Mish's Global Economic Trend Analysis: "Contained Depression


"Contained Depression"
Kevin Feltes, an economist for the Jerome Levy Forecasting Center, solicited my opinion on a couple of their recent articles. Levy comes down on the side of deflation, as do I. However, the devil is in the details, as always. I will go through one of their articles in a point-by-point fashion, stating where I agree and disagree with their analysis. This is a long post. Please give it some time. Please consider Widespread Fear of the Wrong Kind of Price Instability. Levy:

It is not inflation but more disinflation and ultimately deflation that lie ahead in the 2010s. Inflation worries remain a major part of the market backdrop, and the past year has brought new price stability concerns to investors. During that time, we have written about inflation fears, deflation risks, and the relationships between price trends and monetary policy, fiscal policy, Treasury debt levels, foreign debt holdings, and various other issues. We have argued that rising inflation will not be a threat in the coming years and that disinflation and some deflation are the real worries. Our position remains unchanged. 1. Why It Will Be Very Difficult for Inflation to Accelerate in the Next Few Years The dominant influence on price trends in the near future and for years to come will be the deflationary influence of chronically high unemployment. The economy not only has gone through a deep recession but also has entered a contained depression, a long period of substandard economic performance, chronic financial
http://globaleconomicanalysis.blogspot.com/2010/08/contained-depression.html (1 of 14) [8/25/2010 10:50:06 AM]

Labor cost inflation will remain subdued or even negative as long as unemployment remains high. it will end in the latter half of the 2010s at the earliest and could stretch into the 2020s In the years ahead.Mish's Global Economic Trend Analysis: "Contained Depression" problems. Labor costs are the dominant inflation influence not only because they are the single biggest component of prices. but also because labor costs are heavily affected by compensation rates. they will not have a large. oil prices. which are widely believed to be a critical inflation signal.blogspot.html (2 of 14) [8/25/2010 10:50:06 AM] . and generally high unemployment. which fuel consumer spending and are therefore tied to the ability of firms to pass on inflationary price increases to consumers. and global instability and large areas of depression (contained or otherwise) will reduce upward pressures on prices of imported commodities and are likely to cause these prices to fall much of the time. have a weaker relationship to inflation over time. By contrast. http://globaleconomicanalysis. chronic high unemployment will weigh heavily on labor costs. any unemployment rate that is substantially above such a trigger point indicates excessive competition for jobs and a tendency for pay raises to shrink—or pay cuts to become larger and more common. is by any reasonable estimate far below the present figure of nearly 10%. The trigger point. chronic economic weakness will tend to keep profit margins under pressure and firms focused on cost control. A tightening labor market—a falling unemployment rate—would at some point trigger inflationary pay increases. The contained depression is likely to last about a decade.com/2010/08/contained-depression. rise sharply at times. lasting effect on inflation as long as labor costs are decelerating or actually falling. Even if imported commodity prices. most notably oil prices. which varies from one business cycle to another depending on a variety of circumstances. Conversely. and the prospects for a real recovery in labor markets are poor. Mish Response: I like the concept of a "contained depression". although they can be an important short-term influence.

Unemployment Rate 1960 to Present CPI 1960 to Present http://globaleconomicanalysis. Being paid while not working also masks the depression.blogspot. Please note there are 14. as the official numbers mask the depth of the unemployment problem.5 million of them are receiving regular unemployment benefits and another 4. there is massive underemployment with 8. but of them 4. Thus 63% of those unemployed are receiving benefits. For comparison purposes. The following three charts will prove my point. In addition. However. 40 million people on food stamps as of August 2010. The cost of the food stamp program is on schedule to exceed $60 billion in fiscal 2010. Missing the Boat on Labor-Induced Wage-Price Spirals I disagree with Levy when it comes to the issue of wage price spirals. Free from mortgage expenses but having a place to live certainly makes life a lot easier. there was just over 11 million on food stamps in 2005.5 million working "part time for economic reasons" and another 2. countless millions have not paid their mortgage for months or even a year without being foreclosed on. Levy's statement "Labor cost inflation will remain subdued or even negative as long as unemployment remains high" is not true as evidenced by the stagflationary 70's and 80's complete with Nixon's wage-price controls that were dismantled as a failure in 1974.com/2010/08/contained-depression.7 million are receiving extended benefits.6 million "marginally attached" workers who want a job but are not considered unemployed because they have not looked for 4 weeks. Finally. This is "containment" of sorts.html (3 of 14) [8/25/2010 10:50:06 AM] . masks that depression.Mish's Global Economic Trend Analysis: "Contained Depression" We are certainly in a depression.6 million unemployed.

