"Sliding into the Great Deflation"

This post by Christian Weller at Credit Slips, takes a different viewpoint than, say, that of those in the Nouriel Roubini camp who see an apocalyptic meltdown as possible, and a mere severe recession as possible.

Weller instead argues for a scenario more like that of Japan: a grinding period of low growth, falling real wages, and stressed public finances. And the lack of a big crisis will impeded the government taking steps to reverse this decline.

From Credit Slips:

We are headed for the Great Deflation – a period spanning a decade or more of very slow growth, rising unemployment, flat or falling real wages, fewer employer-provided benefits and increasing pressures on government finances.

People borrowed money because they had to. Income growth simply did not keep pace with prices in housing, health care, transportation, energy and food. Much of the debt that families borrowed to finance their consumption came from overseas, which contributed to record high trade deficits. And, the situation is further exacerbated by the fact that productivity growth, the battery in the Energizer Bunny, seems to be running out of juice, since businesses haven’t invested enough in the face of lower demand for their products.

The chickens are coming home to roost. Families either default or repay their debt. Either way, they consume less and economic growth slows. This slowdown can last for some time, just like the run-up in debt did.

At the same time, the structural weaknesses will exacerbate the long-term outlook. Specifically, businesses will have no incentive to invest more if their customers are paying back debt instead of going shopping, thus contributing to less productivity growth. And government revenues will shrink because economic activity is slowing, resulting in less spending, including on education, thereby contributing to the slowdown in innovation. Yet, without faster productivity growth, our competitiveness will suffer and it will be harder to reduce our trade deficit through export growth.

Unlike a recession, these structural weaknesses do not force politicians to act. In a recession, unemployment jumps quickly and businesses go out of business in rapid succession. This generally gets policymakers’ attention. There never comes such a point in time, when policymakers’ attention is forced to focus on the economy, however, when economic growth slows gradually and stays low for some time.

In addition, the political leadership is missing. President Bush is unwilling to acknowledge that the debt crisis is a reflection of long-term problems and not just an isolated phenomenon.

But if the economic stimulus is all there is, we will get back to where we were before the crisis: low income growth that fuels slower economic growth, unless families can borrow massive new amounts of debt again. Another mortgage boom will not come any time soon to save us.

The alternative is to restructure the economy: raise the minimum wage, make the tax system more progressive, and make it easier for people to join unions to boost incomes. We should engage constructively with trading partners to get their domestic demand going, so as to create more stable economies overseas and boost demand for U.S. products. Finally, we should invest in innovation at all levels: in high school, colleges, research labs, and private firms.

Without going the distance on a comprehensive economic recovery effort, we will find ourselves in the midst of the Great Deflation before we know it.

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18 comments

  1. Anonymous

    I just went to the window and screamed that Im not gonna take this anymore. Should I open the window or keep it closed or keep reading more stories?

  2. Yves Smith

    You get desensitized if you read enough of this stuff, just like doctors get used to the sight of blood.

    This might cheer you up. Sports Illustrated deemed it the second best individual achievement in the 20th century (number one was Wilt Chamberlain’s scoring 100 points in a single game, but that makes for more extended viewing):

    http://www.youtube.com/watch?v=cS4f6wiQJh4

  3. Yves Smith

    Independent accountant,

    Don’t discount the possibility that we could have deflation (asset prices) and commodities inflation. Our rate cuts are helping fuel overheated economies in the Gulf, China, and Taiwan, which all have dollar pegs, and are contributing to the commodities boom. Stagflation was novel; we may get a new pattern this time, and something unprecedented will make it hard for the powers that be to take corrective action.

    I do think we will see low growth, and a further squeezing of workers, a la Japan, to restore competitiveness of our domestic economy. We can no longer run on credit-fueled consumption; we will have to get our savings up and export more.

  4. vlade

    That article from Credit Slips is bang on in the league of “US is a closed economy” articles – as you raised some time ago.
    The longer the period of slow growth in US, the more likely it is that China/India starts consuming more, which would also lead to consumer prices inflation (and even larger commodities inflation). In the same way as Japanese economy is now two-tier (strong export, weak domestic), and as Japan was the world mover in 80s.

