Peter T Treadway, PhD
Historical Analytics LLC
August 23, 2010


Be Careful What You Wish For

As a student of the Great Depression of the 1930s and the Great Japanese Stagnation of 1910-1930, Fed Chairman Ben Bernanke has acquired a deathly fear of deflation. Hence most observers including myself have discarded the possibility of any increase in US short term interest rates in 2010 and probably 2011. Renewed quantitative easing is a strong possibility. The Fed’s not going to raise the short rates it controls so long as the US economy is limping along in near recession, real estate prices are heading south and Bernanke thinks deflation is public enemy number one. Actually if Bernanke could he would lower the Fed funds rate further. But rates can’t go below zero. So that weapon of the central bank is useless.

It’s a little disconcerting to have a Fed Chairman whose avowed goal is to debase the currency he is sworn to protect. But it may not matter. Bernanke is concerned with faltering US consumer led demand. But all the quantitative easing in the world won’t do much for the overleveraged American consumer. Bernanke, unlike his Chinese counterparts, can’t just order the banks to start lending all the reserves he has created. And efforts by the Obama Administration to reduce the consumer debt burden are likely to backfire. The private sector debt that gets forgiven will either be added to the already out of control Federal debt or become a hit to the profits of the just recently “rescued” and still fragile banking system. Recent talk of a preelection program of mortgage forgiveness by Fannie and Freddie suffers from the above defects. The US consumer led deflation that Bernanke and the Administration fear so much is beyond their control to prevent.

But the US no longer remotely resembles a closed economy. It’s a big world out there. Unfortunately the only way Mr. Bernanke is likely to get his inflation is by importing it. And I would ask two questions: One, does he really want that? Two, is there anything the Fed can do about this anyway?

Imported inflation is bad inflation by any measure. Deflation – or the threat of it – hangs over the US, Europe and Japan. But in places like India and China it is inflation that is the problem. The US continues to run a massive trade deficit. The export model has been the prevailing paradigm for recent decades and it has driven global economic growth. Massive amounts of cheap labor have been added to the global workforce in countries like China, India and Brazil. Overall, the currencies of these labor intensive exporting countries(especially China) have been undervalued against the US dollar. Their exports have flowed into the US, resulting in what has been called “good supply side” deflation.

But all good things do not go on forever. Dollar reserves, particularly those of China, have been piling up. The renminbi in particular is a candidate for revaluation against the dollar in real terms – either by domestic inflation or nominal currency revaluation. Wages in the exporting countries have been moving up. The profits of many Chinese firms in the export business are said to be paper thin. The US trade deficit has diminished in 2010 largely due to the recession although the July deficit moved back up sharply. The point is that the current level of US current account and trade deficits cannot go on indefinitely. A major decline of the dollar—which is one solution to the current account and trade imbalances and one favored by many in the US — would bring an increase in imported inflation. And of course a major decline of the dollar against the Asian currencies is exactly what the Administration and many in Congress want. Keep in mind that the post 1971 fiat money dollar-based international financial system is inflation prone.

We live in a complicated world. Consumer led deflation in the so-called advanced Western countries is not inconsistent with inflation in the rest of the world.

So far the US has been lucky in this respect. Monthly data on import prices have averaged zero percent in 2010 so far. The good global supply side deflation is still with us. The imported inflation shoe hasn’t dropped…yet. Although we got a taste of it when oil spiked in 2008.

Energy and commodity prices in general deserve mention here. Thus far recessions in the US, Europe and Japan have offset growing demand for energy and commodities in so called emerging nations. Near term that phenomenon may continue. But the long run trend is for increasing global demand as countries like India and China grow their economies. Indians and Chinese want cars; the Americans can walk if they want to. Increasing energy supplies may not be as simple as in the past. For one thing, the environmental costs of energy extraction are rising as the “low hanging“energy fruit has been gathered. The recent BP oil spill in the Gulf of Mexico is an example and one that may contribute to significantly higher costs for offshore oil in the future. Oil derived from shale is high cost and not without environmental negatives. Also, it must not be forgotten that so much of today’s global oil reserves are located in nations which are politically unstable or hostile to the United States. Green energy alternatives? Don’t hold your breath. They will not provide reasonable substitutes for conventional energy for some time to come. The US will remain a net energy importer and a price taker. Every American President since the days of Richard Nixon has put forth the goal of energy independence. It’s an impossible dream and a political con job. Bernanke if he is rational should be hoping that the globally determined energy prices do not rise too much.

But not to worry about Bernanke’s intellectual preferences for inflation. Worry about something else. Bernanke and the Federal Reserve are very limited in their ability to bring about “good” US consumer led inflation or prevent “bad” imported inflation. What we have is an impotent monetary authority. And the potential for the US to be more helpless economically since its emergence as an economic superpower after WWI.

