A while back I warned about the deflation threat to the European economy:
When prices fall over time, tax revenues fall with them. This is especially true in economies with value-added taxes, but the deflation effect on tax revenues spills over on income taxes as well. With deflation fewer workers get raises, meaning that there is much less, if any, growth in the income-tax base. A stagnant or a shrinking tax base is not exactly what the governments of Europe’s welfare states want to have on the horizon.
I also explained that businesses are discouraged from making investments and hiring people. Investment costs are paid upfront, or if financed with loans the costs of principals and interest rate are nominally locked over time. However, deflation reduces per-unit revenue over time, making the investment increasingly unaffordable at constant sales and pushing the break-even point into the territory of growing sales. A similar outlook discourages businesses from hiring people: money wage contracts specify a certain amount to be paid out per worker per pay period, forcing the business that faces deflation to expand sales just to break even.
In the case of new employees this means that the employees have to constantly nudge up their productivity just to produce what their money wage is worth. If they want a raise they have to almost expand their productivity exponentially.
Neither the investment calculation nor the productivity mandate on employees favors businesses under deflation. Therefore, I explained back in my January article that the best Europe can hope for under deflation is that stagnation replaces depression.
The concern about deflation is now spreading. On January 29, Ambrose Evans-Pritchard, the Telegraph’s excellent columnist and experienced political journalist, elaborated on his view of the situation:
Half the world economy is one accident away from a deflation trap. The International Monetary Fund says the probability may now be as high as 20pc. It is a remarkable state of affairs that the G2 monetary superpowers – the US and China – should both be tightening into such a 20pc risk, though no doubt they have concluded that asset bubbles are becoming an even bigger danger.
His point about monetary tightening is based on the premise that monetary expansion fuels inflation and that, by logical extension, monetary contraction would lead to deflation. But it would be a leap to conclusion to say that the combined monetary contraction in the United States and China would automatically add to the deflation trend. While China has had an inflation problem for a while, and while they have been printing money like a runaway train, the technical reason for their inflation is related to their currency sterilization efforts more than anything else. Venezuela’s hyper-inflation is related to a similar type of exchange-rate defense policy. (I will write a separate article about sterilization later.)
The American money-printing spree is evidence that straight monetary expansion does not create inflation. That said, Evans-Pritchard’s link between monetary policy and deflation is not without merit. By contracting money supply, a central bank tightens the supply of liquidity in the economy. That in turn spills over on the banking system as the economy’s interest rates start creeping up. Private credit gets tighter.
If in this higher-interest rate environment there is already a trend of deflation, the rising cost of debt-funded investments is going to further widen the gap between investment costs and expected sales revenues. As a result, even more investment projects become unaffordable. Stagnation prevails and there are no forces at work in the economy to turn around the deflation trend.
Then Evans-Pritchard outlines a global scenario that could follow the aforementioned liquidity tightening:
The World Bank warns in its latest report – Capital Flows and Risks in Developing Countries – that the withdrawal of stimulus by the US Federal Reserve could throw a “curve ball” at the international system. “If market reactions to tapering are precipitous, developing countries could see flows decline by as much as 80pc for several months,” it said. A quarter of these economies risk a sudden stop. … The report said they may need capital controls to navigate the storm – or technically to overcome the “Impossible Trinity” of monetary autonomy, a stable exchange rate and free flows of funds.
In other words, what has kept money flowing to higher-risk economies is the combination of inflation driving asset values in those countries and the low interest rates in more reliable economies. If the latter goes away, there is suddenly more money to be made in, e.g., comparatively low-risk U.S. Treasury bonds.
A reversal of the flow of emerging-market investment funds means that the risk for recession in those economies increases significantly. Emerging economies are usually less able to produce enough liquidity to maintain a fully reliable financial-market system than advanced economies in Europe, North America and East Asia. If international capital flows reverse and start going toward the advanced economies, they have little if any margin before their financial systems stop functioning as intended.
