China's conundrum: Selling FX reserves to support the yuan threatens deflation. But falling yuan fuels capital flight http://t.co/XGz6S4HPz6
— Colin Twiggs (@Colin_Twiggs) August 29, 2015
AND capital flight causes collapsing stock and real estate prices, which could lead to…… deflation.
The global economy faces deflationary pressures as the vast credit expansion of the last 4 decades comes to an end.
Commodity prices test their 2009 lows. Breach of support at 100 on the Dow Jones UBS Commodity Index would warn of further price falls.
The dramatic fall in bulk commodity prices confirms the end of China’s massive infrastructure boom.
Crude oil, through a combination of increased production and slack demand has fallen to around $60/barrel.
Falling prices have had a sharp impact on global Resources and Energy stocks….
But in the longer term, will act as a stimulus to the global economy. Already we can see an up-turn in the Harpex index of container vessel shipping rates, signaling an increase in international trade in finished goods.
The latest OECD export statistics show who the likely beneficiaries will be. Primary producers like Brazil and Russia have suffered the most, while finished goods manufacturers like China and the European Union display growth in exports. The US experienced a drop in the first quarter of 2015, but should rebound provided the Dollar does not strengthen further.
Australia and Japan offer a similar contrast.
Oil-rich Norway (-5.8%,-13.3%) has also been hard hit. Primary producers are only likely to recover much later in the economic cycle.
Nouriel Roubini argues for increased infrastructure investment to accompany monetary easing, else the benefits of the latter will not last:
Simply put, we live in a world in which there is too much supply and too little demand. The result is persistent disinflationary, if not deflationary, pressure, despite aggressive monetary easing.
The inability of unconventional monetary policies to prevent outright deflation partly reflects the fact that such policies seek to weaken the currency, thereby improving net exports and increasing inflation. This, however, is a zero-sum game that merely exports deflation and recession to other economies.
Perhaps more important has been a profound mismatch with fiscal policy. To be effective, monetary stimulus needs to be accompanied by temporary fiscal stimulus, which is now lacking in all major economies. Indeed, the eurozone, the UK, the US, and Japan are all pursuing varying degrees of fiscal austerity and consolidation.
Even the International Monetary Fund has correctly pointed out that part of the solution for a world with too much supply and too little demand needs to be public investment in infrastructure, which is lacking – or crumbling – in most advanced economies and emerging markets (with the exception of China). With long-term interest rates close to zero in most advanced economies (and in some cases even negative), the case for infrastructure spending is indeed compelling. But a variety of political constraints – particularly the fact that fiscally strapped economies slash capital spending before cutting public-sector wages, subsidies, and other current spending – are holding back the needed infrastructure boom.
All of this adds up to a recipe for continued slow growth, secular stagnation, disinflation, and even deflation. That is why, in the absence of appropriate fiscal policies to address insufficient aggregate demand, unconventional monetary policies will remain a central feature of the macroeconomic landscape.
Again, I add the warning that infrastructure investment must be in productive assets, that generate market related returns. Otherwise we are merely swapping one set of problems (a shortfall in aggregate demand) for another: high public debt without the revenue to service or repay it.
Read more at An Unconventional Truth by Nouriel Roubini – Project Syndicate.
Some readers expressed concern about falling commodity prices, especially crude oil, and whether this will cause global deflation. This confuses the cause with the symptom.
Falling prices are largely benign except where caused by a contraction of the money supply. Commodity prices may fall when there is an excess of supply over demand, but this is soon absorbed by changes in consumer behavior. Discretionary spending will rise in response to the savings, so that aggregate demand is unaffected.
A contraction in the money supply, however, is far more serious. Slow growth in the monetary base (below growth of real GDP) results in less money chasing the same goods, driving down prices. Supply and demand in this case are unchanged, but prices fall because of a contraction in the money supply. Wages, however, are sticky and do not fall in line with prices, leading to falling profits, cuts in production and job layoffs. Falling income from lower profits and fewer jobs leads to a contraction in aggregate demand, causing further cuts to production and income.
Contraction of the money supply also places pressure on banks to reduce lending. This danger was highlighted by Irving Fisher in the 1930s. Contracting credit reduces not only new investment but forces existing borrowers to liquidate some of their assets, mainly stocks and property. The surge of selling, and limited availability of credit, drives down asset prices. A feedback loop results, with falling asset prices prompting banks to further contract lending — in turn causing more price falls. That is the central bankers’ equivalent of a perfect storm. The graph below shows how close we came in 2009 to a deflationary spiral.