Interest rates falling from as high as 18% to where they are today increased the ability of consumers to take on debt.the willingness and ability of consumers to take on more debt. and wages. boomer demographics. regardless of what the Fed tries to do. and debt they did take on in the form of second http://globaleconomicanalysis. increasing the ability of households to take on debt. the CPI. The critical factor in that list is consumer psychology . My reasons include global wage arbitrage. a damper on business' ability and desire to expand. households went from one wage earner to two.com/2010/08/contained-depression.Mish's Global Economic Trend Analysis: "Contained Depression" Annualized Wage Growth 1960 to Present Clearly there is no consistent relationship between the unemployment rate. In the 70's. Nonetheless. I believe Levy is correct about labor costs. Belief that rising asset prices (especially home prices) would guarantee a nice retirement increased the willingness of consumers to take on debt. for different reasons.html (4 of 14) [8/25/2010 10:50:06 AM] .) Those forces will act as a huge damper on consumer demand for goods and services. and in turn a damper on both wages and prices.blogspot. and overcapacity in the face of secular changes in consumer psychology (the willingness and ability of consumers to take on more debt.

Inflationists simply do not understand the importance of these secular shifts in consumer attitudes and demographics. blowing briskly in his face.com/2010/08/contained-depression. Bernanke Note the huge difference in the problems of Greenspan as compared to Bernanke. Real interest rates (subtract CShttp://globaleconomicanalysis. However. Now. in the CPI.html (5 of 14) [8/25/2010 10:50:06 AM] . Home prices were relatively stable in the mid-to-late 90's as the real cost of borrowing was high. In contrast. CS-CPI vs. Greenspan had the winds of rising productivity in conjunction with an internet boom. CS-CPI. only the hollow shells of vacant commercial real estate standing as testimony to the blatantly foolish policies of the Greenspan and Bernanke Fed. Greenspan vs. blowing at his back. There is no source of jobs now. CPI-U click on chart for sharper image The above chart compares CPI-U vs. etc. Bernanke has a gale force breeze of a secular change in social attitudes towards debt in conjunction with unfavorable boomer demographics. Here is a chart from Case-Shiller CPI Now Tracking CPI-U that shows what I mean. The internet boom and the housing bubble both provided an enormous source of jobs. followed by the winds of housing and commercial real estate booms. now gone bust. Greenspan never had to act to contain "inflation" because he failed to see any even though it fueled a massive asset bubble in housing and commercial real estate. home equity lines of credit.Mish's Global Economic Trend Analysis: "Contained Depression" mortgages. Luck of the Draw Greenspan was "lucky" in the sense that the credit booms fueled asset prices as opposed to consumer prices. note what happened when Greenspan held rates low in 2002-2006.blogspot. it's payback time for a global credit boom of epic proportion. the latter formed by substituting the Case-Shiller home price index for OER (Owners' Equivalent Rent).

