Is Deflation Even Possible?

"Unemployment is sky-rocketing; deflation is in our future for the first time since the Great Depression.  I don't care whose fault it is, it's the truth." - John Mellencamp

Economics is a very strange discipline.  It tries to work out what will happen to an economy given certain inputs and structural changes.  For example, how will a change in the tax rate help or hurt the economy or how will massive stimulus from the Federal Reserve stimulate economic growth?  The problem with economics is that there are just so many moving parts that the chances of actually get the answer right is pretty much impossible.  What you can do is hypothesis about the future and base it on historical data points and then rely on your instinct to guide you.  Changing your mind is part and parcel of the process as new data is constantly available and there is always the Black Swan event lurking around that will throw all assumptions out of the window and create havoc with your hypothesis.

When I look at the massive quantitative easing program of the Federal Reserve the questions are is it working and will it result in inflation?  Consensus says that it is working (at least that is what it appears when you look at the stock market) and that inflation, while it will rise will be moderate.  At present I disagree with both of these views which is why I am in the camp that is negative on the market because if it is not working and inflation will not be moderate in the future then the market is setting everyone up for a massive reversal.

Now what if we are all wrong?  What if inflation not only remains subdued but due to all of the easing we end up with deflation?  I have mentioned in last week's blog that Japan is already exporting deflation to the rest of the world, but what if deflation takes hold globally?  If I look at the Federal Reserve who has increased their balance sheet by almost $3 trillion you would expect massive inflation but at present it seems relatively mute.

Consider this equation created by Irving Fisher that GDP = MV.  That is to say the size of the economy is equal to the money supply multiplied by the velocity of money.  Now if the velocity of money remains constant (does not change) then by increasing the supply of money through the Federal Reserve monetary expansion then GDP has to increase.  This is inflation.  Now as there is minimal inflation at present and GDP is not growing very fast (if at all) let's dig a bit deeper to see what is going on in the inner workings of the equation.

Money supply as measured by M2, the monetary base, expanded by $277.5 Billion last quarter as the Federal Reserve expanded its balance sheet by that amount.  M (money supply) however declined by $55 Billion to $10.45 Trillion.  This is only possible if the money multiplier shrank.  The money multiplier is the value assigned to the expansion of the money supply when a bank lends out a dollar.  This expansion occurs because the dollar lent does not just stay in your wallet but is used to buy goods and services and is then spent again and again.  This one dollar multiplied itself by a factor of 9 in 2007 when the economy was booming, but today that number has fallen to 3.6.  So the first problem that the Federal Reserve has is that it cannot create demand by printing money.

The second part to the equation is the velocity of money.  Velocity of money was thought to always remain stable but it turns out that this too is a variable.  It appears that the only way in which the velocity of money can remain stable or expand is through lending to increase production.  Lending to finance consumption does not generate a productive income stream and it cannot create resources to repay the debt so therefore velocity collapses.  In fact the current velocity of money stands at a six decade low.

Now the inflation advocates point to the fact that once things turn around you will have an increase in the velocity of money and an increase in the money multiplier and a huge increase in the monetary base and this will lead to outlandish inflation.  The problem is that the money printed is being used to finance consumption and this could result in a spiral into the abyss that is deflation.  This is what Japan has been dealing with for decades.  They too have and are pumping money into an economy in the hopes that it will eventually get their economy started but after more than 20 years there is still no sign of life.  Worse than that they now owe more than 200% of GDP in government debt.

This could easily be the outlook for the United States and if it is then the euphoria of the stock market will quickly turn to dismay.  The reason is that deflation is the worst possible world for the stock market.  The economy is essentially shrinking as prices fall and consumers put off purchasing goods and services as they learn that these will be cheaper in the future.  Businesses struggle to grow and can only keep profits up by stealing market share from others or by cutting overhead such as labor.  If this sounds familiar then you are right as this is where the United States is now.  The problem is that the market and most pundits expect inflation to begin any time soon and as the market looks forward the expectations for inflation are now baked into the prices.  Should this expectation change as the reality sets in then the market will be in for a long downward spiral.  In Japan the market has recently rallied to over 13,000 but that is still a long way from 38,916 which was the all time high set in December 1989!