Evans-Pritchard then makes a good point about the role of economics and economists in this:
William Browder from Hermitage says that is exactly where the crisis is leading, and it will be sobering for investors to learn that their money is locked up – already the case in Cyprus, and starting in Egypt. The chain-reaction becomes self-fulfilling. “People will start asking themselves which country is next,” he said. Emerging markets are now half the global economy, so we are in uncharted waters. Roughly $4 trillion of foreign funds swept into emerging markets after the Lehman crisis, much of it by then “momentum money” late to the party. The IMF says $470bn is directly linked to money printing by the Fed.
Yes, we are in uncharted waters indeed. Traditional, costly and highly sophisticated macroeconomic models, developed for forecasting purposes to be used by global investors, are essentially useless here. These models, as good as they are within their territory, are based on rigid assumptions about the institutional framework of the economy, namely that those will remain unchanged. This includes the balance between emerging markets and advanced markets; in order to forecast the repercussions of an unprecedented capital exodus from the emerging markets, economists would have to make their models inherently unstable.
I am yet to see a model that can do this, and there is a simple reason why such models are practically impossible. The branch of economics known as macroeconomics is based on a model structure where the economy is “self-healing”: after a disturbance, such as a decline in consumer spending, it reverts back to full employment if left alone. The theory behind this mechanism is that you can study disturbances one by one – in my doctoral thesis I referred to them as “singularities” – and estimate how important each one would be in explaining a recession.
The task before macroeconomists at this point is far more complex. Systemic changes to the economic system, such as the slow decline of Europe or a major, rapid change in global financial investment patterns, requires an upside-down approach to the problem: you have to assume that instability, not stability, is the prevailing norm for the economy. This calls for macroeconomic models that are entirely “open”, where there is really no predictable end result. This in turn basically defeats the purpose of developing a traditional model, which in my experience is the reason why economists do not even try to forecast systemic changes.
For better or worse, this means that the economists who otherwise would be able to give reliable advice to politicians, global investors and government bureaucrats on how to handle this situation, are lost for words. There simply won’t be anyone there to give reliable advice (making you wonder why some banking economists make the six figures they do…) which exposes investors to a situation of genuine uncertainty.
How to handle that? Well, that is an entirely different story. Important as it is, we will have to stop at concluding that what the world is looking at now is a combination of deflation in Europe and possibly elsewhere, higher interest rates in low-risk countries, unusually strong and coordinated monetary tightening, and probable capital flight from emerging to advanced economies that could have major political repercussions.
All this in addition to the fact that none of this will contribute to an improvement of the highly troubled European economy. As for the United States, the situation is a bit more uncertain. A global recession will depress exports which have to some degree driven the recovery in manufacturing; at the same time higher interest rates may weaken the recovery in construction. But there is also the growing likelihood that major federal government incursions into the economy will be reversed, the most significant of them being Obamacare. Even the president is now pondering a delay of the nail-in-the-coffin parts of the “reform”.
Add to that the possibility for tax cuts when the shrinking deficit has reached a critical low-point and a regulatory cease-fire if the Republicans win the Senate in November.
In other words, the U.S. economy is better suited than the rest of the world to continue to slowly grow and move forward. There are significant risks, but unlike Europe, we are not standing on the doorstep of industrial poverty. Deflation will hurl Europe into that territory.
Or, in the concluding words of Evans-Pritchard:
Those who think deflation is harmless should listen to the Bank of Japan’s Haruhiko Kuroda, who has lived through 15 years of falling prices. Corporate profits dried up. Investment in technology atrophied. Innovation fizzled out. “It created a very negative mindset in Japan,” he said. Japan had the highest real interest rates in the rich world, leading to a compound interest spiral as the debt burden rose on a base of shrinking nominal GDP. Any such outcome in Europe would send Club Med debt trajectories through the roof. It would doom all hope of halting Europe’s economic decline or reducing mass unemployment before the democracies of the afflicted countries go into seizure.