True. wages and prices are highly likely to be contained. With consumers deleveraging. Although real interest rates are now negative by my measure.” when increasing the money supply does not http://globaleconomicanalysis.” and so forth. and no driver for jobs or economic growth. and more demand associated with that credit creation. The Fed simply has no control where liquidity flows. Just as rising productivity and rising asset prices masked massive inflation of money supply and credit in the early 2000's. it cannot affect prices. more credit creation. and for real interest rates to be positive once again. I do expect home prices as measured by Case-Shiller to start dropping this autumn. Is it any wonder asset prices soared? This is one of many reasons why Bernanke's 2% "inflation" policy is preposterous. boomer demographics.a secular change in consumer attitudes towards credit and debt in conjunction with a secular shift in the attitudes of banks' willingness to lend. and if it does not.Mish's Global Economic Trend Analysis: "Contained Depression" CPI from the Fed Funds Rate) were as low as NEGATIVE 5% in 2004. under normal circumstances. or for that matter if there is a flow at all. Levy has the result correct (deflation) but missed the key reason why . Why Aggressive Monetary Policy Isn’t Causing and Won’t Cause Inflation The notion of an inexorable link between monetary policy and inflation is pounded into our brains by the prevailing economic wisdom: “inflation is a monetary phenomenon.html (6 of 14) [8/25/2010 10:50:06 AM] . But that’s not what happens when the economy faces what has been called the “liquidity trap.” “central banks pump money into their economies to inflate their way out of trouble.com/2010/08/contained-depression.” “inflation is too many dollars chasing too few goods. Ironically. easier money means lower interest rates. Yet creating more reserves in the system does not under all circumstances lead to additional demand. Note that real interest rates as measured by CS-CPI hit POSITIVE 6% in 2009 in the wake of the housing crash. even at a 0% Fed Funds rate! Aftermath of the Credit Bubble Bust Greenspan and Bernanke both failed to spot the massive increase in inflation in the early 2000's because liquidity flowed into assets as opposed to wages and consumer prices. Levy: 2. 2010. the reported CPI-U masked falling home prices (and high real interest rates) from 2006 on. We are now in the aftermath of the credit bubble bust. The above chart is from March 5. talk of the town was "massive inflation". Thus.blogspot.

com/2010/08/contained-depression. deflationary expectations are beginning to work their way into banks’ loan evaluation process on a micro level. Mish Response: Those four points above are perfectly expressed. It cannot create capital. so now banks remain worried about the volumes of bad debt they are carrying and how future loan losses will impinge on earnings and capital. Reserves Second Australian economist Steve Keen has made a strong case that lending comes first and reserves later in Roving Cavaliers of Credit.Mish's Global Economic Trend Analysis: "Contained Depression" induce more activity. not reserve constrained. Presently. So let's try one more time. They don't exist. excess reserves are not inducing lending for several reasons. The Fed can create reserves at will. lending precedes creation of reserves. and many households and firms are trying to reduce debt. but let’s just focus on what is happening now and what is likely to happen in the years ahead. Fourth. ● ● ● ● First of all. interest rates could not fall far enough during this business cycle to enable troubled debtors to refinance their way out of trouble.blogspot. they form the very heart of the deflation argument. Very few understand those alleged "excess reserves" are a mirage. the private sector has too much debt. I discussed that at length in Fiat World Mathematical Model. Inquiring minds are reading BIS Working Papers No 292. In spite of Bernanke's heroic efforts. in more and more areas. Second. More importantly. banks are capital constrained. loan officers are looking at households with shrinking incomes and firms with deflating revenues.html (7 of 14) [8/25/2010 10:50:06 AM] . I discussed those concepts at length in Fictional Reserve Lending And The Myth Of Excess Reserves Lending Comes First. In conjunction with secular changes in consumer attitudes. fewer still understand that reserves are not an issue at all and in reality. Third. and adding to them further will not make much difference. That point alone should seal the hash of the debate but it keeps coming up over and over. especially as more of them worry about deflation in their own incomes or revenues. There are various theoretical reasons given for the liquidity trap. Unconventional monetary policies: http://globaleconomicanalysis. banks are still capital constrained.

