My financial start in life came in the 1970s when rent houses seemed to be a good idea. That was because its rental stream was ratcheting upwards in an inflationary environment and could also be acquired with its original fixed-rate mortgage still intact.
What made the investment especially appealing was that the inflationary wind was to my back; rental streams grew while the mortgage’s interest carry remained low and locked at a fixed rate that reflected earlier and more modest inflation.
And as you might think, the combination of inflation-enhancing income streams and cheap fixed rate financing is an environment that promotes the building of more of the same — not only more houses but more importantly corporate plant and equipment that grows jobs and output. Hence, economic performance benefits from inflation, to some degree.
A return to these conditions is what central banks of the world, especially in Europe and Japan, lust for today. Instead, they find themselves on the edge of exactly the opposite — a deflation that neutralizes the benefit of the low fixed rates that central banks have manipulated since the onset of the Great Recession.
But one must appreciate the full extent of the deflationary threat facing many developed countries today that drives policy and markets.
Deflation more than neutralizes the low interest rates provided by central banks because investment in real physical assets is deterred by the prospect of deflating income streams. And that reduces spending on new physical assets which, in turn, reinforces the deflationary environment.
That is, while deflation may be the product of previous soft economic conditions, it inhibits further physical investment in real assets thus reinforcing the existing deflation.
This is known as the deflationary trap.
And that’s not the end of the self-reinforcing deflationary damage. Deflation also shrinks top-line income of the corporate, government, and consumer sectors which diminishes spending and in turn makes it more difficult to repay existing debt. In other words, the real value of debt increases leading to default and default takes down not just the borrower but also the lenders.
The iconic scenes of bank panics of yore in which depositors line up to withdraw their funds tell a story. The depositors believe deflation induced defaults in the banks’ loan portfolios will cause the banks to fail and they had best retrieve their deposits while they can.
The dynamic leaves the banks not only with loan losses but no lendable cash. It still plays out today though not as visibly as deposit withdrawals are on-line as in southern Europe.
That was the story of the l930s.
If both the desire to borrow and the ability to lend go away, the wheels of an economy no longer function in the way we are accustomed, no matter how much money supply the central bank spreads around.
Since the developed countries are on the edge of the deflationary trap, many of their central banks are resorting to quantitative easing (QE). These epic asset purchases do not produce the lending and spending or inflation that monetarism suggests, nor do the QEs reduce interest rates, as they are already at the near-zero floor. Rather, in a great Hail Mary, the QE at this stage is intended to devalue the home currency so that domestic produced goods become relatively cheaper for foreign buyers and they do buy more.
That is the motive for quantitative easing — to gain greater global market share through a cheaper currency and hence goods, which is all that monetary policy contributes these days.
While selling currency on the foreign exchange markets is the direct route to a cheaper currency as practiced by China, it goes against the rules of central bank monetary chess. So the currency selling needs to be more subtle.
The preferred way to accomplish the same is a QE of large-scale asset purchases of domestic financial assets. The central banks claim its domestic monetary policy and leave it up to private investors seeking higher yield to head for the financial markets of other countries where slightly more than microscopic yield still exists.
In the process, the investors heading abroad sell their currency and cause the currency devaluation and do the dirty work for the central bank. It’s not much of a cover-up, but it’s what central banking has come to be these days.
What other reason would cause, for example, Japan to roll out yet another QE in heroic proportions and then, less than a month later at the news of yet another Japanese recession, to increase its very recent QE by 33%?
If successful, a cheaper Yen attracts foreign buyers of Japanese goods and enough demand to turn deflation into inflation that generates inflation streams for home-grown investment in physical capital. It also gives domestic producers pricing power, when the prices of imported goods rise in terms of the Yen.
So the self-reinforcing deflationary depression leads to often contentious policies of currency devaluation via investors in an effort to capture greater global market share and some modicum of inflation. The Fed’s QE3 of the previous two years that ended last month paid dividends for the U.S. in this game at the expense of Europe, Japan, and others, which, in turn, triggered their re-entry into the currency wars just as the Fed ended theirs.
Other countries are now in retaliation mode in this game of central bank monetary chess, hoping to steal some demand back from the U.S. This leads to not just the depreciation of their currency but the ascendency of the U.S. dollar and the value of U.S. assets, which was nice at first until we find out it’s gained at the cost of a now-perceptible slowdown in the U.S. economy. In this stage of the currency wars, the U. S. is about to lose some of what it previously gained when the Fed was in QE3 mode.
Hence, quantitative easing is no more than a cover-up for currency devaluation: it allows government officials to claim their hands are clean from a practice that is globally frowned upon.
In the process, central banks have revealed that money growth is not the inflationary threat once thought, at least not in this environment. We have come to the understanding that in the deflationary trap, neither fiscal nor monetary policies are what the textbooks say they are.
Public policy has come down to the sorry state of manipulating growth and inflation at the expense of someone else’s deflation. It’s a zero sum game of redistribution among countries that adds little overall lift to the global economy.
Few who lived through the “runaway” inflation of the 1970s would have dreamed that someday inflation would be a desirable public policy? We have come to find out that it surely beats deflation. But how to achieve inflation has proven to be elusive when lenders are fearful of deflationary induced default and business investment borrowers need more inflationary wind to their back.
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