’s been going on, and found this posting (YS carefully argued commentary and the LB excerpts) very interesting and useful indeed, also many of the comments, though there are so many I had to skim some.

    Actually, what has shocked me most recently, and makes this discussion even more important, is the fact that Bretton Woods II is possibly NOT coming to an end! I think many of us thought that with collapsing US consumption the trade deficit would disappear and US Treasury needs would be satisfied by increased propoensity to save in the US itself. But oh no, US exports are collapsing just as fast! So possibly we will see world trade and US trade with it spiralling downwards, but the US trade deficit remaining obstinately intact. We should have realised how structurally established the pattern of trade is, and it means Bretton Woods II may stay with us.

    LB is really very brave to come down off the fence on the deflation/inflation question. I’ve been sitting on that particular fence for years now, and I still feel better off there, even though it is a little uncomfortable. We have had asset inflation without consumer price inflation for some years because the deflationary pressure on prices from East Asia has balanced it out. This is an intrinsic part of Bretton Woods II, and it is possible that if Bernanke/Paulson succeed in preventing further asset deflation it can pick itself up and continue indefinitely, or at least until unforeseen events (most likely) or policy action (less likely) finally destroy this absurd system.

    “Events, dear boy, events!” (Harold Macmillan, UK prime minister in the last 1950s).

  58. Juan

    Yves,

    A crisis of overproduction is not simply demand limitation but an excess of means of production relative to productive living labor and particularly the surplus value it and it alone creates,,,which is then to say profit rate, not share, (which combines production and market) plays a determining role.

  59. Juan

    Foolonthehill:
    RN @“Such a society regards all social relations as essentially innoncent because it believes self-interest to be inherently harmless. It is, in common with Marxism, blind to the lust for power in the motives of men; but also to the injustices which flow from the disbalances of power in the community.”

    As anyone who has ever read Marx knows, above is merely RN’s ideological position.

  60. Knute Rife

    First, as I noted in my comment to LB’s post, “As for foreign investors finally shifting away from the US, I think the operative signal is, when will investors be willing to admit that sunk costs are sunk? That rule of accounting is contrary to human nature. Every casino counts on the human aversion to walking away and not throwing good money after bad. Very few casinos go broke counting on that aspect of human nature. And right now the US is the biggest casino ever.”

    Onward.
    @Anon 1:35
    The money may not be disappearing (although actually it has because much of the “money” was carry and credit, which have definitely shrunk), but the value of the assets bought with the money certainly is, and that’s deflation.

    @mab
    You’re full of barn stuff. Your comments make me wonder if you actually understood LB’s post or if you’re too busy grinding your ideological ax.

    @Anon 5:30
    We seem to be on the same page.

    @Balmain
    The mere fact that the Friedman Twins wrote the peons out of their novelizations of the global economy does not mean we do not exist. Witness the recent warnings from both the US Army War College and IMF about potential civil unrest.

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