Why The Biggest Threat to the UK is still Deflation NOT Inflation

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Alessio Rastani on why most analysts are still getting it wrong

The answer from the majority of the audience was pretty much what I expected: inflation. When I told them that they were wrong, that the correct answer was actually deflation, they seemed quite surprised.

Surely all the money that is being printed will lead to inflation?? The response of the audience is  revealing because it shows a disconnect between what most people are assuming about today’s economy and the actual macro-economic picture.

Only a few weeks ago on Friday it was reported that the UK economy shrank by 0.3% in the last three months of 2016. This further supports my view, as I will explain here, that in the next three years we shall still be fighting the forces of deflation and NOT as many people think, inflation.

Inflation vs. Deflation

Let’s first examine what these terms mean: inflation and deflation.

Inflation is the rate at which the level of price for goods and services is rising and purchasing power is falling. As inflation rises, every dollar or pound will buy a smaller percentage of goods.

Deflation is a general decline in prices (as seen in Japan) generated by a reduction in the money supply or credit. Deflation can also be generated by a reduction in government or personal spending.

Incidentally, deflation is what the banks fear the most. This is because deflation can cause a vicious cycle which can cause a serious threat to economic stability. If left uncontrolled the deflationary cycle can lead to a depression. When people stop spending and instead start saving because they expect prices to get cheaper if they wait, this often causes a deflationary fall in the price of goods and services.

A Balance Sheet Recession

It does not take a genius to figure out that this particular recession is unlike any other recession the UK has suffered on record.

But few have asked why.

The influential economist Richard Koo of Nomura Research Institute has argued very powerfully that what we are currently experiencing is a balance sheet recession.

In a normal recession, you cut rates and you move on. In a balance sheet recession, it does not matter how low you cut rates ? the rates have been very low for a very long time. In this recession, you cut rates but nobody seems to care.

But why is this?

As Koo argues, the main issue that governments and economists have ignored is NOT that there is a lack of supply of money (the money is there), but the lack of demand for credit. Companies have responded to the alarming balance sheet by minimising debt.

We are faced with an economic situation where everyone (including banks) is scared of the amount of debt they have and they just want to pay that debt off. People don’t care if money is cheap and interests are low.

People want to deleverage themselves and pay off debt.

Large amount of credit is available to medium to large businesses, but they don’t want to make use of it. They don’t have great deal of need for investment and don’t want to borrow. There is a lot of saving and hence that is why interests are so low.

In fact, the UK is only half way through the great deleveraging which began in 2008.

Based on the fact that we have not yet managed to deleverage in the UK, we probably have another four to five years of the status quo, i.e. of not much growth and not much inflation ? as people continue to delever.

Given this context, it is hardly surprising that the UK economy shrank by 0.3% in the final quarter of 2016.

In a paper published in October 2016 the IMF stated that they have completely changed their thinking on the issue, and that they had underestimated the UK’s fiscal multiplier. Economists are now suggesting that the fiscal multipliers which were half (0.5) in the past 3 decades are now more than 1*. That is the biggest change, and the biggest surprise to all the economists.

Liquidity Trap

Many people have assumed that the central banks? policy of indefinite money printing (or ?quantitative easing?) will lead to inflation in the next three years. Wrong.

The big surprise of this economic crisis is that money has stopped flowing through the economy! They threw more money into the banking system and it stuck there. This is a liquidity trap.

The money was not washing around and was not doing any good. So what did the central banks do? They put more money in! The expansion of the money supply is enormous, but it is not really being demanded.

Conclusion

The problem is not that we have a supply of money. The money is there and credit lending is now reasonably loose in both the EU and US. The problem (as Richard Koo has argued) is that there is no demand to borrow the money and to spend it.

In fact, people and companies don’t want to do that ? they are trying to borrow less and minimise debt.

Debt reduction by itself is deflationary.

Debt reduction takes time, a long time, and to see growth you need patience.

When the velocity of money increases then we will see inflation. Until people want to borrow money in the UK and Europe, the UK’s problems will not be solved and we are faced with the threat of deflation.

Alessio Rastani is a full-time stock trader and founder of www.leadingtrader.com

*More than 1 means reduction of £1 spent on the economy will result in more than $/£1 loss of GDP output.