Not Your Father's Inflation

My previous post talked about what is going to happen with the recession, but I didn't spend too much time on monetary policy and what the Fed will do. This is sort of unfortunate, as the Fed has a very big role to play. In fact, it probably has an even bigger role than the Treasury or the Obama Administration in ending this recession. So, now that I have considered the fiscal side of things, let's look at the monetary side.

Without a doubt, we are currently in a deflationary scenario, or at least very minimal inflation. The sort of interesting thing is that while the prices of goods and services haven't really fallen in the past few months, the asset price deflation has had a profound impact on the economy. For at least the next few months we can expect more of the same.

Deflation in modern economies is bad, first because prices are sticky (for example, wages go up much more easily than they go down), second because deflation increases people's real (i.e., inflation-adjusted) debt burden, and third because deflation can lead to a spiral of falling prices as people keep on waiting to buy things, knowing that prices next month will be even lower. This is very bad for production and employment. Knowing this, what options does the Fed have available? It's already taken a few steps that can tell us what it plans on doing.

The Fed desperately wants to avoid deflation for the reasons stated above. Until recently, it focused on trying to get the frozen credit markets moving again through various programs such as the Term Asset-based Securities Lending Facility (TALF). There seems to have been a few signs that it has been working. The commercial paper market, vitally important for businesses in funding their day-to-day activities, has more or less recovered. But what is really important is the announcement the Fed made about a month ago, declaring that it would buy hundreds of billions of dollars worth of Treasury bonds. The Fed has effectively declared a policy of quantitative easing -- in other words, the Fed is going to print its way out of the recession.

I gave several reasons in my previous post as to why the Fed would want inflation, but it bears some repeating here. First, inflation "greases the wheels," so to speak. Inflation would get things moving again. The credit markets would unfreeze, and companies would finally be able to get the credit they need. Second, there's too much debt in the US. The easiest way to solve that problem is to inflate. Of course, there are plenty of problems with inflation, but if it had to choose between the two, the Fed will always choose inflation over deflation.

The TALF really only addresses the liquidity problem of the asset-backed securities markets. A completely liquid ABS market, however, is not going to stop a recession. This is where quantitative easing comes in. By buying Treasuries, the Fed is deliberately pushing the interest rate down. Its hope is that with such low rates, companies will be able to borrow money in these times.

Japan in the 1990s also adopted a policy of quantitative easing, and it still hasn't recovered from its bubble. So why worry about QE? I have three reasons. First, Japan never really tried hard enough. The simple fact that deflation was still happening until very recently is proof that Japan didn't print enough money. After all, printing more money is by definition inflationary. The US, I hope, has learned its lesson. The Fed will look at Japan and see that they can't afford to make the same mistake; they will have to print more. Second, I think a major reason why Japan didn't try harder was because the Japanese are big savers. When a large portion of the population is savers, you can't exactly go for deliberate inflation without incurring the wrath of your constituency. The US, on the other hand, has had a dismal savings rate. We even had a negative savings rate not too long ago. The government will feel much less compunction than Japan did in trying to inflate its way out of the recession. Finally, partly because of incompetence, partly out of politics, but mostly because of an unavoidable lag between the Fed's actions and its effect on the market, the Fed will not be able to control the money supply as effectively as it would like. Thus, the Fed will end up printing too much money, and when it tries to tighten policy, it will be too little, too late. The Fed always has a problem of reacting too late to a situation. Take for example the Fed leaving rates too low for too long in 2004 or so. It's completely unavoidable, though. There is always a lag, usually between one and two quarters, from when the Fed decides on an action -- raising rates, for example -- to when that action will finish filtering its way through the market. Given this lag, the Fed would essentially have to do the impossible: It would have to be able to forecast what would happen 6 months from now based on today's data.

Even if it could do that, its actions would be completely counterintuitive to the populace. Currently, the Fed Funds rate is between 0% and .25%. If the Fed sees a recovery by December of this year, then it should start raising rates in June so that its policy can match the market correctly. But in June, the economy is still declining, and the Fed decides to raise rates!? The Fed would not able to survive the onslaught of criticism and outrage from people and politicians. And that's assuming the Fed knew with certainty that the economy would recover in December. The more likely thing is that it has a feeling that it might recover, but it could be wrong. If it's wrong, though, and the economy doesn't recover until March 2010, then the Fed will be raising rates at precisely the wrong time. That would be the worst possible thing to do, raising rates while the economy is still declining. So the Fed will always act too late.

Why did I title this post "Not Your Father's Inflation?" Using the three scenarios I outlined in my last post, let's look at what the Fed would do in each case.