Black Swan in Waiting

There is a giant black swan out there and it’s the risk of a huge decline in the dollar. It is unlikely that the dollar is going to seriously weaken against the euro, the pound or the yen. All of these currencies are from countries that have the same problems, i.e. bloated public sectors, aging populations, huge debt to GDP ratios, underfunded pensions. Tweedleedee tweedleedum. But against the some of the major emerging market exporters and against gold, the dollar could crash sometime in the next few years. Bernanke is not going to voluntarily raise US short term interest rates. But a crashing dollar would send US long rates upward.

This scenario probably has a low probability of happening until after the midterm elections. If in 2011 the US is perceived as not being able to get its fiscal act together despite presumed gains in the 2010 elections by fiscal conservatives, then the dollar will have big problems. Actually I take back that the Fed is totally impotent. Bernanke in this case could do substantial harm if he gets so carried away by quantitative easing that he is perceived to be financing US fiscal profligacy. That will help bring about a dollar crisis.

A crashing dollar against emerging market currencies and gold would probably send stock markets and bond markets around the world crashing themselves. But it might be the necessary step for renewed global prosperity. The old export model has to go. In the future, I want to be investing in Asian consumers and US exporters.

The Great Depression—Sui Generis?

Bernanke has been influenced by the work of Milton Friedman who attributed the Depression to the Fed’s allowing the money supply to contract. Friedman may have been right in his criticisms of the Federal Reserve and since he is now one of the established “gods” in economics I hesitate to challenge his conclusions. But I think Friedman leaves out a lot regarding the ultimate nature and causes of the Depression. In my opinion it was far more than a case of a mismanaged monetary system.

Bernanke may have done a decent job in preventing a total collapse of the banking system in 2008. But that’s now history and monetary policy isn’t everything. Tax policy, the questionable desirability of totally wasteful and politically driven stimuli, avoidance of burdensome regulations, resistance to protectionism and international economic policy coordination are what matter now. Going forward, piling up reserves in the banking system coupled with wasteful stimulus programs may be a futile exercises with unfortunate long run consequences.

The Great Depression in my opinion was unique and offers its own lessons. Consider:

First, Florida land booms notwithstanding, there was no serious national real estate bubble prior to 1929. Take a look at Robert Shiller’s data which is the best historical record of American house prices. ( Unlike with Japan over 1985-90, or the US over 2000-2007 or with the countries involved in the Asian crisis of 1997, US national house prices did not spike upward in the nineteen twenties. There was no Kindleberger -Minsky overlending to the real estate sector and there was no bubble which is the crucial aspect of their model. The collapse in real estate prices subsequent to 1929 was the result of a collapsing US and global economy. When unemployment goes from under 5 % to 25% as it did from 1929 to 1933, house prices will collapse every time in every country. The Great Depression, unlike the recent crisis, the Asian Crisis or the Japanese Great Stagnation, cannot be explained in the Kindleberger/Minsky context. No bubble, no Minsky. The decline of house prices was the result of and not an initial cause of the crisis.

Second, the 1920s were a period of no inflation in the US. Agriculture experienced deflation world wide. Global agricultural capacity had been vastly augmented during World War I as the war disrupted productive capacity among some of the combatants. This overcapacity was vastly aggravated when the combatants’ agriculture came back on line after the war. Moreover, US money supply grew modestly throughout the 1920s. The only bubble was the US stock market and a good deal of that was financed by nonbank broker loans. And the stock market bubble by the way was not really a global phenomenon.

Third, the world was recovering from WWI which had a devastating effect on the global economic system. Germany was saddled with punitive reparation debts that it could not pay and experienced hyperinflation in the early 1920s, attempts to reimpose a version of the gold standard were bungled and the gold standard became a deflationary force by the mid-1920s, Russia fell to Communism and autarky and the Austria-Hungary and Ottoman Empires were broken up. Britain, which had been the global economic leader prior to the war, emerged broke and unable to resume its former role. The United States, unlike after WWII, refused to assume a global leadership role.

Fourth, when the Depression began in 1929, the nations of the world undertook a number of deflationary and misguided actions which help plunge the world into Depression and then keep it there. The passage of the infamous Smoot Hawley tariff in 1930 and President Hoover’s raising of taxes in 1932 are just two. The Roosevelt Administration’s constant campaign of holding wages above market, raising taxes, pillorying businessmen and attacking capitalism are now thought by a new generation of economic historians to have prolonged the depression in the United States. Policy makers trying to avoid another global depression or long period of stagnation today should be studying the non-monetary factors that were so important in the Great Depression.


Peter T Treadway, PhD
Historical Analytics LLC
pttreadway -at- hotmail -dot- com
305 761 4718
852 9409 1186
Fax: 305 489 7807

Peter T Treadway also serves as Chief Economist, CT RISKS, Hong Kong

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