Roubini: The Deadly Dirty D-Words: We Have Reached Such Bermuda Triangle of a “Liquidity Trap"

[RedEarth]

Roubini's new post...if you don't subscribe to Roubini's site, you might want to...it's free, and he's one of the few people that predicted this mess.

The Deadly Dirty D-Words: “Deflation”, “Debt Deflation” and “Defaults”. And How Central Banks Will Have to Resort to “Crazy” Policies as We Have Reached Such Bermuda Triangle of a “Liquidity Trap”

Nouriel Roubini | Nov 21, 2008
I have been warning since January 2008 that the biggest risk ahead for the US and the global economy is one of a stag-deflation, the deadly combination of an economic stagnation/recession and deflation.

Let me discuss the details of this toxic mixture of deflation, liquidity trap, debt deflation and rising household and corporate defaults:


We Are Close to Deflation and Stag-Deflation

First of all, signs of stag-deflation now are clear: we are in a severe recession and now the recent readings of both the PPI and the CPI are showing the beginning of deflation. Slack in goods markets with demand falling and supply being excessive (because of years of excessive overinvestment in new capacity in China, Asia and emerging market economies) means lower pricing power of firms and need to cut prices to sell the burgeoning inventory of unsold goods; slack in labor markets with sharp fall in employment and sharp rise in the unemployment rate means lower wage pressures and lower labor cost pressures; and slack in commodity markets – that have already fallen by 30% from their summer peaks and will fall another 20-30% in a global recession – means lower inflation and actual deflationary forces. Given a severe US and global recession deflation will soon be a reality in the US, Japan, Switzerland, UK and, down the line, even in the Eurozone and other economies.

The Risk of a Liquidity Trap

When deflation sets in central banks need to worry about it and worry about a liquidity trap. Take the example of the 2001 recession: that was a mild 8 months recession in the US and over by end of 2001. But by 2002 the US inflation rate had fallen towards 1% (effectively 0% or negative given imperfect measurement of hedonic prices) that the Fed was forced to cut the Fed Funds rate to 1% and Ben Bernanke - then a Fed Governor – was writing speeches titled “Deflation: Making Sure “It” Does Not Happen Here” meaning it would not happen in the US as Japan was already in a deflation at that time. So if a mild recession – that was not even global – led to deflation worries how severe deflation could be in a recession that even the IMF is now forecasting to be global in 2009?

When economies get close to deflation central banks aggressively cut policy rate but they are threatened by the liquidity trap that the zero bound on nominal policy rates implies. The Fed is now effectively already in a liquidity trap: the target Fed Funds rate is still 1% but expected to be cut to 0.5% in December and down to 0% by early 2009. Also, while the target rate is still 1% the effective Fed Funds rate has been trading close to 0.3% for several weeks now as the Fed has flooded money markets with massive liquidity injections; so we are effectively already close to the 0% constraint for the nominal policy rate.

Why should we worry about a liquidity trap? When policy rates are close to zero money and interest bearing short term government bonds become effectively perfectly substitutable (what is a zero interest rate bond? It is effectively like cash). Then further open market operations to increase the monetary base cannot reduce further the nominal interest rate and therefore monetary policy becomes ineffective in stimulating consumption, housing investment and capex spending by the corporate sector: you get stuck into a liquidity trap and more unorthodox monetary policy actions (to be discussed below) need to be undertaken.

...........

And indeed with global – rather than U.S. alone – deflationary forces setting in the global economy dealing with global deflation becomes much harder. The world economy has been massively imbalanced for the last decade with the U.S. being the consumer of first and last resort, spending more than its income and running ever larger current account deficits while creating a massive excess productive capacity via overinvestment; while China and other emerging markets have been the producers of first and last resort, spending less than their income and running ever larger current account surpluses. With U.S. spending (consumption, residential investment, capex spending) now faltering and structural rigidities to a rapid growth of domestic consumption demand in China and emerging market economies, a global glut of unsold goods may lead to persistent and perverse deflationary forces that may last for a longer time unless proper policy actions – mostly non-necessarily monetary – are undertaken.

Thus, dealing with this deadly combination of deflation, liquidity traps, debt deflation and defaults that I termed as global stag-deflation may be the biggest challenge that U.S. and global policy makers may have to face in 2009. It will not be easy to prevent this toxic vicious circle unless the process of recapitalizing financial institutions via temporary partial nationalization of them is accelerated and performed in a consistent and credible way; unless such actions are combined with massive fiscal stimulus to prop up aggregate demand while private demand is in free fall; unless the debt burden of insolvent households is sharply reduced via outright large debt reduction (not cosmetic and ineffective “loan modifications”); and unless even more unorthodox and radical monetary policy actions are undertaken to prevent pervasive deflation from setting in.