    As for nominal deflation/inflation, well, does really anyone believe that the inflation (as cost of living) in US is running at 3%? Govt changing the inflation measures so that it better suits them happened before, and it will happen again.

  5. Yves Smith

    vlade,

    Good point, but any adjustment process will be slow. India has a substantial middle class, so the shift to more consumption may be easier there. China is committed to high trade surpluses; not clear how quickly they will embrace fostering a consumer economy.

    Unfortunately, the Fed seems to believe the official inflation figures.

  6. vlade

    Yves, I agree that the move in China will take longer, my point was that the longer US is in slump the more time China will have to make the move.

    As one of their main markets (US) disappears, they will have to do something with all the factories etc.
    Initially, it will of course mean lower prices, but if the slump is global and protracted, they will find out quickly that some of the stuff can’t be sold to foreigners at any price, simply because they don’t have the money to buy it (unless the quality improves dramatically, as was the case with Japan, and they will be able to compete not only on price but on quality-for-cost ratios).

    So they will have to start selling to themselves, as that will be the market where they will be able to make the most money fastest.

  7. Anonymous

    Yves:

    “Wilt Chamberlain’s scoring 100 points in a single game”

    No way….! Wilt Chaimberlain’s 100,000 sexual partners. That’s #1 anyway you cut it….

    Pull out your calculators if you don’t believe me.

    Econolicious

  8. Ivan Kitov

    I also put this comment at Credit Slips.

    It is interesting that using a different, pure quantitative, approach I get the same conclusion: the USA will run into a recession in 2012. Moreover, the comparison with Japan is absolutely right – the cause of deflation is the same (and common for all developed countries).

    According to this analysis, unemployment in the USA will not be increasing, however. It is more likely that the unemployment rate will be decreasing from 5.5% in 2010 to 3% in 2020.

    Similar quantitative analysis has been carried out for some other developed countries:
    Australia, Austria, Canada, France, Japan, Germany, the UK:

  9. Francois

    “In addition, the political leadership is missing. President Bush is unwilling to acknowledge that the debt crisis is a reflection of long-term problems and not just an isolated phenomenon.”

    I wasn’t aware that this President had ever acknowledge reality-based events.

  10. s

    Excellent point on demographics helping reduce structural unemployement rates – especially in Europe. The baby boom generatuion leaving the workforce will help keep the rate anchored. That says nothing of wages of course or standard of living…

  11. L'Emmerdeur

    I don’t see how we can have a “Great Deflation” and not see GDP get hacked to pieces by a machete.

    Take the components of GDP and figure out what happens to each one over a few years of radical asset deflation. If we assume that the world comes down with us, and commodities come down to Earth (a big assumption), the only thing that will be positive for GDP will be the GDP deflator.

    The Great Depression in the 1930s was essentially a Great Deflation. So was the Great Depression of 1873-1896. Although both periods saw significant asset price deflation, they were very different economic events. Common theme? Both periods left the U.S. more economically powerful relative to he rest of the world.

    I believe this Great Deflation will have the reverse effect. Just as the 1873-1896 depression signaled the sunset of the British Empire, this coming event may do the same for Pax Americana.

    May, not will. How we deal with these developments in the next two decades will determine this. Do we educate and empower our masses? Do we facilitate America’s greatest strength, (legal) immigration? Do we punish via tariffs and sanctions those who treat their work force as slaves to win the wage arbitration game? Do we simplify our tax code and rewrite every budget from township to federal from scratch? Do we pull our military kicking and screaming into preparing for the next war instead of the last one?

  12. L'Emmerdeur

    I don’t see how we can have a “Great Deflation” and not see GDP get hacked to pieces by a machete.

    Take the components of GDP and figure out what happens to each one over a few years of radical asset deflation. If we assume that the world comes down with us, and commodities come down to Earth (a big assumption), the only thing that will be positive for GDP will be the GDP deflator.

    The Great Depression in the 1930s was essentially a Great Deflation. So was the Great Depression of 1873-1896. Although both periods saw significant asset price deflation, they were very different economic events. Common theme? Both periods left the U.S. more economically powerful relative to he rest of the world.

