Understanding the Great Deflation

by George Hatjoullis

One of the problems with blogging is finding a level to pitch the blogs. In order to overcome this problem I wrote a number of pedagogic blogs on economics and finance. Some of these have been very popular. However, they were designed as  a set and this may have detracted from their effectiveness. It is hard for people without an economics background to grasp (or stay awake through) many of the concepts. Indeed I have found that they were appreciated by some with an economics background which implies I pitched them at the wrong level. For this I apologise. This blog is going to try to get a an idea across that is very relevant today; deflation. It has been covered in many previous blogs and in many ways but I suspect it cannot be covered too often. For one thing, policy makers appear not to grasp (or pretend not to grasp) the risk of deflation today.

First a metaphor. Medicine often treats symptoms because symptoms are uncomfortable and can lead to complications. Body temperature is such a symptom. If it is too high or too low it can lead to complications that are often fatal. Hence irrespective of what is causing the temperature deviation from normal body temperature (37 C or 98.6 F), doctors will treat the symptom. However, they will then look for the underlying disease and try to treat this as well if possible. So it is with aggregated price changes in an economy. Policy makers have some concept of normal and recognise that deviations may have consequences that are undesirable and will treat the symptom of inflation or deflation. Interestingly ‘normal’ is not zero price change but some positive level of inflation typically close to 2%. Unlike doctors, economists and policy makers seem to treat inflation as the disease and often do not look too closely at the causes, or have a simplistic singular model of causation. Body temperature can deviate for any number of underlying reasons. No such complexity with inflation it seems.

Let us look at the problem from a different point of view. The lubricant of any market economy is money. This can be anything that people will accept as a means of exchange but we will focus on fiat money generated by the central bank and distributed via the banking system. Notes and coins are used to effect transactions, measure price and store wealth. Most people do not hold cash but keep their balances on deposit at a bank and use a debit card. Bank deposits are money, in a sense. When a bank makes a loan it makes a deposit available to the borrower. It has just created money. The terms under which a bank can create money are controlled by the central bank. The binding condition is solvency because the central bank will not normally allow a solvent bank to fail because of liquidity. This is known as the lender of last resort function of central banks. Of course, the CB determines solvency. The amount of money created by the banking system is up to the banks, subject to this solvency constraint. The CB can encourage/discourage money creation through reserve and interest rate policy but it does not determine the stock of deposits. It does not determine the stock of bank money.

Money in a fiat system strictly speaking is a liability of the CB. However, because it stands ready to provide solvent banks with such money on demand (at a price), bank deposits are treated as equivalent. Up to a point they are equivalent. The insured deposit is equivalent to CB money but deposits are only insured up to some amount (£85k in the UK). Deposits above the insured amount are not equivalent. They are not strictly speaking money. The clue is in the word ‘insured’. If the CB declares a bank insolvent it can require uninsured depositors to contribute part of their deposit to the bank’s capital. An important characteristic of money is that it is risk free. If you have £20 you can spend £20 (unless you are robbed of course). If you have £1 million you may not be able to spend £915k. Check out recent history of Cyprus banks, if in doubt. Uninsured deposits are not money but near money. They are unsecured but senior loans to the bank. They are debt that you can draw on to spend but they are not strictly speaking money.

The CB can make liquidity available to the public either through banks by encouraging lending or directly by buying assets from them in the open market. This has come to be called quantitative easing or QE. Of course, if you deposit it in the bank then it becomes a mixture of £85k of money and a larger deposit of near money. The habit of regarding all the deposit as money arose because it was unheard of for uninsured depositors to lose their deposits except in rare cases; until Cyprus and eurozone banking reform that is. My precision is not pedantic. There is a point. Be patient!

Individuals use money in their wealth decisions as well as current spending. Wealth decisions can be viewed as plans for lifetime spending. This is a very complex area but in a very general sense these decisions depend upon perceptions of risk and reward. In times of extreme uncertainty there is a tendency to hold something deemed to be low risk or even no risk. In the post war period cash has typically been viewed as risky because of inflation and was not regarded as a very useful asset for accumulating wealth. Borrowing was regarded as a good practice as the real value was eroded by inflation and interest rates never seemed to quite compensate. However, inflation is not the only risk out there and at the moment does not seem to be much of a risk at that. From 2008 onwards, credit risk overtook inflation as the risk de jour.

Individuals rapidly became aware that even money in the bank was not safe beyond a certain amount. The hunt for credit risk free assets grew just as they started to disappear. Government debt was diminished because of austerity. The CBs reduced the stock of such assets further via QE. Sovereign debt in the eurozone was seen not to be risk free. Uninsured deposits at banks were recognised as not wholly risk free. Money is the ultimate risk free asset in the absence of serious inflation risk. The demand for money increased dramatically after 2008. The supply diminished. The consequence of the banking crisis was the reduction of bank lending; the supply of money, or at least near money. The demand for near money, risk free, assets jumped just as the supply decreased.

So what happens in such an environment? First, any asset that is deemed risk free and near money starts to trade at a premium. In practical terms this means very low and even negative interest rates. Second, assets that offer relatively secure and stable long-term cash flows become highly valued. London rental property is a prime example. Finally, collective assets that are not highly leveraged, have good cash flow and may even contain a large stock of cash become highly valued. Many large corporations started to fit this description in the aftermath of 2008 as investment plans were shelved. In this environment cutting investment plans can actually enhance stock valuations. This is not a wholly inaccurate description of the present context.

The environment that we face at the moment is what J.M. Keynes might have referred to as perfect liquidity preference. Individuals want to hold wealth as cash or some risk free near cash. If forced into stocks, which carry a high degree of credit risk, they prefer cash rich companies. Investment is viewed with scepticism unless cash flow prospects are good. People do not want to spend or take risk. They want cash in the bank, so to speak. This seems to be the prevailing state of mind at the moment.

Potential GDP is the output that could be produced without triggering upward price pressure. Actual GDP is that which is produced in a given time period. It belongs to those that made it (labour) and those that own the means of production. The two groups will not want to consume all of it but rather save some for the future in the form of money balances. They need to sell some to get these money balances. The problem is everyone is cutting back spending in order to build up money balances and reduce debt. Money is king. Getting GDP up to potential is thus a struggle and so there is no pressure on prices. As long as there is no pressure on prices, the one thing that might get people to stop seeking cash balances (inflation) is not available. It is a vicious spiral that the current monetary policy framework not only cannot affect, it may be making matters worse.

The phenomenon of poverty in the midst of plenty is with us again. The economy cannot reach potential yet people are going to food banks. The problem is income and wealth distribution. The owners of the means of production neither want to spend nor invest sufficient to absorb potential GDP and no one else can. Some income redistribution would help everyone, including the owners. Governments persist with austerity. Weak oil, food, and commodity prices hold back investment. Technological innovations make some people astonishingly rich but they have no incentive to do anything else. They are already rich. The wealth does what? In the meantime the technological innovation renders swathes of people unnecessary in employment.

The demand for money balances exceeds supply. This is suppressing spending and investment. Income distribution has become too extreme. This is suppressing spending and investment. GDP cannot reach potential so there is no, and can be no, pressure on prices until capacity destruction reduces potential. However, technological change is expanding capacity faster than capital destruction can reduce it. This is the ‘disease’ at the heart of our great deflation.

This is not the raving of a neo-marxist. These are the observations of a retired investment banker educated in economics and psychology. It is the thought process of someone who grew up in the inflationary 1960s/70s/80s and recognises that the policy makers are obsessed with solving the last problem even though the situation has changed, and fundamentally so. It is the observation of a very concerned man.