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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.

In the meantime, the debasement of paper money continues.

This article was previously published at Paper Money Collapse.

3 comments to The deflation delusion

  • Joe V

    2% inflation might not be bad if it were really 2% inflation. But it isn’t because the whole system is rigged.

    Wages have been falling off toward 1950’s and 1960’s levels for some time now. This should retard demand and cause prices to deflate to 1950’s and 1960’s levels before eventually restoring demand and stabilizing prices at their proper levels. But this doesn’t occur because central banks keep pumping money onto certain sectors of the economy to prevent it. These are the so called “bubbles” we hear about all the time.

    One reason they do it is to maintain the gap between income and expenses. This forces people to go to the bankers for loans to fill the gaps. Then the people become slaves that work primarily to serve the bankers.

    It’s quite a well constructed manipulation. Legalized stealing I would call it. And it only works because the bankers own the politicians and the government.

  • Michael J Bodger

    I am not a particularly intelligent individual and do not profess to a knowledge of the market system, but! I do know an absolute mess and a criminal enterprise when I see it. “Ignorance, is not a defence” they say in courts and I wonder what those who will be held responsible will say in their defence (if they havent already jumped out of tall buildings) when they are taken before a court for their actions in destroying the worlds economies whilst making vast fortunes for themselves. I have read about keynes and I have read monetarist policy theory, I understand the “augmented expectations graph” and how it indicates trends. It seems to me the whole system is badly flawed because of “theory” and consequently trends are easily identifiable as the system can be read like a book, it is “predictable”. Unfortunately those in a position to sort the mess out seem to be to busy fencing their portfolios and personal wealth against the eventual and certain collapse without considering the implications of being the only ones left with anything of value. It certainly doesnt mean “I’ll be alright jack” I hope that makes sense to you.

  • Samuel Eglington

    The Bank of England was slow to react at first because it considered Northern Rock’s problem to be a solvency one not liquidity. It was right. Solvency is the problem with Europe and Britain’s banks and short term liquidity will not solve it or prevent the deflation your hedge fund friends fear.

    Firstly the money is not really making it into the economy because banks arn’t lending to each other and the money is electronic not actual paper. The money sits in excess reserves it moves between balence sheets all the time but but always ends up in the same place. Due to the saturation levels of debt it is only being used to pay the banks own debts which is not an increase in the money supply.

    The other issue is a you and Corrigan have pointed out in a previous pieces inflation impoverishes people. The effect of this is that they have less money for debt re-payment increasing deleveraging (debt-deflation)

    This short term lending is entirely dependant upon asset prices recovering something they are unlikely to do due the the reduced income of most people in the economy. This zero hedge except explains it better

    Zerohedge pointed out a spike in additional collateral being posted at the ECB. According to some documents, the ECB is required to impose variation margins on its financing operations. This means that the collateral posted is not a one-time deal. If the collateral a bank has posted declines in value, the banks would have to post additional collateral. This is a big deal. Somehow the world seems to have an image that banks can borrow 3 year money at 1%, pledge an asset against it, and let the carry take effect with no other consequences. That is far from the truth if variation margins are being used.

    Having to post variation changes the product a lot. Buying longer dated bonds becomes very risky. They remain volatile and although banks could hold them in non mark to market books to avoid that volatility hitting their P&L, it wouldn’t save them from posting variation margin if the holdings decline in value. That helps explain why the curves are so steep, and really will limit the ability of banks to hold down longer term yields if we get another round of weakness, the death spiral risk is too scary.

    Portuguese banks should be of particular concern – again. The 2 year Portuguese bonds have jumped from a price in the low 80’s to the low 90’s. If banks bought these bonds as LTRO the potential for death spirals is on. As the bonds start declining in value, the banks would have to post collateral. Since the Portuguese banks are surviving almost exclusively on central bank money, their only choice would be to pledge some unpledged assets (if they have any), or sell the bonds and try and repay some of the LTRO. Selling bonds would put additional pressure on a then weak market. So the banks will pledge more assets. This does nothing to stop the slide in the underlying bonds, but would subordinate senior unsecured debt holders further. Senior unsecured debtholders will run for the hills again. They will see assets being taken out of the general pool – where they have a claim – and get shifted to the ECB, where ECB has the first rights.