    I believe this Great Deflation will have the reverse effect. Just as the 1873-1896 depression signaled the sunset of the British Empire, this coming event may do the same for Pax Americana.

    May, not will. How we deal with these developments in the next two decades will determine this. Do we educate and empower our masses? Do we facilitate America’s greatest strength, (legal) immigration? Do we punish via tariffs and sanctions those who treat their work force as slaves to win the wage arbitration game? Do we simplify our tax code and rewrite every budget from township to federal from scratch? Do we pull our military kicking and screaming into preparing for the next war instead of the last one?

  13. L'Emmerdeur

    I don’t see how we can have a “Great Deflation” and not see GDP get hacked to pieces by a machete.

    Take the components of GDP and figure out what happens to each one over a few years of radical asset deflation. If we assume that the world comes down with us, and commodities come down to Earth (a big assumption), the only thing that will be positive for GDP will be the GDP deflator.

    The Great Depression in the 1930s was essentially a Great Deflation. So was the Great Depression of 1873-1896. Although both periods saw significant asset price deflation, they were very different economic events. Common theme? Both periods left the U.S. more economically powerful relative to he rest of the world.

    I believe this Great Deflation will have the reverse effect. Just as the 1873-1896 depression signaled the sunset of the British Empire, this coming event may do the same for Pax Americana.

    May, not will. How we deal with these developments in the next two decades will determine this. Do we educate and empower our masses? Do we facilitate America’s greatest strength, (legal) immigration? Do we punish via tariffs and sanctions those who treat their work force as slaves to win the wage arbitration game? Do we simplify our tax code and rewrite every budget from township to federal from scratch? Do we pull our military kicking and screaming into preparing for the next war instead of the last one?

  14. Anonymous

    Since most of the conclusions from Creditslip is intellectual liberal gobbly-gook…I shall deconstruct it line by line. This is nothing more than tried and FAILED liberalism

    “The alternative is to restructure the economy: raise the minimum wage”
    Comment:
    that is pure socialism…this will only decrease employment and increase costs of good and services

    “make the tax system more progressive”
    Comment: this is more marxism…tax the rich will only decrease investment in business and the economy. They are the ones that create jobs and business. When is the last time you went to an illegal immigrant and asked them for employment! Again, another socialist free-market-bashing power grab. also known as Class-warfare.

    “and make it easier for people to join unions to boost incomes”
    Comment:
    Unions actually decrease employment by driving up costs to the employer and thus consumer…This will kill the economy. Why do you think GM is in Such bad shape…pension obligations to high prices union workers

    “We should engage constructively with trading partners to get their domestic demand going, so as to create more stable economies overseas and boost demand for U.S. products”
    Comment:
    This is no more than code-speak for communist central planning

    Finally, we should invest in innovation at all levels: in high school, colleges, research labs, and private firms.
    Comment: we do!…but I think the author means GOVERNMENT directed innovation….more communism!!!

  15. Anonymous

    anon of 7:47:

    All the policies you disparage were characteristic of the prosperous post-WWII US economy. They were all successfully attacked by conservatives, and that is where we are now. So, whose policies have failed?

  16. Anonymous

    The boom has been the result of an unprecedented growth in the money supply rather than the traditional organic growth path. The MS growth was created and fueled by an expansion of debt, supplied by the financial industry.

    The reduction in capital now being experienced by the banks is leading to a reduction in money supply growth and, if left unchecked, will lead to deflation and the collapse of uneconomic businesses.

    The governments are trying desperately to lean against the deflation of the collapsing debt bubble. However, the markets appear to be discounting the stimulus as inflationary. It seems an awkward moment is at hand where the policy or rescue movement may have overshot, creating more turmoil in markets that are seeking a level.

    I guess I’m uneasy about the fevered attempt, or at least the degree, of reflation. When you bring a knife to a gunfight, you don’t want to help your opponent reload. Faux rallies in asset markets are such a reloading, forestalling and perhaps worsening future asset repricings. IMO, that was one aspect of the depression.

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