Ad Hoc Policy of Inflation My friend "HB" aka Pater Tenebarum discusses the Fed's misguided policy The Ad Hoc Policy of Inflation Contrary to Bullard's hypothesis that rising prices are desirable. What about the "Liquidity Trap"? My only point of contention in the above section by Levy is in regards to the alleged "liquidity trap". Note: The above link is a lengthy and complex read. The reality is falling prices are a good thing (they are only bad in the construct of a credit bubble bust where banks can't be paid back and the Fed feels obliged to steal from taxpayers to increase bank profits to make up for their losses). It is not light reading. The article addresses two fallacies Proposition #1: an expansion of bank reserves endows banks with additional resources to extend loans Proposition #2: There is something uniquely inflationary about bank reserves financing .Mish's Global Economic Trend Analysis: "Contained Depression" an appraisal..html (8 of 14) [8/25/2010 10:50:06 AM] .blogspot.. Japan attempted to fight deflation for 20 years and all they have to show for it is debt to GDP ratios of 200% and an enormous demographic problem staring them square in the face. recommended only for those with a good understanding of monetary issues. The "liquidity trap" concept is a Keynesian artifact that presumes something needs to be done about falling prices and lack of credit expansion.com/2010/08/contained-depression. What causes asset bubbles? Why inflation of monetary supply and credit of course. Note here that producers need not suffer either from a fall http://globaleconomicanalysis. Simply put. anyone who thinks those "excess reserves" are going to produce haunting inflation simply has no idea how the credit system even works. A depression is a necessary aftermath of a credit boom. we tend to think that most consumers would probably be quite happy to see falling prices..

html (9 of 14) [8/25/2010 10:50:06 AM] . If their input costs fall to the same extent as their sales prices.Mish's Global Economic Trend Analysis: "Contained Depression" in prices. Public debt growth may have accelerated to roughly $2 trillion annual rate. the idea that +2% CPI inflation is a good thing is doubly stupid. the total debt level in the economy is not. becoming negative (chart 4). The Rapid Increase In Public Debt Is Not Likely to End in Disaster Although public debt issuance is massive at present and will continue to be so. Until Bullard explains how such an 'exception to the rule' can not only exist. they will continue to be profitable. and coincided with steadily falling prices. If falling prices were bad for an industry. and it will remain depressed. total debt issuance— public plus private—is much smaller than it has been in recent years. We already mentioned in the past that this view can neither be supported theoretically nor empirically. Since Bullard does simply not say anywhere why he thinks the price level should always be rising. it is not. Thus. the computer industry would not be an engine of economic growth. Bullard's error is the widely held belief that falling prices are synonymous with economic depression. Levy: 4. http://globaleconomicanalysis. The fastest period of real economic growth in US history of the past 150 years occurred before the Fed was founded. However. private debt growth had been running at about $4 trillion annual rate in recent years but has shifted into reverse. but actually thrive. Thus. the Fed cannot control where liquidity flows or if it does at all. Also note. The housing bubble is proof enough. What is important for producer profits are relative prices. as I pointed out above.com/2010/08/contained-depression.blogspot. but net private debt issuance will likely be minimal or negative for many years as the private sector delevers. but would always be in depression. we fail to follow his argument in favor of more inflation. he seems to assume that this is self-evident. although the federal debt is rising rapidly.

blogspot. If you have not yet done so. The few that aren't are close at hand and likely. TMS2 vs.TMS1 vs. Nearly every condition one would expect to see in deflation is happening.com/2010/08/contained-depression. they are at best a symptom of rising inflation. M2 . private credit is contracting faster.Mish's Global Economic Trend Analysis: "Contained Depression" Mish Response: Levy was kind enough to produce a larger more up-to-date version of the above mentioned chart. Austrian Money Supply (AMS or M Prime) Update Money Supply Divergence . please read Are we "Trending Towards Deflation" or in It? There is plenty of information in that article about how to spot inflation and deflation by looking at symptoms of inflation and deflation. Given that "excess reserves" just sitting don't do a damn thing. right now.What does it Mean? We Are In Deflation Here and Now Rising prices do not constitute inflation.True Money Supply is barely growing we have a rock solid case for saying deflation is here and now.html (10 of 14) [8/25/2010 10:50:06 AM] . and given that TMS1 . Here it is: click on chart for sharper image Note that net credit has been in contraction for 5 quarters! In spite of huge government deficits. True Money Supply For more on TMS1 and TMS2 please see ● ● True Money Supply (TMS) vs. If all or nearly all the conditions one would expect to see in deflation are happening http://globaleconomicanalysis.