1. Recovery soon
If the economy is going to start recovering by the fourth quarter of this year, then the Fed should actually be ready to start raising rates soon. We know that this won't happen though; the Fed won't start raising rates until it sees actual proof that the economy is improving, meaning that the Fed won't be taking any action until midsummer at the earliest. Thus, we'll have several months where monetary policy is too loose. However, it's not exactly clear if that would have any bad effects on the economy. On the one hand, we'll probably have anemic growth even after the recession ends, so the easy money will simply make things a little less anemic. On the other hand, the Fed has pumped astronomical amounts of money into the system. The only reason why we haven't had massive inflation so far is because the velocity of money has been falling even faster. Once the economy recovers, the velocity of money will start to recover too. And since there is so much money sloshing around now, a small rise in velocity will have a much bigger effect on inflation than before. We could end with a situation where we have no inflation one day and then lots of inflation the next. Similar to interest rates, the Fed will be acting late in turning off the spigot of quantitative easing , thus ensuring that this scenario is a distinct possibility.

2. Recovery in 2010 or 2011
In our second scenario, the recovery would not occur until much later, but overall, I don't see much of a difference in what the Fed would do or what would happen. I would like to consider, though, how much inflation we could have as a result of the Fed's actions. If things play out as I described above, then we could have anything from bad inflation (8%) to very bad inflation (15%) to a hyperinflation (30%+). Much of this will depend on how much the velocity of money recovers.

3. The Greater Depression
As I mentioned in my section in the previous post on the Greater Depression, the government, if faced with this scenario, has two choices: It can endure the years of economic suffering under a crippling deflation, or it can hyperinflate its way out. I would place my bets on the latter choice. In that case, we'll soon be ruing the day when gas cost only $4 a gallon. The government might start with a "stimulus check" of $10,000 or $20,000 for every taxpayer. Everyone will feel richer, and for a very brief moment, it will look like things are actually recovering, with asset markets unfreezing, people finding jobs, and even banks making money again. But this is merely the illusion of prosperity. People sooner or later will realize that if everyone has more money, then everyone has more money to pay for things. What starts out as $3 cup of coffee will become $4, then $5, then $7, then $10, then $15, and on and on until the currency collapses. The flow of money that will slowly make its way through the economy, lifting all boats at first, will quickly turn into an uncontrollable tsunami that mercilessly kills all without an ark. Those with any savings will find that their decades' worth of hard work has become worthless. On the other hand, anyone with a mortgage will gladly trade $20 bread or $50 milk for a complete repudiation of his debt.

The endgame? If we're looking at bad inflation for the future, then you should have some money in commodities like gold or oil, but your life will be business as usual for the most part. The Fed might have some trouble controlling the inflationary beast, and maybe we'll even have a 70s-style period of economic malaise, but nobody gets hurt. If we're looking at hyperinflation, then I'm sorry to say that you're screwed... unless you happen to be one of the many who owe more money on your home than it's worth, or one of the few who judiciously put some cash into the shiny, yellow metal.

In either case, it would behoove you to carry a little bit of the barbarous relic. We're looking at some barbaric times ahead.

The Future of the Economy: Three Scenarios

From the look of things, it seems like we're nowhere near the end of the recession. The consensus economists have become more optimistic in the past few weeks, however. They point to the recent signs in consumer spending and home sales that might be pointing to a turnaround for the economy, or at the very least, a decrease in the rate of decline. The stock market likes the optimism and has been (irrationally) rising very strongly in the past few weeks. I don't see anything to change my mind, though. Things still look bad, and I think things have a good chance of becoming even worse. Looking at the Great Depression, people are thinking we are in 1933 after Roosevelt's bank holiday. I, on the other hand, worry we're in 1930. Things were becoming bad after the stock market crash in 1929, but what started the Great Depression was not the crash; it was the bank panics that started in 1931 and lasted until 1933. That was what made the Great Depression so Great. With that in mind, here are three ways the economy could play out in the next year or two.

1. Consensus: The bottom is a few months away
Frankly, this is the most unrealistic scenario, but it is something we should consider, however unlikely it is. Suppose that Geithner and Bernanke can pull off their trick and actually instill some sort of confidence in the banking sector. A stabilization of the banks might cause housing prices to at least slow their rate of decline. With banks able to lend again, companies can get the credit they need to expand their business. Consumers slowly begin spending again, and the economy gradually recovers. We might have many quarters of anemic growth, but at least we'll be out of the woods.

This seems to be the consensus picture. Most economists have been moving the time they predict the bottom will occur forward to somewhere around the fourth quarter of 2009 or so. If this actually is the case, then it makes sense for the stock market to be rallying right now, since the stock market is a leading indicator of the economy.

What's wrong with this picture? Well, everything. Obviously, Geithner and Bernanke truly, truly hope that things will play out this way, but let's be realistic. The biggest linchpin is the stabilization of the banking sector. But the banks are suffering not from a liquidity problem, as the Treasury and Fed would have us believe, but from a solvency problem. Given that the banks are technically bankrupt (haha, sorry), making it easier to trade won't actually do anything. The government's new PPIP plan implicitly assumes that the market for toxic assets is frozen (hence, a liquidity problem), and that because the market is frozen, the bid-ask spread between the banks and investors is too large, and that is what is keeping the banks from recovering. This is also the reasoning behind the suspension of mark-to-market accounting. By adding money to the market, the government hopes that the price for toxic assets will reach its so-called "true" value.

