Are we headed for deflation?

The difference between a deep recession and a full blown depression is if prices begin to slide precipitously. Historically, once that process starts it becomes very difficult to stop until the market finds its own bottom.

With that in mind, this article in the Wall Street Journal by Christopher Wood, an expert on the Japanese deflation of the 1990's, is instructive for a variety of reasons, not the least of which is his contention that the government has shot its last bullet in bailing out companies:

The origins of the modern conventional wisdom lies in the simplistic monetarist interpretation of the Great Depression popularized by Milton Friedman and taught to generations of economics students ever since. This argued that the Great Depression could have been avoided if the Federal Reserve had been more proactive about printing money. Yet the Japanese experience of the 1990s -- persistent deflationary malaise unresponsive to near zero-percent interest rates -- shows that it is not so easy to inflate one's way out of a debt bust.

In the U.S., the Fed can only control the supply of money; it cannot control the velocity of money or the rate at which it turns over. The dramatic collapse in securitization over the past 18 months reflects the continuing collapse in velocity as financial engineering goes into reverse.

True, this will change one day. But for now, the issuance of nonagency mortgage-backed securities (MBS) in America has plunged by 98% year-on-year to a monthly average of $0.82 billion in the past four months, down from a peak of $136 billion in June 2006. There has been no new issuance in commercial MBS since July. This collapse in securitization is intensely deflationary.

It is also true that under Chairman Ben Bernanke, the Federal Reserve balance sheet continues to expand at a frantic rate, as do commercial-bank total reserves in an effort to counter credit contraction. Thus, the Federal Reserve banks' total assets have increased by $1.28 trillion since early September to $2.19 trillion on Nov. 19. Likewise, the aggregate reserves of U.S. depository institutions have surged nearly 14-fold in the past two months to $653 billion in the week ended Nov. 19 from $47 billion at the beginning of September.

The question then becomes a matter of triaging companies and perhaps even entire industries. Are they worth saving? What criteria does the government use to determine who might be worth the effort to help?

Wood believes that allowing some businesses to fail will help speed the recovery later:

There are no easy policy answers to the current credit convulsion and intensifying financial panic -- not as long as politicians and central bankers are determined not to let financial institutions fail, and so prevent the market from correcting the excesses. This is why this writer has a certain sympathy for Treasury Secretary Henry Paulson, even if nobody else seems to. The securitized nature of this credit cycle, combined with the nightmare levels of leverage embedded in the products dreamt up by the quantitative geeks, means this is a horribly difficult issue to solve.

Virtually everybody blames Mr. Paulson for the decision to let Lehman Brothers go. But this decision should be applauded for precipitating the deflationary unwind that was going to come sooner or later anyway.

The Japanese precedent also remains important because the efforts in the West to prevent the market from disciplining excesses will have, as in Japan, unintended, adverse, long-term consequences. In Japan, one legacy is the continuing existence of a large number of uncompetitive companies which have caused profit margins to fall for their more productive competitors. Another consequence has been a long-term deflationary malaise, which has kept yen interest rates ridiculously low to the detriment of savers.

So perhaps we are headed not for a Great Depression style deflation but rather a persistent problem where deflationary pressures keep the economy in a 1970's style malaise. But this time with very low interest rates, a vastly weakened dollar, and higher unemployment. This would keep profits down and prevent the kind of investment that could lead to a robust recovery.

Read Woods entire article.


The difference between a deep recession and a full blown depression is if prices begin to slide precipitously. Historically, once that process starts it becomes very difficult to stop until the market finds its own bottom.

With that in mind, this article in the Wall Street Journal by Christopher Wood, an expert on the Japanese deflation of the 1990's, is instructive for a variety of reasons, not the least of which is his contention that the government has shot its last bullet in bailing out companies:

The origins of the modern conventional wisdom lies in the simplistic monetarist interpretation of the Great Depression popularized by Milton Friedman and taught to generations of economics students ever since. This argued that the Great Depression could have been avoided if the Federal Reserve had been more proactive about printing money. Yet the Japanese experience of the 1990s -- persistent deflationary malaise unresponsive to near zero-percent interest rates -- shows that it is not so easy to inflate one's way out of a debt bust.

In the U.S., the Fed can only control the supply of money; it cannot control the velocity of money or the rate at which it turns over. The dramatic collapse in securitization over the past 18 months reflects the continuing collapse in velocity as financial engineering goes into reverse.

True, this will change one day. But for now, the issuance of nonagency mortgage-backed securities (MBS) in America has plunged by 98% year-on-year to a monthly average of $0.82 billion in the past four months, down from a peak of $136 billion in June 2006. There has been no new issuance in commercial MBS since July. This collapse in securitization is intensely deflationary.

It is also true that under Chairman Ben Bernanke, the Federal Reserve balance sheet continues to expand at a frantic rate, as do commercial-bank total reserves in an effort to counter credit contraction. Thus, the Federal Reserve banks' total assets have increased by $1.28 trillion since early September to $2.19 trillion on Nov. 19. Likewise, the aggregate reserves of U.S. depository institutions have surged nearly 14-fold in the past two months to $653 billion in the week ended Nov. 19 from $47 billion at the beginning of September.

The question then becomes a matter of triaging companies and perhaps even entire industries. Are they worth saving? What criteria does the government use to determine who might be worth the effort to help?

Wood believes that allowing some businesses to fail will help speed the recovery later:

There are no easy policy answers to the current credit convulsion and intensifying financial panic -- not as long as politicians and central bankers are determined not to let financial institutions fail, and so prevent the market from correcting the excesses. This is why this writer has a certain sympathy for Treasury Secretary Henry Paulson, even if nobody else seems to. The securitized nature of this credit cycle, combined with the nightmare levels of leverage embedded in the products dreamt up by the quantitative geeks, means this is a horribly difficult issue to solve.

Virtually everybody blames Mr. Paulson for the decision to let Lehman Brothers go. But this decision should be applauded for precipitating the deflationary unwind that was going to come sooner or later anyway.

The Japanese precedent also remains important because the efforts in the West to prevent the market from disciplining excesses will have, as in Japan, unintended, adverse, long-term consequences. In Japan, one legacy is the continuing existence of a large number of uncompetitive companies which have caused profit margins to fall for their more productive competitors. Another consequence has been a long-term deflationary malaise, which has kept yen interest rates ridiculously low to the detriment of savers.

So perhaps we are headed not for a Great Depression style deflation but rather a persistent problem where deflationary pressures keep the economy in a 1970's style malaise. But this time with very low interest rates, a vastly weakened dollar, and higher unemployment. This would keep profits down and prevent the kind of investment that could lead to a robust recovery.

Read Woods entire article.