Will We Have a Deflationary Depression?

I have been seeing more stories out there about the possibilities of some sort of deflationary depression, either in the United States or worldwide.  To be sure, it is not the so-called mainstream media saying this, but there is discussion out there on the web.  Even the United Nations recently had some grim things to say.

With the massive monetary inflation we have seen since 2008, along with the piling up of government debt, there is no question that we are going to see some rough waters ahead.

Western Europe is a mess.  The Italian banks are the latest story, but don’t for a minute believe that Italy is isolated in its problems.

Japan is a complete disaster waiting to happen.  The government debt-to-GDP ratio is around 250% now by some measures.  Meanwhile, the central bank there is creating money on an unprecedented scale.  In spite of all this, the economy is extremely weak.  They can’t even get an artificial boom out of their stimulus.

China is another story of massive debt.  The central government and central bank have misallocated resources on a massive scale.  The real estate bubble and its inevitable bust has not come to full fruition yet.

We know the problems in the U.S. are similar, although they don’t seem to be as bad as elsewhere.  While the Fed did major damage from 2008 to 2014 by quintupling the monetary base, the Fed has kept the monetary base steady for nearly two years now.  Still, the debt continues to grow, despite record tax receipts by the Treasury.

There is going to be some kind of a massive correction due to all of the malinvestment.  It will be mostly global too, because all of the major central banks have done damage.  I think the U.S. will fare better than China, Japan, and Western Europe, but that may not be saying much.

The place where I dissent from some of the stories out there is that I don’t think it will be a deflationary depression.

Prices for some assets will fall, especially where there is bubble activity.  I would expect U.S. stocks to fall quite a bit.  Real estate will likely fall too, but this will be more dependent on each area.  It won’t be like the housing collapse 8 years ago because the bubble has not been blown up as big.  Areas such as San Francisco, where there are major housing bubbles, will suffer.  All of Silicon Valley will probably suffer.

There may be a slight and temporary decline in consumer prices as measured by the CPI.  This will be a reflection of a higher demand for money.  It means that people will not be spending as much due to fear, and rightly so.

If there is deflation in prices, it won’t be a monetary phenomenon.  Much of the new money since 2008 went into bank reserves.  Perhaps there will be a reduction in lending, but it probably won’t be so dramatic that it will be hugely deflationary, which would be a reversal of the fractional reserve lending process.

If anything, if we hit a depression, we should expect the Fed to enact more monetary inflation.  This is unfortunate, as it does not allow a full liquidation of the malinvestment.  It does not allow resources to get fully redirected in accordance with consumer demand.

If there is any kind of price deflation with a depression, there should be no doubt that we will see massive quantitative easing.  It may top what we saw with QE3, where the Fed created about one trillion dollars out of thin air in 2013.

The Fed hasn’t even been able to raise its target rate in 2016 during a supposed recovery.  Does anyone think the Fed will just sit on its hands if we have some kind of a deflationary depression?

And we should not be fooled that the Fed is unable to produce positive price inflation.  This can always be done at some point.  Perhaps initially the fear will overwhelm the monetary inflation, but a determined Fed can reverse this.

Ben Bernanke himself said in a speech on deflation in 2002, prior to becoming Fed chair, that, “the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.  By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services.  We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

We should listen to Bernanke on this one occasion.  He is absolutely correct in his assertion.

If the Fed announced QE4 for $3 trillion annually, is there any doubt that we would see prices jump quickly, even in the midst of a depression?

In conclusion, I can envision some sort of depression, but I don’t think it will be a deflationary depression.  It won’t be like the 1930s, especially prior to the FDIC when banks were failing.

The Fed will not let the banking system implode.  It will not allow for sustained price deflation, even though we would be better off in the long run if it allowed the proper correction.

We could see a temporary period of consumer price deflation, but it will not likely last.  We should plan for a major correction, but we should also plan for the Fed’s reaction to the correction, which will be more of the same – mainly monetary inflation.

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