But investors are asking for 30 cents on the dollar for these toxic assets because these assets are actually only worth 30 cents. The PPIP might actually succeed, though, in inflating the value of these toxic assets... at least until housing prices fall enough that banks have to take yet more writedowns. The PPIP is simply a way to obscure the fact that the government will be bailing out the banks... again.

If banks truly were facing a liquidity crisis, then loaning money would work because banks could rely on their future profits to pay back the loans. But if the banks are insolvent -- which they clearly are -- then loaning money simply delays the inevitable. More money does not make a company turn a profit. The issue is profitability, and the banks are not profitable.

2. The bottom will be in the second half of 2010 or the beginning of 2011
This is the most likely scenario in my mind. The economy cannot recover until the banks get through their solvency crisis. I think several months from now, the government will finally realize that the only realistic scenario is for some sort of "reorganization" (i.e., structured bankruptcy through a nationalization) of the banks, which will involve the culling of the weakest ones. Citigroup will certainly not survive. Neither will AIG, or Bank of America, at least as a public company. Wells Fargo has been substantially weakened by its acquisition of WaMu. JP Morgan will be facing a lot of pain, but it will probably survive. Goldman Sachs will likely survive as well, though it has yet to face any significant test.

Housing prices will continue to fall. But the bigger thing will be mortgage resets. What caused all of this was the default on subprime mortgages. The next wave of resets will be hitting homeowners sometime next year. This time it will be option ARMs. The defaults on option ARMs will make subprime look like prime. When homeowners see their mortgage payments tripling, there's no chance in hell they're going to continue paying it -- even assuming they had the ability in the first place to make those payments. This will cause massive losses for the banks, and could in fact be the 1931 event that we're looking for. Allow me to be optimistic(!) , but there is a silver lining here. The banking panic redux will quite possibly provide the impetus necessary to finally deal with the banking problem properly. The government will realize that it simply cannot continue pouring money down a bottomless pit. The losses will continue, but at last we'll be able to start anew. As I have said, once we solve the banking problem, we can finally start getting through this recession.

Meanwhile, unemployment will continue rising and could possibly reach a peak of around 15%. We'll continue having a massive asset deflation. The stock market will certainly fall from its current price. If the recession ends in the beginning of 2011, it will have lasted for three years. To put this in perspective, that is about as long as the 1980-82 double recession (though technically there was a year of growth in between) and a bit shorter than the 1929-33 recession. So things will be bad, but probably not worse than the Great Depression.

3. The Greater Depression
I have to admit that the second scenario might actually be a bit optimistic. I assume that the government will finally get its act together and do what's necessary for the banks, but as we all know too well, government has a pretty poor track record of doing things right. That was part of the problem of the Great Depression. The government, through its action and inaction, turned what was a bad recession into an entire decade of misery. For all the talk about how we have learned the lessons of Japan and the Lost Decade of the 1990s, what amazes me is how much we're copying Japan. Though we may know what to avoid, will we actually do things differently? That remains to be seen.

In considering the Greater Depression, there are actually two ways this could pan out. The first is a Great Depression but on a greater scale. We end up with massive unemployment (well over 15%, maybe even over 20%), and the stock market completely crashes. The stock market in the 1929-33 recession lost 90% of its value. If the same thing happens to the market today, then we'll be looking at a Dow of around 1400 and S&P of 150! The recession will last for years, until early 2012 at the earliest, possibly until 2014. The government will be powerless like Japan was to stop it. It will be a slow and painful bleeding of wealth and energy, but eventually all the bad blood is removed from the body, and the economy can start to rebuild itself.

Alternatively, the government could go with the nuclear option. That is, the problem we have right now is deflation. What the government might end up doing is pulling a Zimbabwe and going for hyperinflation. Through the printing of huge amounts of money (or rather, adding more zeros to an account in a database), the Fed can get the housing market, the credit market, and the banking sector all moving again. Of course, the only problem is that they'll be moving at incredible speeds as everyone tries to dump their dollars before they become worthless. The currency collapses, but we destroy all debt in the process, and we finally have the chance to start all over.

In both scenarios people lose. The difference is who loses the most. In the Greater Depression, those who don't have a job will be having a miserable and painful experience. Those who do have a job, on the other hand, might actually finds things to be not so bad. As they say, the Great Depression was great if you had a job. Prices were constantly falling, meaning that you could buy more and more for less and less. By forcing everyone, including the government, to pay down their debts, the foreigners get to keep their money at the expense of the Americans. In the Weimar Republic/Zimbabwe scenario, the middle class will be totally wiped out, though they will get to start with a clean slate, as all their debts will be cancelled in the process. The foreigners, too, will be wiped out when we repudiate our debt. The poor actually might not do so badly because they have no assets to lose, while those who own tangible assets like gold, commodities, and real estate will be able to preserve their purchasing power. They will probably even end up ahead after the hyperinflation ends, as they will be the ones with all the remaining wealth.

No matter how it plays out, somebody has to lose. The Devil demands his due.

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I talked about monetary policy a little bit in this last scenario, but I haven't talked too much about it when I should be, because how the Fed acts will have a big effect on what will happen in the coming years. I'll talk about inflation and deflation in more detail in the next post or two. I'll also talk about some investment ideas for the future.