Wednesday, August 11, 2010

Pushing on a string

From a longer article at Automatic Earth further debunking the recovery mythology and forecasting harder times to come. Deflation, liquidity traps, the implications of the death of the debt economy, all the good stuff in this one.
"Williams also points out that the actions of the FED so far are not having an inflationary effect:
"The banks are not lending. The money the Fed put into the system in terms of buying mortgage-backed securities from the banks and trying to help bank liquidity ended up back with the Fed as excess reserves. We have well over $1 trillion there; had the banks loaned that money in the normal stream of commerce, it would have added more than $10 trillion to the broad money supply, which otherwise is up around $14 trillion. That certainly would have had some inflationary impact if not in terms of actual business activity. You can't always get the economy to grow by pushing money into it. Sometimes it's like pushing on a string.

It is indeed pushing on a string. Trying to stuff more credit into a system that is already choking on it will do nothing to increase the money supply in circulation. It cannot -even possibly- be inflationary. We are already in monetary contraction, as Williams has noted, and the contraction of credit makes the situation considerably worse than it appears from traditional money supply measures. Contraction is being aggravated by a fall in the velocity of money, as people, companies and banks hang on to what cash they have.

In a deflation, real interest rates are always higher than nominal rates. The real rate is the nominal rate minus inflation, and when inflation is negative, the numbers are added rather than subtracted. Even zero in nominal terms is not low enough to make the real rate sufficiently low to reignite borrowing and lending.

This is the liquidity trap, and governments are thoroughly caught in it already.

There is no chance that the money injected by the Fed will find its way into the real economy, and no chance that it will ignite a wage/price spiral in an era of credit contraction and rising unemployment. Employees will have no pricing power at all under such circumstances, which means that wages will fall rather than rise. Prices will also fall, as the withdrawal of credit will remove price support across the board. However, even as prices fall, affordability will be getting worse, because purchasing power will be falling faster than price.

People typically understand that inflation can make things less affordable over time, but deflation can do so much more quickly and much more comprehensively. The scenario that Williams describes is one of the effects of deflation, with real prices shooting up and everything becoming  dramatically less affordable in a very short space of time.

We agree with Williams as to the prospects for the real economy in the near term:
"I expect an accelerating pace of downturn in the next couple of months. The numbers will turn sharply worse....

....By then we'll find the consensus pretty much in the camp that we're in a double-dip recession. The popular press will describe it as a double dip, but we never had a recovery. Actually, this is just a very protracted, very deep downturn that has had a pattern of falling off a cliff, bottoming out, having a little bit of bump due to stimulus and then turning down again. Sort of shaped like the path of a novice skier going down a jump for the first time. Speeding sharply down the hill, he goes up in the air and starts spinning wildly as he tries to figure out which end is up with his skis. Then he takes a pretty bad tumble. We're beginning to spin in the air."

We also agree with Williams as to the nature of the problem - credit expansion - and his observation that credit availability is decreasing:
"Most of the growth we'd seen in the last decade prior to this downturn was due to debt expansion. The debt structures have pretty much been put through the wringer and consumers are not expanding credit, generally because it's not available to them. Absent debt expansion and/or significant growth in income, no way can the consumer expand personal consumption."

Without the ability to expand consumption, there is no price support even at current levels, let alone a chance for prices to rise.  Credit expansions are based on Ponzi dynamics - the creation of multiple and mutually exclusive claims to the same pieces of underlying real wealth pie, as opposed to cutting the pie into a larger number of smaller pieces as currency inflation would do. The Ponzi nature of credit expansion is the determining factor in the ultimate fate of all bubbles."

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