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Long-term deflation is possible but unlikely [ClearOnMoney]
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Long-term deflation is possible but unlikely

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Commentary

Long-term deflation is possible but unlikely

30 Nov 2009 by Jim Fickett

Niall Ferguson, the well-known economic historian, suggests the possibility of long-term deflation with high real interest rates. This seems possible but unlikely to me, as political pressure to spend, combined with rising borrowing costs, would lead to printing money. To hedge one's bets, it may be reasonable to dollar-cost-average one's way into hard asset positions.

Niall Ferguson, who holds positions at Harvard in both History and Business, wrote an interesting piece in Newsweek, entitled An Empire at Risk. His main point is that excessive debt has often played a role in the decline of great powers, and could easily do so again in the case of the US. Along the way he considers scenarios for how the rapid rise in debt could play out.

He points first to the fundamental problem, a government that is not addressing the long term growth of debt:

under the CBO's alternative (i.e., more pessimistic) fiscal scenario, the debt could hit 215 percent [of GDP] by 2039. That's right: more than double the annual output of the entire U.S. economy.

Forecasting anything that far ahead is not about predicting the future. Everything hinges on the assumptions you make about demographics, Medicare costs, and a bunch of other variables. For example, the CBO assumes an average annual real GDP growth rate of 2.3 percent over the next 30 years. The point is to show the implications of the current chronic imbalance between federal spending and federal revenue. And the implication is clear. Under no plausible scenario does the debt burden decline. Under one of two plausible scenarios it explodes by a factor of nearly five in relation to economic output.

After pointing out that high unemployment and much unused capacity in industry will work against inflation, he considers a different scenario:

So here's another scenario—which in many ways is worse than the inflation scenario. What happens is that we get a rise in the real interest rate, which is the actual interest rate minus inflation. According to a substantial amount of empirical research by economists, including Peter Orszag (now at the Office of Management and Budget), significant increases in the debt-to-GDP ratio tend to increase the real interest rate. One recent study concluded that “a 20 percentage point increase in the U.S. government-debt-to-GDP ratio should lead to a 20–120 basis points [0.2–1.2 percent] increase in real interest rates.” This can happen in one of three ways: the nominal interest rate rises and inflation stays the same; the nominal rate stays the same and inflation falls; or—the nightmare case—the nominal interest rate rises and inflation falls.

Today's Keynesians deny that this can happen. But the historical evidence is against them. There are a number of past cases (e.g., France in the 1930s) when nominal rates have risen even at a time of deflation. What's more, it seems to be happening in Japan right now. Just last week Hirohisa Fujii, Japan's new finance minister, admitted that he was “highly concerned” about the recent rise in Japanese government bond yields. In the very same week, the government admitted that Japan was back in deflation after three years of modest price increases.

It's not inconceivable that something similar could happen to the United States. Foreign investors might ask for a higher nominal return on U.S. Treasuries to compensate them for the weakening dollar. And inflation might continue to surprise us on the downside. After all, consumer price inflation is in negative territory right now.

This scenario is easily possible in the short term. Ferguson does not really analyze how the longer term might play out, but does seem to be suggesting that deflation with high real interest rates is a good possibility long-term.

This seems very unlikely to me. Most discussion around these issues centers on the Fed, and it is true that the Fed is responsible for managing the money supply. But in the current crisis, many other mechanisms have been used to increase purchasing power today and put off the cost until later. The stimulus and rescue measures implemented by Congress spend future revenues today. The conservatorship of Fannie and Freddie, together with a ramp-up in the role of the FHA, have kept mortgage availability at something not too far below normal levels. The FDIC guaranteed bank bonds to keep bank balance sheets from shrinking too rapidly. In other words, all available means have been used in a consistent push towards avoiding a shrinking of credit and money supply.

The scenario that Ferguson paints, of rising real interest rates with deflation, closes off one avenue – namely borrowing – by which one can increase spending today and put off the cost. The other avenue is inflation. If we do find ourselves in a period with deflation and high real interest rates, then, the US will be forced into either cutting off the stimulus measures and rescues, or printing money. Discipline seems a much less likely outcome than inflation to me.

In my view, in fact, the most likely scenario is that low inflation in the short- to medium-term is likely to provide a rationale for keeping an expansion of credit and money supply going on for far too long, thus providing a foundation for serious inflation.

But Niall Ferguson has an excellent perspective on both economics and history, so perhaps long-term deflation really is a possibility. How do you position yourself in this case?

The most common way to protect against inflation is to buy something real – a house or commodities, for example. If you buy such things at reasonable prices, and then go into a deflationary period, you have not lost long-term value, even if prices go down temporarily. It is true you have lost liquidity, so certainly not all your savings should be in real assets. And you have lost an opportunity, because you could have bought them cheaper. But your long-term savings are intact.

The bottom line for me is that inflation is the most likely long-term outcome. Thus buying into real assets is a reasonable strategy. To cover both the short term opportunity of a likely slowdown next year, as well as to hedge one's bets about the long-term scenario, it may be reasonable to dollar-cost-average into asset positions over the period of a year or two, allowing time to change strategy if it looks like long-term deflation is a real possibility.