Debt Deflation and False Dawns

There's a debate raging in the financial world right now over whether the biggest threat to the American economy's health is deflation or inflation.

Off to the top left of the screen you'll see a poll I put up asking that very question. Please vote, if you feel inclined.

Today, somebody linked me to a rather old article from January of this year. Its an interview of economist Dr. Lacy Hunt by the Business Spectator publication from Australia. You can find the article here.

Despite the fact that it was published over half a year ago, I felt strongly compelled to share this article with my readers because it presents a coherent, cogent argument that not only supports the case for deflation but, if true, puts the broader economic picture into sharper focus.

Dr. Hunt essentially argues that:

1. We are entering a period of deflation. Debt deflation to be exact. Other historical instances of debt deflation include (a) the U.S. during the 1870s-1880s, (b) the global Great Depression of the 1930s, and (c) Japan, beginning in 1988 and continuing until the present.

2. What pulled the U.S. out of its debt deflation during the Great Depression was its participation in World War II and not President Roosevelt's New Deal program. Furthermore, the Japanese have also run stimulus programs funded by large deficits over the past two decades which have led to minor, cyclical growth but which have been unable to shake off the stronger, overall deflationary trend.

3. Debt deflation lasts a long time. The deflationary period beginning after 1873 in the U.S. lasted approximately 20 years. The Japanese debt deflation that begin in 1988 is ongoing until today. As a side note, her argument is corroborated by a report from Friday which states that Japan experienced record year-over-year deflation of 2.2% in July. Click here to read a report on this development from Bloomberg. Hunt comments that in her view it is quite possible that we're entering a 15-year deflationary period right now.

4. The markets are very susceptible to what she calls "false dawns." I'll let her explain it:

Well, one of the things that has happened in these debt deflations is you get a number of false dawns. People believe that the normal business cycle is going to take control and you're going to get a cyclical recovery and the model that soon prevails is that you get three to 10 years of expansion. You have one year, maybe a year and a half of a recession or nasty economic conditions, but after a year and a half at most, the economy then has another expansion for 3 to 10 years.

When we have these very rare debt bubbles occurring at these long irregular intervals, the normal business cycle model doesn't really apply. We do get some false dawns. Some intermittent cyclical recoveries but the unwinding of the debt process proves to be very very long and difficult. One of the reasons for that is that borrowers don't know anything about paying back loans in harder times, which is what's now beginning to occur and as a consequence there is a major behavioural shift or there has been historically in which consumers decide to live inside of their means as opposed to living outside of their means and normally the saving rate goes up for a long time.

Keep in mind that this was published on January 30th of this year, when the Dow Jones Industrial Average closed at 8,000.86 points. Today (August 30th, 2009) the DJIA closed at 9544.20 points[1]. This backs up the argument I and others have made that the current rally is unsustainable. Nouriel Roubini refers to it as a "dead cat bounce" while Dr. Hunt refers to it as a "false dawn," but the premise is the same.

5. The government stimulus program is not working and actually may be making things worse. She states:

The most recent academic research that I have seen, published in 2008, indicates that the multiplier on government expenditure is just close to zero. If the government spends an additional dollar it has to fund that dollar either by raising taxes on the private sector or borrowing funds in the capital markets that would have gone to the private sector. Government spending, the government sector in the US, the productivity is at best zero and perhaps slightly negative, so when we enlarge the government sector and shrink the private sector we reduce the growth, potentiality, of the US economy. We shrink the pie and we make things worse off.

She thinks the TARP program could have gone another, alternative way:

The alternative, which the Japanese would have done and the better way to go, is to use the treasury borrowing capacity to protect the depositors and the customers of the banks and the insurance companies and perhaps extend unemployment benefits for their employees that are laid off. Zombie-like institutions intact with wholesale federal dollars, borrowed federal dollars – those institutions are really not able to grow or contribute to the economy. If instead we had protected the savers and the depositors, then institutions would have failed, but the healthy banks and insurance companies would have taken over the business of the institutions that made the mistakes and then we would have a growth trajectory going forward. So it's quite possible that the actions that we've taken and cost hundred of billions dollars, hundreds of billions of dollars have actually not helped the situation and may have had severe unintended negative consequences.

6. The U.S. trade deficit is narrowing and may be eliminated in the next few years.

She also has some advice for investors, but I'll let you visit the site and read for yourself. Overall, I thought Dr. Hunt presented one of the most compelling arguments in favor of deflation. She managed to fit her take on the current crisis into a coherent historical context and made some predictions that are strongly supported by the current financial data available.

Sources:

1: http://finance.yahoo.com/q/hp?s=^DJI&a=00&b=30&c=2009&d=07&e=30&f=2009&g=d