Slow growth in the monetary base caused a sharp contraction in bank lending (below zero) in 2009. Only prompt action by the Fed averted a 1930’s-style collapse of the financial system.
The Fed indicated in October that it will curtail QE and no longer expand its balance sheet to support money supply growth. Should we expect another contraction of the money supply as in 2008?
The answer is: NO. When we look at the graph of the Fed balance sheet below, we can see that total asset growth [red] is slowing. But bank deposits at the Fed — excess reserves that earn interest at 0.25% p.a. — are slowing at an even faster rate. That means that the actual amount of money flowing into the banking system is not contracting, but increasing.
The following graph shows a net growth rate (of Total Assets minus Excess Reserves on Deposit) of more than 20 percent. Expect growth to slow over time, but the Fed can adjust the interest rate payable on excess reserves to ensure that it remains positive.
Deflation is a far bigger problem for the Euro. After a “whatever it takes” surge in 2012, the ECB attempted to contract its balance sheet far too soon — withdrawing treatment before the patient had fully recovered. They also do not have excess reserves on deposit, like the Fed, which could soften the impact.
The result has been faltering economic growth and price levels falling dangerously close to deflation.
The ECB appears to have recognized its error, indicating that it will expand its balance sheet if necessary to avert a monetary contraction. If they learn from their past mistakes, the ECB should be able to avoid any threat of deflation.
Kyle Bass, founder and principal of Hayman Capital Management, on China’s debt bubble:
China’s banking assets have grown to over 100% of its GDP in the last three years, according to Bass. If the U.S. had engaged in similar policies – which he said would translate to $17 trillion in lending over that time period – it, too, would have achieved more than 7% GDP growth.
China’s banking assets now total approximately $25 trillion, or almost three times the size of its $9 trillion economy. Its low default rate on bank loans – about 1% – is about to rise, according to Bass. Much of that lending is construction-related. Bass said that 55% of China’s GDP growth has been in the construction sector. The marginal return on those loans must be very small, he argued.
“A rolling loan gathers no loss,” Bass said, “and that’s what’s been going on in China for the last few years.” He said it is impossible to believe China could “manipulate” the inputs of its financial system without losing control of the outcomes.
Deflation is also threatening China. Bass said that its GDP deflator is now below zero. He expects the PBoC to engineer a devaluation of the renminbi as a way to stimulate exports and avert further deflation…
China may well attempt to engineer a devaluation of the RMB, but neither the Fed nor the ECB are likely to tolerate China exporting their deflation to the US/Europe.
Read more at Kyle Bass On China And Japan – Business Insider.
Ambrose Evans-Pritchard reports:
The region’s core inflation rate – which strips out food and energy – fell to 1pc in March. This is far below expectations and leaves monetary union with a diminishing safety buffer. “The eurozone is tracking the experience in Japan in mid-1990s. There is a very high risk of a slide into deflation,” said Lars Christensen, a monetary theorist at Danske Bank.
Read more at Eurozone risks Japan-style trap as deflation grinds closer – Telegraph.
Reproduced with kind permission from Lars Christensen at The Market Monetarist:
History is fully of examples of massive monetary policy failure and today’s policy makers can learn a lot from studying these events and no one is better to learn from than Swedish monetary guru Gustav Cassel. In the 1920s Cassel tried – unfortunately without luck – to advise Danish and Norwegian policy makers from making a massive monetary policy mistake.
After the First World War policy makers across Europe wanted to return to the gold standard and in many countries it became official policy to return to the pre-war gold parity despite massive inflation during the war. This was also the case in Denmark and Norway where policy makers decided to return the Norwegian and the Danish krone to the pre-war parity.
The decision to bring back the currencies to the pre-war gold-parity brought massive economic and social hardship to Denmark and Norway in the 1920s and probably also killed of the traditionally strong support for laissez faire capitalism in the two countries. Paradoxically one can say that government failure opened the door for a massive expansion of the role of government in both countries’ economies. No one understood the political dangers of monetary policy failure better than Gustav Cassel.
