Monday, December 1, 2014

Deflation, or Something to that Effect

The Age of Uncertainty

Deflation: a fall in the general price level or a contraction of credit and available money. This is the simple definition provided by; from there it only gets more complicated.

In one form or another, from Asia, to Europe, and on to the Americas, the specter of deflation is present. Usually, in order for general price levels to fall, there also needs to be a drop in wages. Workers earn less relative to before, so they spend less relative to before, which puts downward pressures on prices. During the boom times leading up to the Great Recession, low wage growth was offset by borrowing. The borrowed money was consumed, and put upward pressure on prices, which resulted in inflation, and hence more production to capitalize on higher prices.

Now, in the age of uncertainty, driven by household deleveraging (in developed economies at least), borrowed money is not being used to offset low wage growth. Household consumption is therefore subdued, producing very little inflationary pressure on prices.

Another driver of inflationary pressures which is no longer present in the global macro environment is government spending. Again, in the boom times leading up to the Great Recession, governments around the world competed to attract multinational business by lowering tax rates, while in most cases increasing the services that they offered, with shortfalls being covered with borrowed money.

But, in the age of uncertainty, the fiscal sustainability of many governments is being questioned. In many cases fiscal consolidation, and even austerity programs are being pursued. Services are being watered down, reduced, or cut all together. The next step in the fiscal consolidation march is to start raising tax rates.

The third leg in the borrow-and-spend trifecta are corporations. Of the three, they tend to be the most logical, and in many cases realistic with spending borrowed money. In the boom times leading up to the Great Recession, corporations invested in expanding capacity and territory to capitalize on global economic growth, as well as reshuffling addresses to capitalize on competing tax regions.

Post crisis, in the age of uncertainty, corporations have been spending 10s of billions at a time. But at this point the spending is more defensive in nature. Mergers and Acquisitions have been occurring in record numbers and with record price tags. Money is being spent to combine efforts and abilities instead of in outright competition. This has the overall effect of putting upward pressures on equity prices, but not much else, and of course synergies reduce the need for as much labor.

Who Really Benefits?

With easy monetary policy being the prevailing trend around the world, the idea being to entice households in particular to borrow more and spend to stimulate growth. But, since the bursting of the dotcom bubble, households around the world had ramped up borrowing to unsustainable levels, in tune with governments. The households, governments and even some corporations that were over-leveraged have been foreclosed, bailed out, or bankrupted in that order (with a few exceptions). Since then the macro environment has had an air of debt aversion, especially among households, as they are the last to receive assistance in times of crisis. 
Governments have been an obvious benefactor of the easy monetary policy trend, as the use of their debt instruments as collateral for central bank lending has helped to keep borrowing costs low.
The search for yield resulting from the low returns on government debt has spilled over into the corporate debt market, allowing corporations to borrow at relatively lower rates as well to fund the rash of Mergers and Acquisition transactions in recent years.

Households have seen their main source of collateral; real estate, struggle to regain values lost during the Great Recession. Uncertainty in the labor markets have receded from crisis levels, but a residual uncertainty still remains as corporate employers and governments continue to consolidate in one form or another. Debt also has to be repaid with money that is worth a little more in the now low-inflation environment, than when it was borrowed during the previous higher-inflation environment.

By the time households have paid down their debt (or GDP has caught up) to levels that allow a reintroduction of an appetite for more (hopefully sustainable) borrowing, it would be time to start tightening monetary policy. Governments would have had the opportunity to refinance mountains of debt at lower rates, corporations would have had the opportunity to strategically invest for competing in a low growth environment, and household would get to borrow again at higher rates. Hopefully, and I do mean hopefully on top of higher tax rates to hasten the fiscal healing that is needed in most (if not all) developed economies. 

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