How big is the risk of global deflation?
Wolfgang Münchau asks the question in Monday’s FT, with a mind, perhaps, to settling a broader debate only recently engaged. Now that the dust has all but settled on a recessionary reality for 2008, the question is, how deep will it be?
Perma-bears, notably Nouriel Roubini, are questing back to the 1930s. And some bank analysts too have raised the possibility of a second “Great Depression”.
For Münchau though, a depression and the severe deflationary environment it would involve is unlikely.
If a debt crisis coincides with severe deflation, the value of outstanding debt rises even as debt gets repaid. While all this is happening, central banks are constrained in their ability to stimulate the economy by the zero nominal interest rate bind.
But it is important to remember that these destructive mechanisms do not kick in the minute the officially recorded rate of inflation falls a fraction below zero. The deflation we fear is a large slump in the price level and a permanent shift in price expectations. During the Great Depression, the US wholesale price index fell by 33 per cent. Such a price fall is not likely in our globalised economy.
It’s also, of course, a scenario central banks will act most strongly to avoid. Thus perhaps, the alacrity with which interest rates have been cut.
And with those cuts, of course, market hopes that the recession won’t be too bad.
But a bearish consensus is emerging slightly beyond what the market is hoping for. Notwithstanding a bear-market rally, even Teun Draaisma at Morgan Stanley sees a recession running through to 2009.
The likelihood of a such middling recession is also born out in a recent Harvard paper, by Carmen Reinhart and Kenneth Rogoff - available here. In their analysis, the US recession will certainly be worse than 1990 or 2001, but not quite, perhaps as catastrophic as 1930. As Paul Krugman of the NYT comments:
On one side, the bursting of the housing bubble is playing the role that the bursting of the dot-com bubble played in 2001. On the other, the subprime crisis is creating a credit crunch reminiscent of the crunch after the savings-and-loan crisis of the late 1980s, which led to recession in 1990.
All of this, of course, is for now, academic.
Tony Jackson writes in Monday’s FT, the current behaviour in the markets is still dominated by a “new phase of global apprehension”. Apprehension perhaps fuelled by the fact that so many variables differ from previous historical examples.
Peter Bernstein, another heavyweight market watcher, goes as far as to suggest we are in an utterly unique situation - a somewhat ahistorical macro-economic environment arisen since we broke the back of inflation in the last decade.
When you look back over history I dont think there’s anything like this… the bad news grew out of too much good news. From 1982 - going that far back - once we broke the back of inflation, the economy got stronger and stronger, inflation anxieties diminished and the world knitted itself together: central banks seemed to have everything under control. Within the system itself, over an extended period of time, we had a gradual –valid — reduction in sense of risk, and therefore you could take bigger risks.
Finally, even if the recession does prove to be shallow and short - and here’s hoping - then as Münchau points out, we may not be totally out of the woods. With 10-year T-bills currently yielding just 3.7 per cent, a much longer recession has been priced. If it’s over too quickly, those yields may spike - to 6 or 7 per cent.
The price of avoiding deflation, may be a bond market meltdown.
