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2009.04.25
Is it possible to have deflation when the central banks print money?
The short answer to the above question is
yes. There are two reasons that I why this is so. The first reason
is that in an economy that is shrinking, debt is being defaulted upon.
This happens as more and more people lose their jobs and as the value of their
assets (houses, stocks) fall below the amount of debt that they incurred to buy
these assets (mortgages, stock margins). This leads to bankruptcy as
the amount of income is no longer able to support debt payments. If the
amount of new credit created by the banks is less than the amount of debt that
is being destroyed, we will end up with deflation.
So why can't the central banks just print more
money in order to compensate for the amount of debt that is being
destroyed? Believe me they are trying to do just that ... even though this
will lead to a new problem of inflation or hyperinflation later on. The
central banks believe that it is better to have inflation than deflation.
They want to avoid deflation at all costs. They want to create "positive"
inflation and if they overshoot their targets (usually 2%) they will try to
slay the inflation dragon later on. This brings us to the second reason
why we can have deflation in the face of quantitative easing (the central
bankers prefer this terminology to the negative connotations of "printing
money"). Believe it or not the central banks may not be able to print
money fast enough to cause inflation. Why not? Because the quantity
of money in the economy does not equal total Gross Domestic Product (GDP).
In fact it is the quantity of money times the velocity of money that equals GDP
(M*V=GDP). The velocity of money is essentially how quickly the money
changes hands. Although the central banks can control the amount of money
in the economy they cannot control the velocity of money. You and I
control that variable since the central banks cannot force us to borrow and
spend.
Essentially what happens is that when the economy
becomes too saturated with debt the consumers no longer want to borrow and
the banks no longer want to lend. This means that the velocity of money
falls as money is hoarded and does not change hands as fast as it once
did. Consumers no longer want to borrow because they either no longer have
the income necessary to support further debt payments or they are worried that
they will lose their jobs or be forced to take a drop in pay in which case they
may not even be able to service existing debt. In a prolonged economic
downturn the focus of consumers is to repair their balance sheets by increasing
savings and paying down debt ... not by taking on new debt.
Also the banks have made some very bad investment
decisions. They ignored the amount of risk that they were taking on by
lending to people who were more likely to default such as subprime
borrowers. The banks thought that they could offload this risk by
securitizing the debt (carving it up into tranches and selling the debt to
unsuspecting investors such as pension funds and municipalities) and by buying
Credit Default Swaps (CDS) from companies such as AIG which were intended
to serve as insurance against default. The bad (or "toxic") debt in the
system thus increased exponentially and spread globally. This increased
risk which spread quickly and widely throughout the world began to threaten all
the world banks as well as pension funds. local governments and insurance
companies and is thus known as "systemic" risk.
This is why banks are not willing to increase their
lending. They have their own balance sheet issues and they know that there
will be many more bad loans and mortgages defaulting in the next few
years. They need to keep the bailout money that they have received either
in the form of cash or held on deposit by the central banks. They are
reducing their capital ratios to more sustainable levels lest they themselves
fall into bankruptcy.
Ben Bernanke (the Fed Chairman) is an academic
economist who has staked his reputation on his belief that the central bank can
always print enough money to avoid a depression. The methods employed by
the Fed under his direction are experimental and have never been tried
before. He is not only attempting quantitative easing (printing money) but
has also attempting a policy of qualitative easing (buying toxic assets instead
of government bonds). This experiment may or may not work. I believe
that it is possible that it will work for this crisis. However if it does
work this time it will only make the next crisis worse. The total amount
of debt in the system must be drastically reduced. This can only
occur by either paying down the debt or by defaulting on much of the debt.
As our governments increase the amount of debt that they owe they are trying to
replace with public debt the private debt that is shrinking. Any way that
you look at it this cannot end well. We will either pay for this
foolishness in the short term or in the long term ... but we will
pay.
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