Recent positive GDP numbers lay bare the extent to which the supposed recovery is based on government paper-hanging and wishful thinking and is, in the end, non-sustainable. The New Depression began in 2007 and will run through 2011 or longer depending on policy. Semantic back flips, such as calling our condition the Great Recession to avoid using the word depression, will not change this fact.
Economics has no formal definition of a depression, but they are distinct from recessions and financial panics. Recessions are business-cycle-related and triggered by shocks, disintermediation, higher interest rates or combinations of these and other factors. They are sometimes severe, but typically brief, and can result in robust growth from the bottom. Financial panics are even more brief and often unrelated to the real economy as seen in the crash of 1987.
Depressions are different. They are often long and characterized by persistent high unemployment, widespread deflation, and extended lags before former highs are achieved in stock prices and output. The U.S. experienced depressions in 1837, 1873, 1893, 1920 and 1929. Their distinguishing feature is severe asset liquidation. Money borrowed in the boom is misallocated, followed by liquidation and price declines that are the consequence of wasted investment. If this sounds familiar, it should, because it’s what we’re experiencing now.
U.S. policy in 2009 successfully masked the symptoms of a depression. But masking symptoms of a depression is not the same as preventing one. Policy has power to cause timing differences, bringing some demand forward. Policy can socialize losses, moving them from the deserving losers, the banks, to undeserving losers, the taxpayers. The Fed and Treasury have done this well. Future growth has been stolen and bankers have prospered at the expense of citizens. Alas, depressions cannot be papered over. Asset price declines and general deflation are relentless even in slow motion. And deflation is the condition most feared by central bankers.
Deflation is believed by central bankers to be dynamically unstable, feeding on itself as citizens defer consumption waiting for lower prices, leading to lower sales, more layoffs and less consumption in a downward spiral. But nothing is more important for policy than getting cause and effect right, otherwise you treat symptoms instead of solving problems. Despite correlation, empirical evidence for causality from deflation to less consumption is scant; endlessly repeating a claim is not the same as data. It is far more likely that causality runs the other way. Consumers first stop spending due to some exogenous shock; price declines are the natural consequence. Thereafter, liquidations and layoffs occur but the point is that deflation is a consequence of reduced consumption not a cause.
Treating deflation as the root of all evil also ignores its benefits. When workers cannot obtain wage increases, deflation provides an increase in living standards because the prices of goods are less. Deflation drives prices to the point where consumption begins to grow because bargains are to be had. Economists also assume deflation hurts debtors because the real cost of debt goes up. But in deflation, the real cost of debt becomes so onerous that debtors readily default and free themselves of debt while reckless creditors deservedly suffer the loss.
So, if this is a depression, where is the deflation? The producer price index and consumer price index are near zero. This is seen as a victory by the Fed and evidence of successful monetary policy. Deflation is like the dog that didn’t bark. And for that matter, where is inflation? Massive expansions in reserves, zero interest rates and quantitative easing should all point to inflation ahead.
In fact, we are experiencing massive deflation, exactly as seen in the history of depressions. And we are experiencing massive inflation exactly as monetary theory predicts. The conundrum of tame price indices is solved when we realize that we are experiencing inflation and deflation at the same time. This is not the same as price stability; it is something new and far more dangerous.
Imagine a tug-of-war between two teams of footballers. Enormous force is being exerted in opposite directions, yet little happens at first as the teams are evenly matched. Suddenly one team collapses and the rope goes in the direction of the winners, with the losers dragged along in disarray. Our price signals today resemble this tug-of-war. The natural deflation that comes with depressions is being masked by the policy inflation of the Fed. The result is no change in the price indices but enormous hidden stress. We can observe this stress elsewhere. We see deflation in the rolling collapse of residential and commercial real estate values. We see inflation in asset bubbles in stocks, gold and China. This situation cannot persist; sooner or later one side will prevail. The longer the force of inflationary policy leans against the force of generalized deflation, the more disorderly the collapse will be. This is not the stuff of soft landings.
The Fed’s hoped-for outcome is prolonged low inflation to reduce the real cost of public and private debt while rebuilding bank capital through the magic of the yield curve and waiting until when private demand restarts and allows the Fed to exit. But the consumer, drowning in debt, harried by unemployment and out-produced by China, is unable to play her part. Only sound money, lower taxes, light regulation and a heavy dose of unpleasant but unavoidable deflationary medicine will put us on the path to sustainable growth. The key point about deflation is not that it is good or bad—but that it is inevitable. If we had taken this medicine in 2008, we’d be off the bottom by now. Instead the worst is yet to come. Unlimited money printing is even more dynamically unstable and potentially harmful than deflation. Moderate inflation may be the goal of monetary policy but it is the least likely outcome. Expect either deflation or hyperinflation—or both.
James G. Rickards is a writer, lawyer and economist. He can be found on Twitter as @JamesGRickards.