Here you see the impact of the Price Level (Index 1924=100) of the deflation policies in Denmark and Norway. Sweden did not go back to pre-war gold-parity.
While most of the world was enjoying relatively high growth in the second half of the 1920s the Danish and the Norwegian authorities brought hardship to their nations through a deliberate policy of deflation. As a result both nations saw a sharp rise in unemployment and a steep decline in economic activity. So when anybody tells you about how a country can go through “internal devaluation” please remind them of the Denmark and Norway in the 1920s. The polices were hardly successful, but despite the clear negative consequences policy makers and many economists in the Denmark and Norway insisted that it was the right policy to return to the pre-war gold-parity.
Here is what happened to unemployment (%).
Nobody listened to Cassel. As a result both the Danish and the Norwegian economies went into depression in the second half of the 1920s and unemployment skyrocketed. At the same time Finland and Sweden – which did not return to the pre-war gold-partiy – enjoyed strong post-war growth and low unemployment.
Gustav Cassel strongly warned against this policy as he today would have warned against the calls for “internal devaluation” in the euro zone. In 1924 Cassel at a speech in the Student Union in Copenhagen strongly advocated a devaluation of the Danish krone. The Danish central bank was not exactly pleased with Cassel’s message. However, the Danish central bank really had little to fear. Cassel’s message was overshadowed by the popular demand for what was called “Our old, honest krone”.
To force the policy of revaluation and return to the old gold-parity the Danish central bank tightened monetary policy dramatically and the bank’s discount rate was hiked to 7% (this is more or less today’s level for Spanish bond yields). From 1924 to 1924 to 1927 both the Norwegian and the Danish krone were basically doubled in value against gold by deliberate actions of the two Scandinavian nation’s central bank.
The gold-insanity was as widespread in Norway as in Denmark and also here Cassel was a lone voice of sanity. In a speech in Christiania (today’s Oslo) Cassel in November 1923 warned against the foolish idea of returning the Norwegian krone to the pre-war parity. The speech deeply upset Norwegian central bank governor Nicolai Rygg who was present at Cassel’s speech.
After Cassel’s speech Rygg rose and told the audience that the Norwegian krone had been brought back to parity a 100 years before and that it could and should be done again. He said: “We must and we will go back and we will not give up”. Next day the Norwegian Prime Minister Abraham Berge in an public interview gave his full support to Rygg’s statement. It was clear the Norwegian central bank and the Norwegian government were determined to return to the pre-war gold-parity.
This is the impact on the real GDP level of the gold-insanity in Denmark and Norway. Sweden did not suffer from gold-insanity and grew nicely in the 1920s.
The lack of reason among Danish and Norwegian central bankers in the 1920s is a reminder what happens once the “project” – whether the euro or the gold standard – becomes more important than economic reason and it shows that countries will suffer dire economic, social and political consequences when they are forced through “internal devaluation”. In both Denmark and Norway the deflation of the 1920s strengthened the Socialists parties and both the Norwegian and the Danish economies as a consequence moved away from the otherwise successful laissez faire model. That should be a reminder to any free market oriented commentators, policy makers and economists that a deliberate attempt of forcing countries through internal devaluation is likely to bring more socialism and less free markets. Gustav Cassel knew that – as do the Market Monetarists today.
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My account of these events is based on Richard Lester’s paper “Gold-Parity Depression in Denmark and Norway, 1925-1928″ (Journal of Political Economy, August 1937)
Richard Koo in his latest report makes that the point that central banks in the US and UK have not cured their economies of deflationary pressures, they have merely kicked the can down the road:
Central bank officials in the US and the UK claim quantitative easing has been a success because it prevented a Japan-like deflation. But as I noted in my last report (2 April 2013), the rate of Japanese wage growth four to five years after the bubble collapsed was roughly equal to the levels now being observed in the US. Deflation took root in Japan only after 1997, when the nation fell off the fiscal cliff following the Hashimoto administration’s ill-fated experiment with fiscal consolidation. That was seven to eight years after the bubble burst.
Read more at Richard Koo Quantitative and Qualitative Easing 2013 04 16.
In his 2003 paper Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others Lars E.O. Svensson describes the liquidity trap experienced by countries such as Japan and lately the US, when central bank interest rates are close to zero percent.
