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Deflation, Not Inflation, is the Threat

April 26, 2022 | Last week, The Economist proclaimed the failure of the Federal Open Market Committee when it comes to managing inflation, causing quite a fuss among American economists and investors. The Economist correctly identifies the political corruption of the Federal Open Market Committee, first lurching headlong into progressive inflationism during COVID, then swerving into what passes for Austrian School austerity described by St Louis Fed President and Uber Hawk James Bullard.

The Economist goes on to blame the current bout of wage and price inflation on the fact that Congress spent that last $2 trillion in COVID stimulus in 2021. No, say we to our friends in London, the inflation is not caused by surging demand due to the last bit of fiscal benevolence from Washington. Instead the inflation today is caused by war in Ukraine, the effects of COVID in China and a lot of external factors like shortages of products from silicon chips to single family homes.

Truth to tell, The Economist has missed the point about markets and inflation consistently since Walter Bagehot reported for them in the 18th Century. The operative model for the global economy is not banking in the City of London circa 1861 but rather Adam Smith. Bagehot's famous notion of charging "punitive rates" to punish speculation during a crisis, for example, has destroyed the British economy and, more important, a financial system based on the pound sterling. US benevolence after WWII created the dollar system.

Where would the world be today had John Maynard Keynes not contributed his essay, "How to Pay for the War," after the Battle of Britain began and before the US entered the conflict? The US and Britain raised marginal tax rates, sold lots of debt to pay for the war effort and created a safety net for the soldiers who fought and died. The allies beat the Nazis and eventually won the cold war with the Soviet Union because of benevolence, not Bagehot-style austerity.

The US and its allies in Europe and Asia must use the same approach taken in WWII to stop the deflation set in motion by Vladimir Putin's dictatorship in Russia. If the Great Wheel stops circulating (and the US economy stops growing), then we are all in deep trouble. This is the key insight that has guided the FOMC's at time clumsy actions over the past decade.

One of the supposed authors of the Fed’s excesses in terms of inflationary bond buying and low interest rates was then Fed Chair Janet Yellen, who has moved from strength to strength now as Treasury Secretary. Yellen recently declared that inflation has peaked, her imitation of the famed economist Irving Fisher, the first celebrity economist.

To recall, just nine days before the Great Crash of 1929, Fisher confidently declared the bloated US stock market had reached "a permanently high plateau." In fact, the US was about to go through the horrors of debt deflation for the next decade. He wrote in his classic essay, "The Debt Deflation Theory of Great Depressions":

"While any deviation from equilibrium of any economic variable theoretically may, and doubtless in practice does, set up some sort of oscillations, the important question is: Which of them have been sufficiently great disturbers to afford any substantial explanation of the great booms and depressions of history?"

In a strange way, Yellen is right about inflation, but not for the reasons that the Secretary and members of the Biden Administration probably hope. May of 2022 may indeed mark the peak of the post-COVID price bubble, but it may also be the start of a deflationary down leg in a global economy that has lost a couple of trillion dollars in economic output in the past three months. The real GDP projections by the International Monetary Fund are shown below. We expect to see a lot more red on this map by the end of 2022.

Source: IMF

The threat to the global economy comes not from the Fed, but from the fact that the world faces a huge output gap and thus a lack of productive endeavors that can absorb capital and drive growth. Thus as consumer prices are soaring, stock prices are falling and investors are fleeing to the apparent safety of government debt. Readers of The Institutional Risk Analyst will recognize the chart from FRED. Note that high-yield bond spreads have reached almost 500bp over risk-free assets, a major danger sign for the US economy.

"The effect of Russia's invasion to stimulate inflation has been enormous," notes Fred Feldkamp, our co-author in Financial Stability: Fraud, Confidence and the Wealth of Nations. "The 10-year Bund has gone from a low of -35 bps late last year to +97 bps recently. Russia may have 'cured' the EU's problem with negative interest rates."

Significantly, both Xi Jinping in China and Putin in Russia have decided to turn their backs on the global economy and embrace authoritarian terror in order to maintain power, Feldkamp argues. Both nations are now a drag on global growth and a potential source of serious instability in the future. The color for China ought to be red in the above map, but the IMF persists in using bogus official economic data from the Chinese government.

Without quick action to offset the yawning canyon of missing economic output that stands before the global economy, we may indeed see hyperinflation and deflation at the same time. As global capital flows into the remaining investment opportunities away from China and Russia, prices are likely to rise even faster than dictated by supply chain blockages. Look at the swarm of investors buying single family homes and commercial real estate in the US at the top of the market. Of note, the price of interest rate caps for commercial loans rose by an order of magnitude in the past 60 days.

In 2008, the US had to offset $30 trillion in acts of stupidity accumulated in the bond market between 2003 and 2006. The Treasury supported the banks, the Fed supported the financial markets, and the US economy did the rest, outperforming the rest of the world in terms of growth by a large margin. Today the question comes down not to fighting demand-led inflation, which is transitory and will subside, but to create a financial counterweight to the deflationary wave caused by the Ukraine war and the COVID lockdown in China.

The authoritarian turns of both China and Russia can be explained by the relatively poor economic performance of both societies since that time. Putin invaded Ukraine not due to worries about NATO, but because Russia is a failed society politically and economically. Kyiv is the economic center of a prosperous nation that boasts many transformational industries. Moscow is a military citadel that rules a nation that makes a living selling commodities and third-rate military hardware. Like Venezuela, Russia is largely dependent upon imports for most technology, manufactured goods and even food.

China likewise is a failed state politically and economically due to communist misrule. Xi Jinping fears COVID as a random, idiosyncratic event of the sort that has in past centuries driven dynastic change in China. The simple fact is that the ineffective response to COVID by China is now a threat to continued communist rule. Massive waves of infections and death could literally result in social upheaval in China, thus Xi locks his people behind fences guarded by soldiers and lets them starve to death.

Between Congress and the Fed, America marshalled the cash necessary in 2009 to keep the global economic system from tipping over. Fed Chairman Ben Bernanke understood that the sudden drop in economic output that occurred after 2008 had to be offset, otherwise we end up in a classic debt deflation described by Fisher in 1933. Today the sources of deflation are different, but the threat remains deflation rather than inflation.

While many analysts argue about a century old narrative defined by hard money, on the one hand, and tolerance for inflation on the other, perhaps its time to recognize that keeping the economy liquid and functioning is really the common goal. When a large part of the world suddenly is taken offline from the global economy, the result must be a decline in aggregate economic activity, rising events of default and a gradual slide into debt deflation.

When times change, people need to change their minds. Fed Chairman Jerome Powell is said by some members of the media to be “losing control of the inflation narrative,” but we think otherwise. Powell, like Bernanke, understands the lesson of the 1930s and debt deflation. “Global growth is projected to slow from an estimated 6.1 percent in 2021 to 3.6 percent in 2022 and 2023,” reports the International Monetary Fund. “This is 0.8 and 0.2 percentage points lower for 2022 and 2023 than projected in January.”

We suspect that growth estimates for the US and the world will be falling over the rest of this year and next. Given that scenario, a slow approach to raising interest rates and reducing the size of the central bank’s portfolio is the optimal strategy at present. But the real challenge facing Secretary Yellen and the US government is how to marshal the resources of the G-20, minus totalitarian China and Russia, to combat the true threat to global economic stability, namely the deflationary wave that now threatens to engulf the world.


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