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Sliding into the Great Deflation

posted by Christian E. Weller

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.


If there was a silver lining in all of this pain that will come is that maybe some attention will be paid to providing some real solutions for consumers other than non-binding credit counseling programs that operate at the whim of creditors, or bankruptcy.

It is interesting to see that in the U.S., creditors ratchet up collection pressure as people near the OCC default dates in order to conform to banking regulations and in the UK, the very same creditors, embrace reduced payment solutions because they don't hit the banks as bad debts.

Rather than reactionary solutions that dance to banking regulations it seems to make more sense to create legislative solutions that put the consumer first and allow them to have a real chance at resolving their financial problems without bankruptcy or repayment limbo.

Your analysis leaves out what I think will be the 800 pound gorilla in the U.S. economy in the coming years: a drop in the value of the dollar against other currencies.

The budget and trade deficits are going to push the value of the U.S. dollar downward, continuing (at an accelerated pace) a secular trend that started more than five years ago.

Inflation will rise, debt that is denominated in dollars will "shrink", and American labor will become proportionately cheaper. Savings - particularly retirement savings - in dollar denominated investment vehicles, will plunge in purchasing power, as will the purchasing power of all dollar denominated fixed streams of income.

There won't be a "great deflation" as you describe it. Instead, we are going to see higher inflation in the coming years as our shrinking currency buys less and less of the commodities in the global economy.

Real wages in the U.S. have barely grown in over 40 years, excepting a small blip up in the mid-90's. In real terms, the average American worker makes about the same as his father did in 1978.

But as long as there are 400 million or so in China that haven't yet even left subsidence farming for industrial and commercial jobs, not to mention those in India, Bangladesh, Pakistan, Indonesia, Viet Nam, etc., wages in America can't and won't increase by much, if at all, and all the governmental mandate and interest-free money won't change the fact.

Once the developing world becomes developed, the U.S. worker, if he still exists, might have a chance at seeing some real income gains. Until then, the Great Deflation in real wages that started mid-70's continues, ad infitum.

Check me on this, but didn't Canada have a similar decade-long deflationary/stagnation period some years ago? If I'm not mis-remembering (forgive my ignorance), was it similar to our state?

Many of my Candian friends had talked about a long, plodding down time that ended some years ago, I was curious.

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:

This all ties into "Peak Oil" and global warming and environmental deterioration in general. The time line for these looks to be within the next 20 years. It seems as though the "Limits to Growth" people got it about right. "Power Down" covers the various responses and suggests we start working on our own life boats.

A response to AMC on the link between the dollar and inflation.

There is clearly some support for the inflation story, although it runs more through an interest rate cycle, rather than the exchange rate.

I think that inflationary pressure from the dollar carries a small probability.

The dollar has already fallen for six years on a real, trade-weighted basis and it hasn't translated into accelerated, sustained inflation.

Also, a lower dollar has a build-in, anti-inflation mechanism. It means fewer trade surpluses for our trading partner countries, thus less money to be lent to the U.S., hence higher interest rates in the U.S., which could translate into slower growth and less inflationary pressure.

I do think, though, that the Great Deflation story carries with it an inflationary threat. Specifically, if businesses do not invest at a faster rate, productivity growth will slow. This means that the growth rate that can be sustained without any inflationary pressure will also be lower. The Federal Reserve has already lowered its "economic speed bump" to around 2.5%. That is, the Fed will intervene sooner by raising interest rates than it would have in the past. Thus, monetary policy could actually contribute to the Great Deflation.

A response to Don.

The wage threat from overseas is certainly a contributing factor to rising inequality and slower income growth. There are, however, a few entry paths for policy.

First, for the past two decades, with the exception of the late 1990s, economic growth was fairly robust. That is, the economy had the resources to give to workers in the form of higher wages and faster job growth. Public policy can intervene to strenghten the link between economic growth and income growth. For instance, a higher minimum wage is a good first step as is an improved Earned Income Tax Credit. In addition, policymakers could make it easier for people to join a union, which is still the most effective private market mechanism to let workers share in the fruits of their labor. Furthermore, universal health insurance, universal pensions, and access to low-cost college education can be important steps to lift families' incomes in a growing economy.

Second, I agree that higher incomes and faster demand overseas will ultimately help to bolster wages and incomes in the U.S. Public policy, though, has two important roles to play in this arena, too. For one, it could engage creatively and strategically with trading partner countries to improve their labor standards, educational outcomes, social safety nets to raise incomes and domestic demand overseas. Moreover, the last few years have shown that an export boom does not necessarily translate into more manufacturing jobs, which would be the primary link from trade to U.S. jobs. Much of the underlying problem is that public policy has abandoned manufacturing. It is critical to reverse this trend to make sure that faster growth overseas actually translates into more jobs and higher wages in the U.S.

your cure sounds worse than the disease:

"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."
--these three alone will certainly discourage entrepeneurship and reduce job creation. the tax rates should be flattened and simplified so that investors and job-creating business owners can make decisions with more certainty and so that the wealthy can not escape a fair tax burden through manipulating the code with armies of accountants. and what's the point of raising the minimum wage when ten million illegals are there to work "off the books"?

"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."
--umm..what exactly does this entail? foreign aid? tariff policies that reduce american competitiveness? political policies that favor the survival of corrupt foreign regimes? what action can be taken that won't have an effect here?

"Finally, we should invest in innovation at all levels: in high school, colleges, research labs, and private firms."
--if you want innovation in our educational system, instead of throwing more funds at it (from a source you dont disclose, but undoubtedly more of my tax dollars) i would applying the forces of competition to the public school systems by allowing parents choice among the providers, both public and private. investment in private firms is best handled by the private sector, not government edict.