If the nominal interest rate is initially low, which it is when inflation and expected future inflation are low, the central bank does not have much room to lower the interest rate further. But with deflation and expectations of deflation, even a nominal interest rate of zero percent can result in a substantially positive real interest rate that is higher than the level required to stimulate the economy out of recession and deflation. Nominal interest rates cannot fall below zero, since potential lenders would then hold cash rather than lend at negative interest rates. This is the socalled “zero lower bound for interest rates.”
In particular, conventional monetary policy seems unable to provide sufficient stimulus to the economy and address recession and deflation once the zero lower bound for interest rates has been reached. The problem is that the economy is then satiated with liquidity and the private sector is effectively indifferent between holding zero-interest-rate Treasury bills and money. In this situation, standard open-market operations by the central bank to expand the monetary base by buying Treasury bills lead the private sector to hold fewer Treasury bills and more money – but this has no effect on prices and quantities in the economy. When this “liquidity trap” occurs, expanding liquidity (the monetary base) beyond the satiation point has no effect. If a combination of a liquidity trap and deflation causes the real interest rate to remain too high, the economy may sink further into a prolonged recession and deflation.
By Houses and Holes on September 20, 2012
The grey-beards of Australian economics today unite to deliver one enormous wake-up call to the nation, its government, its interests, its media and its people.
Don’t get me wrong, the bucket of cold water is not deserved in equal measures. For mine, the Australian people have been awake to the dangers facing the country since the GFC, hence the community embrace of saving. But the nation’s media and government have existed in a bubble of hubris, forging ahead with yesterday’s policies and arguments as if Australia is immune to global and historic forces.
I am talking about the end of the mining boom, which is nothing more than the march of the GFC to those that have escaped until now, and the persistence of policy settings that assume that the private sector is immune to deleveraging, as well as the failure to plan beyond the next hole in the ground.
Ross Garnaut and Bob Gregory deliver the bad news today via a string of speeches and articles in the [Australian Financial Review]. For those that don’t know, Garnaut is the architect of the open economy policy settings that have delivered 30 years of prosperity and Gregory is the local pioneer of arguments about the effects of Dutch disease. Both are eminent economists.
So what do they have to say? Nothing good.
Garnaut warns of falling living standards:
“I think we’re going to have a very difficult time adapting to the decline in living standards that’s going to be a necessary part of the adjustment to the end of phase one and two of the boom,” he told a conference on the rise of Asia. Professor Garnaut’s warning that the looming economic adjustment would be more painful because governments had not saved enough of the resources boom in budget surpluses came as international ratings agency Standard & Poor’s reaffirmed Australia’s AAA sovereign rating assuming budget cuts continue.
…Professor Garnaut said Australians would not be so anxious about potential risks if governments had saved more of the resources boom since 2003.
…“The time for careful management of a difficult adjustment is the time that lies ahead,” he said.
Meanwhile, Bob Gregory with Peter Sheehan write an opinion piece that endorses the Garnaut position but goes further with proposed solutions:
As the resources boom unwinds over the next few years, Australia will experience a large deflationary impact, primarily driven by the fall in the terms of trade and in resource investment. The production and export of resource commodities will rise as projects are completed, but this will generate few jobs and limited domestic income to offset the terms of trade decline and the falls in mining investment.
Many have argued productivity growth or labour market reform are central issues to be addressed as the resources boom passes. Productivity growth in the long run is particularly important but the key challenge over the next few years lies in addressing the change in the impact of the resources boom from expansionary to deflationary.
Until recently, theory and practice around the world has given primacy to monetary policy in responding to macroeconomic shocks. But, with many economies in the zero interest rate trap, the limits of monetary policy are being realised. Monetary policy cannot be expected to play the central role in addressing the long-term demand shocks Australia faces. The current de facto policy settings – that monetary policy will support the economy in the short-run while fiscal policy is restrictive – contain risks for the longer term.
They go on to argue that the Federal government will need to spend big on infrastructure to support growth and propose a new fund to finance the spending, in part through guaranteeing state debt.
I agree with every word. But there is little hope that those in power do. Treasury Secretary Martin Parkinson responded:
“Because boom implies there’s a bust,” he said. “Where we will end up at the end of this is with mining being a much larger share of a reshaped economy.”
Ironically, this is the very thinking that all but guarantees a bust.
Reproduced with thanks to Houses and Holes at Macrobusiness.com.au