The deflation delusion

March 9, 2012

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The deflation delusion

Years ago a friend of mine in New York told me about his massively overweight neighbour who took to wearing a black t-shirt with “I beat anorexia” printed on it.

I think that is how our central bankers look at the wonderful job they are doing. Since the last link to gold was severed in August 1971, the dollar has lost 82 percent of its purchasing power and the global economy is more geared than ever and now in the death throes of a four-decade leveraging bonanza but our central bankers proudly tell us, hey, at least we beat deflation!

Every day we are told that the world is in the grip of a deathly deflationary spiral. Or that it would be in a deathly deflationary spiral if it weren’t for the valiant efforts of our central bankers. Here is the Wall Street Journal reporting on those efforts:

“The growth in balance sheets (since 2007) has been startling: The combined assets of the four central banks will top $9 trillion by the end of March, compared with $3.5 trillion five years ago, Deutsche Bank says. The European Central Bank’s €3 trillion ($3.93 trillion) balance sheet is the biggest relative to the economy, at 32% of nominal euro-zone GDP,…”

Remember the ECB just gave another freshly printed €1 trillion to European banks at practically no cost for three years.

So, how are we doing on the deflation front?

Here is the outlook from the ECB at yesterday’s press conference:

“Euro-zone inflation will stay above 2% this year ‘with upside risks prevailing’ Mr. Draghi (the President of the European Central Bank) said.”

Upside risk? No kidding.

Is anybody surprised that an orgy of money printing has lead to, what’s the term Draghi used, ‘stubbornly high inflation’?

In 2011, inflation in the eurozone rose throughout the Greek debt crisis. Now inflation is above target and ‘stubbornly high’, yet the ECB expanded its balance sheet by a cool 55% (in words: fifty five) over the past 12 months – most of it towards the end of the period, meaning the full inflationary effects are still to be felt in the future. Upside risk indeed.

Is inflation caused by inflation?

No doubt, the ECB will take credit for avoiding deflation but will take no blame for inflation. This is entirely somebody else’s fault.

“The ECB raised its inflation forecasts in response to a mix of higher oil prices and tax increases. ECB staff expects inflation to average 2.4% this year, well above the ECB’s 2% target, before declining to 1.6% in 2013.”

Get it? Deflation can be avoided through money-printing, but money-printing doesn’t cause inflation. Inflation is rising prices, which can be explained by, er, rising prices, such as oil prices. Genius.

But the advocates of easy money, and they are numerous, tell us that we are splitting hairs here. Thank God we didn’t get that nasty deflation. Because economies grow when they have inflation and contract when they have deflation. Every child knows that.

So with that stubbornly high inflation we get some growth in Europe, right?

Well- no, we do not.

“The ECB said its staff economists shaved their euro-zone gross domestic product forecast for 2012 from 0.3% growth to a slight contraction. Still, Mr. Draghi said he expects the economy to recover “gradually” over the course of the year,…”

So an explosion in euro-liquidity has raised prices but the economy is still contracting, if only mildly. No surprises here, I would say. Just what one should expect. The ECB’s policy – and that of any other central bank – is not designed to solve the crisis but to arrest the collapse, to cover up the problems, to sustain balance sheets and asset prices at artificial levels, and to postpone the day of reckoning – preferably to after the retirement date of the present policy elite.

Not on my watch.

But, of course, by extending the problem they are making it bigger.

No deleveraging please!

When I presented my book to various groups of investors and hedge fund managers at the end of last year, I was often told that we would be subject to considerable deflationary forces as a result of the deleveraging of the European banks. That deleveraging would, of course, be an important step towards unwinding the excesses from the credit boom but it would be deflationary.

Guess what. Deleveraging has been put on ice. With limitless money for free the European banks are not in the mood for scaling back. Here is the Wall Street Journal again:

“The long-awaited restructuring of Europe’s banking industry has creaked into motion, but the pace may remain sluggish thanks in part to the European Central Bank’s recent wave of cheap lending to the Continent’s banks. …

‘It isn’t as important now,’ said the chairman of a major European bank. His bank has temporarily shelved plans to sell certain portfolios of real-estate assets, figuring that the bank can afford to wait until prices bounce back from their current lows.

The ECB loan program ‘has bought time,’ said Richard Barnes, a credit analyst at Standard & Poor’s.”

Pricewaterhouse Coopers estimates that European banks plan to shed €2.5 trillion of non-core assets over the next, wait for this, ten years. That is right. Slowly, slowly catchy monkey.

Make a guess how much will be shed this year! – €50 billion.

Well, the ECB just pumped a nifty €1,000 billion into the banking sector in three months and the banks ‘delever’ by €50 billion in 12 months? – Dear hedge fund managers, please forgive me if I do not take the deleveraging argument seriously.

Where we are going.

I am not saying that two-and-a-half percent inflation is a disaster in itself. But it won’t stay at 2 percent, and it certainly won’t go down to 1.6 percent as the eggheads at the ECB with their stupid output-gap models are telling us. All central banks tell us that inflation will go down next year. Always next year. That is what their models tell them.

I am not arguing for deflation per se. Deflation in itself has no benefit but deleveraging has. After a credit boom that is what is needed to get the economy back in shape. Economies are not growing because of deflation. That is nonsense. Economies are not growing because of the massive imbalances that have accumulated as a result of years and decades of cheap credit. A cleansing correction – in balance sheets, state budgets and debt levels – is urgently needed. Present policy doesn’t allow it. So the economy won’t grow.

We should accept that deleveraging is ultimately unavoidable. If it comes with a period of deflation – so be it. But we will get neither. The system will be sustained at this stage of arrested collapse for as long as policymakers can get away with it. My outlook is that we will get even bigger central bank balance sheets (forget exit strategies! There is no exit!), we will get no sustained growth but inflation will creep higher.

The noisy advocates of easy money and of government stimulus always pretend to care for Europe’s unemployed youth. It is today’s youth that would have most to gain from a cleansing correction now, and it is those who already made their money and who sit on inflated assets and overstretched balance sheets that have most to gain from the central bank’s policy of extend and pretend. That is, until the whole thing goes pop anyway. Which won’t take too long.