as did treasury yields. The model is predictive. we need to agree on what inflation is. Unfortunately. This will further impair bank balance sheets and any presumed recovery from this so called $150 billion "stimulus". 2008: Time To Short Treasuries? Kass: Inflation is still an issue. with credit marked-to-market. inflation remains elevated and is not reflected in the current level of interest rates. With rising unemployment will come still more foreclosures on both residential and commercial property. with credit marked-tomarket. and we are back in it now. One could not have predicted recent events (even in hindsight) simply by looking at the Levy chart. The expected fiscal and monetary stimulation in the upcoming months will only serve to exacerbate inflationary pressures. In turn.html (11 of 14) [8/25/2010 10:50:06 AM] . From a practical standpoint "mark-to-market" accounting better explains what is happening and why. even though the real economy stagnated. Deflation is a net contraction of money supply and credit.blogspot. Time to Short Treasuries? Flashback January 20. the Fed and the FASB have conspired to prevent mark-to-market accounting. The reason I use "mark-to-market" accounting of credit in my definition is twofold. One could also not have predicted what would happen to treasury yields without an understanding of what collapsing credit would do. treasury yields this low seem reasonable. It http://globaleconomicanalysis. Credit is being destroyed far faster than any monetary printing. credit expansion/contraction. In context of understanding what inflation is. Mish: Before we can have a debate about whether or not inflation is a problem. Money Supply Trends Are Deflationary. Despite the Bureau of Labor Statistics' readings. Why? The massive bailout of banks by the Fed and Congress hugely lifted the value of credit on the books of banks. Currently. The Levy chart shows 2008 to be an inflationary year and 2009 a deflationary year. 1. I suggest that those who say we are not in deflation have the wrong definition of the word.Mish's Global Economic Trend Analysis: "Contained Depression" (the scorecard is close to unanimous).com/2010/08/contained-depression. simply by looking at action in treasury yields in conjunction will all of the other indicator mentioned in the article. it is relatively easy based on market reaction. Inflation and Deflation Defined Bear in mind my definition of inflation is a net expansion of money supply and credit. However. asset prices rose. continued through 2008. was interrupted in 2009. 2. and moves in interest rates to state that deflation started in 2007. Asset prices crashed in 2008 and rose in 2009 although total credit fell in both years. Note the Levy chart for 2008 and 2009.

the deficit will tend to narrow rapidly on its own. Neither the Fed. Those variables suggest we are indeed bank in deflation after a short interlude in 2009. Virtually no one. population growth. Unfortunately. As in the late 1940s and early 1950s. nor the banks want anyone to know true marks. etc. need to look at Japan. The result will be Deflation American Style. on purpose. it is not possible to put together a chart of credit "mark-to-market". Think of the baby boomer dynamics. Note how useless the CPI and the price of oil were and still are. I love that Levy chart. http://globaleconomicanalysis. There is no bubble in treasuries if you look closely at the fundamental issues. in predicting treasury yields.com/2010/08/contained-depression. My position is that Things That "Can't" Happen are about to. including Bernake thinks deflation can happen in the US. There is no such thing.html (12 of 14) [8/25/2010 10:50:06 AM] .blogspot. and the accounting board has delayed "mark-to-market" accounting as well as rules that would require more off balance sheet transactions to be brought back onto bank balance sheets. Mish: The conditions in the 1940s and 1950s have absolutely nothing in common with the conditions now. Yields in the US are going to go far lower and stay lower longer than nearly everyone thinks.Mish's Global Economic Trend Analysis: "Contained Depression" will likely take months. before that money gets into consumer hands and perhaps a year before Congress figures out it is meaningless. Those who want to see how low treasury yields can get and stay there. Unfortunately. We now have a massive wave of boomers headed for retirement with a need to draw down savings. Levy: As revenues strengthen and social safety net spending eases. However we can easily deduce the trend by a number of variables. By the way. those savings are nonexistent for a huge chunk of retirees and hugely insufficient for nearly all the rest. the debt-to-GDP ratio is likely to fall rapidly.

