Although Gregor.us is ostensibly an energy blog I sometimes feel the need to tackle macro issues. Over the past few weeks I’ve been trying to focus my thoughts on our current moment, where we find that deflationary pressures are rampant but reflationary policies globally are of a historic magnitude. What follows is my attempt to take the two outcomes through, to their most obvious conclusions.
Deflationists
If you believe deflation will take hold, and no amount of monetary policy or fiscal policy globally can prevent it, then prepare for the collapse of the US financial system for the following reason: there will not be enough economic activity to support the asset base of the key banks and financial institutions. Operations of the kind that took place last week with Citigroup would occur on a weekly basis. In such an environment, even the good debtors will lose their jobs, run down savings, or walk away from their homes. The FED will respond with more printing of money to give to the banks, but this frankly becomes nationalisation and then the government will mediate the aggregate private debt by forgiving most of it: all the mortgages, credit cards and commercial loans. It will become painfully clear that no future economic activity will take place unless 90% of the previous debt is forgiven.
Bottom line: in deflation there will be no condition present that will allow Americans to increase their savings, pay down debts, and repair balance sheets. In deflation, the repair model simply will not happen. It will be a collapse. And the government will also default on its debt.
Infllationists
If you believe inflation takes hold and/or deflation never takes hold, then there is a chance that enough growth can take place while the debt is reduced by inflation that would allow Americans to keep working and devote capital to pay down debts with weaker dollars. But, even with inflation, there is only a chance that this happens. But, it’s a decent chance.
Bottom line: it’s crucial that the USD weaken substantially so that purchasing power is reduced to inhibit consumption of foreign goods, while at the same time earnings inflate via wage growth and proceeds are used to reduce debt. The sign that reflation is taking hold would be a weakening of the USD, a rise in the stock market, and a good uptick in demand for money which would initially take place on a landscape of very low interest rates.
The Surprise
Thus, we arrive at the conundrum that I don’t think the deflationists have figured out yet. They are at present busily cheering on the rally in Treasuries, as yields plummet, only happy to have their thesis (apparently) confirmed. What they have not figured out yet, and I am unclear why, is that deflation will detonate the private banking system, which will in turn detonate the US ability to rollover its own debt. The government will own the banks, but, will not have enough tax revenues to service its debt. Treasury auctions will fail, because supply will either be too large, or, the FED will be monetizing the auctions. There will simply not be enough buyers of US debt under those conditions.
The surprise is therefore counter-intuitive: US Treasury bonds will default eventually if deflation takes hold, but, if inflation takes hold US Treasury bonds will simply go into a bad bear market–they’ll be paid off but with cheaper dollars.
For the United States, a nation of debtors not savers, no truer words were ever spoken: inflate or die.
-Gregor
