Reflation – the basics
Posted by Harry Stotle on December 24, 2008
A major stock market crash reduces both the capacity (as a mechanical effect) and willingness (as a psychological effect) of consumers to spend, and the capacity and willingness of suppliers to produce. The crash, as a matter of fact, reduces the value of all assets (except cash). Therefore consumers have fewer saving to spend and suppliers get less financing to produce. Moreover, consumers, who depend on corporations for their income, also have less income to spend, and suppliers have fewer assets to use as collateral for their borrowings. The most logical cure is to restore first the capacity and willingness of consumers to spend, as this also creates not only revenues but also backlogs for suppliers who in turn can use such backlogs to obtain leverage.
Reducing interest rates is part of the treatment, but increasing the money supply in the hands of consumers is the main one. Some consider it wiser to increase public spending under the main form of new infrastructures. If these infrastructures are not productive, however, they cannot be as efficient as private spending which brings stronger social and psychological benefits. Increasing consumer spending can be achieved in many ways, such as tax reductions or subsidizing pensions.
The well-known risk of this type of cure is of course inflation when demand eventually overreaches supply. There is yet a long way to go in the present situation. The mistake would be to consider only the monetary mass and its strictly defined aggregates, which vary must less throughout a depression than the value of the assets that can be used as collaterals. An injection of additional monetary mass, as a matter of fact, can and should compensate the loss of asset value.
The global loss of asset value is reaching gigantic proportions: perhaps up to $ 200 trillion (¼ for the stock market and ½ for commodities as of today, and ¼ for real estate within the next 12 months). All were assets that could be used as collaterals and can no more. On the other hand substituting this entire loss would be madness, as prices vary much faster than demand. For instance a 10% increase in the demand for commodities can raise the price of commodities by over 50%, just in the same way than 10% of more cars in the streets create major traffic jams and vice versa. A tripling of the current plans (about $3 trillion were announced worldwide), however, would seem a strict minimum.
There is unfortunately no way I am aware of to adjust the money supply to the loss of asset value with precision. The effects (particularly the psychological ones) are certainly not linear. This means that when governments realize they need to change gear, and they now do need to, or when they realize afterwards, they should start reducing the supply again, inflation will be triggered at some point. I would thus personally consider inflation-protected securities as a wise choice for a while.
Once the depression is more or less over (this is not happening overnight), only technological innovation can sustain new growth. Technological ‘reserves’ in the pipes are not many: green techs will have to wait until the price of dirty energy is on the rise again; biotech will have to wait even longer for budget deficits to stabilize; and hopefully military spending (until now the main source of innovation) will be kept under control if we really want the planet to survive. This implies to concentrate already the new public infrastructure spending on civilian research, the most productive of all methods, while leaving a place to subsidizing pensions and other social benefits on the short term.
Dissenting voices can be heard. The ones consider the monetary mass as the Holy Grail and will simply not back reflation or not back it enough. Others believe in sheer magics, and expect the end of the recession for next year, based on a combination of Obamania and a blind belief in some anonymous ability to rebuild as fast as mankind can destroy. Beware: such voices can become very loud and could make the depression even longer.
This is how the world goes.
chicagoadam said
Harry, throughout your recent postings there is something of a refrain. Most people expect that tomorrow will mostly be like yesterday. When they invest with Maddof, they expect that tomorrow he will produce like yesterday — just as they expect from all the many investing groups they interview. For those who are evaluating massive reflation programs, the view is “get past this crisis, for if we do tomorrow we can return to the way things used to be.”
People do not like to accept that things irretrievably change. When an enormous meteor hit the Yucatan Peninsula a few millenia ago the dinosaurs would only hope that the resulting cloudiness and cold would yield – and the world would return to the climate which made them earth’s kings. So too, today, those who have run capitalism long for a return to what resulted at the end of their 200 year reign as the allocator of resources on this planet.
But things have changed. We are now awakening to the reality of instant, incredibly cheap global communications. We must awaken to the reality of massive shifts in power based upon access to global resources – including not only fossil fuels and manual labor but highly trained and well educated skilled workers (such as engineers).
While historically we know who exerted global power – we can now see that is shifting. Geologically, religiously and nationally things are shifting. Those who look to the past will be unable to compete – to thrive – perhaps even to survive in the future.
Keep up the postings good Harry.