I think Japan faces disaster first. We could be 5 years away or 10. They are one cycle ahead. In spite of that massive effort by Bernanke the US is in deflation. The savings rate in Japan is now under 1% while the US savings rate is soaring. accumulate massive government debt. a lack of savings in the US strengthens (not weakens) the deflation case. Headed For Disaster Levy makes another error in stating "The Rapid Increase In Public Debt Is Not Likely to End in Disaster" Assuming we stay on the same course. for nearly two decades — can run huge deficits. http://globaleconomicanalysis. Ho-hum. What cannot be paid back won't. we are indeed headed for disaster. Others will claim Japan is a nation of savers. this is not 1940. What they really mean is Japan WAS a nation of savers. However. What isn't paid back results in a collapse in credit (i. Please consider Bernanke's Deflation Preventing Scorecard and my followup post Are we "Trending Towards Deflation" or in It?. Is debt-to-GDP rising or falling in Japan? I think we all know the answer to that.e. we are Japan. and too many ways the problem can change in the meantime. the primary threat to price stability will remain deflation rather than inflation. No doubt many will chime in "the US is not Japan" citing Bernanke's massive reflationary effort. deflation).com/2010/08/contained-depression.Mish's Global Economic Trend Analysis: "Contained Depression" The Model is Japan NOT 1940 We have a model to look at and that model is Japan. Levy: 8. There are too many variables to figure out. Could the Economy Begin to Overheat When the Contained Depression Is Over. The real inflation question concerns what will happen once the contained depression ends. and still experience disinflation and deflation.html (13 of 14) [8/25/2010 10:50:06 AM] . and no. Leading to Rapidly Rising Inflation? As long as the contained depression persists. So yes. Interestingly. and our best estimate is that it will last roughly a decade.blogspot. timing the disaster and the nature of it is the problem. Japan provides a graphic example of how an economy in contained depression — in Japan’s case.

it appears that occasional spikes will be more likely than an ongoing upward wage-price spiral after many years of disinflation or deflation. unless one figures out where money supply and credit are headed. If it does. but overall I like their analysis. It is very difficult to draw correct conclusions about what is happening and more importantly what is likely to happen.html (14 of 14) [8/25/2010 10:50:06 AM] . and why.com/2010/08/contained-depression. so why should ours? Interestingly. Mish: Levy is back on track.com http://globaleconomicanalysis. The report was well presented.blogspot. Levy did go astray on some minor issues as well as one major point. accumulate massive government debt. Conclusions I commend Levy for coming to what I believe is the correct overall conclusion.Mish's Global Economic Trend Analysis: "Contained Depression" Although the future that far out holds many uncertainties. Levy hits the nail on the head with "Japan provides a graphic example of how an economy in contained depression can run huge deficits. Thanks It is not often that economists ask me for an opinion on their works. Japan's didn't. and still experience disinflation and deflation" while stating something sounding way different in the preceding section. One problem in reading the report is that at times Levy seems to confuse "price inflation" with "inflation". there is no reason to think the deficit will shrink. please consider Fiat World Mathematical Model. I appreciate this opportunity by economist Kevin Feltes to comment on the works of the Jerome Levy Forecasting Center. That Levy managed to come to what I believe is the proper overall conclusion stems from Levy's rock-solid case presented in section 2: Why Aggressive Monetary Policy Isn’t Causing and Won’t Cause Inflation. Mike "Mish" Shedlock http://globaleconomicanalysis. I too suspect the "contained depression" may last as long as a decade.blogspot. If you have not done so.