"The dollar has already fallen for six years on a real, trade-weighted basis and it hasn't translated into accelerated, sustained inflation.

Also, a lower dollar has a build-in, anti-inflation mechanism. It means fewer trade surpluses for our trading partner countries, thus less money to be lent to the U.S., hence higher interest rates in the U.S., which could translate into slower growth and less inflationary pressure."

You are anticipating a mechanism kicking in that hasn't happened during the 5 or 6 years of the dollar's drop against other world currencies - the U.S. trade deficit hasn't dropped much yet.

In contrast, during that same period, a number of "commodity" items have increase substantially in U.S. dollar prices - oil, wheat, corn, copper, gold, as examples. At some point, the inflation in the "volitile food and energy" sector is going to translate into broader inflationary pressure.

And we may be seeing the beginnings of it now:


Consumer Confidence Sinks Amid Economic Concerns

By Matthew Cowley and Jeff Bater

* * * * *

Wholesale Prices Rise

The producer price index for finished goods rose 1.0% on a seasonally adjusted basis after a 0.3% decrease in December, the Labor Department said Tuesday. Originally, prices in December were estimated down 0.1%.

The core index, which excludes food and energy items, rose 0.4% last month, seasonally adjusted. It rose 0.2% in December.

Wall Street expected smaller price increases. Economists surveyed by Dow Jones Newswires had called for a 0.4% jump in the overall index and a 0.2% increase in the core index.

In the 12 months ending in January, prices climbed 7.4% on an unadjusted basis. In the 12 months ending in December, prices were up 6.3%. The 7.4% climb is the largest since 7.5% in October 1981.

Data released a week ago showed consumer prices last month climbed 0.4%, a worrisome sign because the economy is slowing. Dealing with creeping inflation and a weakening economy is a balancing act for the Federal Reserve, which has cut the federal funds rate 2.25 percentage points since September.

We'll see how well the breaking mechanism works if we get into slower version of the East Asian currency meltdown that occurred a little more than a decade ago.


Dollar Falls to Record Against Euro on Fed Rate-Cut Speculation

By Kim-Mai Cutler and Kosuke Goto

Feb. 27 (Bloomberg) -- The dollar weakened below $1.50 per euro for the first time on speculation Federal Reserve Chairman Ben S. Bernanke will indicate the U.S. central bank is ready to cut interest rates from a three-year low.

The dollar also dropped after German business confidence unexpectedly strengthened for a second month in February, prompting traders to reduce bets on a cut in interest rates by the European Central Bank. The currency fell to an all-time low against the Swiss franc and to a 23-year low versus the New Zealand dollar.

``We're in a new regime for the dollar,'' said Bilal Hafeez, London-based global head of currency strategy at Deutsche Bank AG, the world's biggest foreign-exchange trader. ``The proximate cause has been European data, which has indicated that Europe hasn't suffered on the growth side as the U.S. has.''

The dollar fell to $1.5088 per euro, the lowest since the European single currency's debut in 1999, before trading at $1.5037 as of 7:33 a.m. in New York, from $1.4974 yesterday. It also declined to 106.40 yen from 107.28 yen and to 1.0688 Swiss franc, after slipping to 1.0665, from 1.0756. The euro was at 160.07 yen from 160.67, after reaching 161.39. The dollar may fall to $1.55 per euro by the end of the first quarter, Hafeez predicted.


Dollar Falls Below 100 Yen

Thursday March 13, 7:06 am ET
By Yuri Kageyama, AP Business Writer

US Dollar Falls Below 100 Yen for 1st Time in 12 Years on US Economic Woes

TOKYO (AP) -- The dollar dipped below 100 yen for the first time in 12 years Thursday and hit record lows against the euro amid a growing consensus that synchronized efforts by central banks will not stop a deterioration in the U.S. economy.

The euro exceeded $1.56 for the first time and the dollar fell as low as 99.75 yen before bouncing back to 100.16 yen. It was the first time the U.S. currency has traded below 100 yen since November 1995.

The dollar has been declining on growing speculation that the Federal Reserve will cut interest rates further to shore up the sagging American economy and calm jittery financial markets.

"The momentum is definitely downward for the dollar," said Daisaku Ueno, senior economist at Nomura Securities Co. "With the momentum going like this, no one knows where it will stop."


Oil surpasses $125 a barrel on weakening U.S. dollar

By PABLO GORONDI, Associated Press Writer

Oil prices surged past $125 per barrel Friday on the eve of the U.S. driving season as a weakening U.S. dollar drove investors to snap up commodities.

Light, sweet crude for June delivery rose as high as $125.12 a barrel in electronic trading on the New York Mercantile Exchange at midday before falling back to $124.86 by early afternoon in Europe.

* * * * * *

By midday in Europe, the euro stood at $1.5466 compared to $1.5404 in late trading Thursday night in New York. The dollar was also weaker Friday against the British pound and the Japanese yen.

Investors view commodities such as oil as a hedge against inflation, and some analysts think the dollar's protracted decline is the main reason behind oil prices doubling from a year ago. Also, a weaker dollar makes oil cheaper to investors overseas.

A prediction by analysts at Goldman Sachs seeing oil rising as high as $150 to $200 a barrel within two years also has boosted prices.

Analysts, however, struggled to explain the continued rise of oil futures after a larger-than-expected build in crude oil stocks reported Wednesday in the United States.

Still waiting on that lower dollar anti-inflationary mechanism to kick in....

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