Thus, while the Fed may pursue radical, “crazy” and “crazier” monetary policy actions the true policy responses to the risk of deflation may lie elsewhere: when monetary policy is in a liquidity trap a properly-targeted fiscal stimulus is more appropriate and effective; cleaning up the financial system and properly recapitalize it is necessary; and debt deflation and debt overhang problems are more directly and properly resolved through debt restructuring and debt reduction than by trying to reduce the real value of such liabilities via higher inflation.

http://www.rgemonitor.com/blog/roubini/254515/the_deadly_dirty_d-words__deflation_debt_deflation_and_defaults__and_how_central_banks_will_have_to_resort_to_crazy_policies_as_we_have_reached_such_bermuda_triangle_of_a_liquidity_trap

[notadmblnd]

1. I've thought for a long time that one of the solutions is to reduce the intrest on mortgages and CC'

across the board. I know personally, it would help me. I'm current on my mortgage, but it takes more than half my income to do it. If I could get a rate reduction and make my payment substantially less, I'd have more to make up the phone gas, and electric. As It is now, I just keep juggling these bills.
This would help people stay in their homes, and the banks would still make money. Of course, they'd be making less.. and I don't see our corporate masters being allowed by congress to suffer, so it will probably never happen. But anyway I ranted, it's off my chest.

[GoesTo11]

2. If the fed rate goes to zero and sticks there, will we be able to refinance

at 3% or something? Or are we stuck with our mortgages. You make a great point that low interest would turn out to be a plus if we could take advantage of it. Anyone know how this works? What happened in Japan? I'd feel a lot better about owning an overpriced and declining house if my interest payments were declining too.

[barb162]

7. Or extend the length of mortgages another 5 or 10 years. n/t

[Hawkowl]

3. No shit sherlock.

I've been screaming about the impending liquidity trap for over a year. It is inevitable now. A liquidity trap was sprung in the 1930's and prolonged the Great Depression.

The remaining two months of the Shrub administration could cost us a decade of economic growth and stability. And no, a liquidity trap doesn't mean your debts get to be refinanced. Not unless the government insists--which we may see next year as one of those "crazy policies". Usurious interest rates will remain high on everything from credit cards to installment loans because the lenders need to extract every penny from current loans because they won't make new ones.

[barb162]

8. I'd like to see a regulation passed that credit card companies

could have a max rate of 10-15 points above the FED rate. It's ridiculous what credit card companies are charging on interest rates as the FED rate is almost zero.

[Dover]

4. Central bankers wary of deflation, euro zone mired (Reuters)

Central bankers wary of deflation, euro zone mired

LONDON (Reuters) - Euro zone demand is plunging and price pressures vanishing, business surveys showed on Friday, while central bankers weighed the bleak prospect of deflation.

The Bank of Japan left its key interest rate at just 0.3 percent and said there would be a long road to recovery.

The United States, Britain and Europe are expected to ease their rates further next month as the worst financial crisis in 80 years hastens recession across much of the globe.

BoJ Governor Masaaki Shirakawa said he was on watch for the risk of deflation as Japan lapses into recession, although he did not forecast its return.

"The global economy is expected to experience a severe adjustment for some time," he told reporters.

//snip//

St Louis Federal Reserve President James Bullard said with interest rates already low, the U.S. central bank may have to rely on "quantitative easing" to ward off deflation, recalling large BoJ liquidity injections during the 1990s to jump start the economy by flooding it with cash once rates reached zero.

cont'd

http://www.tiscali.co.uk/news/newswire.php/news/reuters/2008/11/21/topnews/central-bankers-wary-of-deflation-euro-zone-mired.html&template=/news/feeds/story-template-reuters.html

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Deflation creeps up on Japan
Fri Nov 21, 2008 5:21am EST
By Tetsushi Kajimoto - Analysis

TOKYO (Reuters) - Japan is bracing for another spell of deflation next year, but chances are price declines will be less protracted and damaging than the last, decade-long run.

Falling prices may be good for consumers, but if the declines persist they discourage spending -- why buy anything now if one can get it cheaper later? That cripples investment and triggers a vicious spiral of falling prices and economic stagnation.

For most nations deflation has been a bogey-man confined to economic textbooks, but in Japan declining consumer prices and weak growth have been a fact of life for much of the past decade.

Soaring oil and food costs helped push prices higher in the past year or so, but analysts say the retreat in commodities markets and a recession in Japan and much of the developed world mean consumer prices are set to start falling again next year.

"You can't underestimate the chance of prices falling again in Japan," said Hideo Kumano, chief economist at Dai-ichi Life Research Institute.

"It will likely happen next year, just when domestic demand will suffer more from the lagging effect of the global slowdown."..cont'd

http://www.reuters.com/article/topNews/idUSTRE4AK2RR20081121?virtualBrandChannel=10112&sp=true

[Dover]

5. The Death of Money

...The last period of significant deflation occurred during the Great Depression in the 1930's. Our monetary system had just come off the gold standard. To compare present times with the 1930's is comparing apples to oranges. Coming off the gold standard involved the dissolution of complex inter-market dynamics that throws meaningful comparisons out the window.

Purchasing Power

Loss of purchasing power is crucial in understanding today's financial crisis. Money is used as a medium of exchange to purchase other goods with. Purchasing power is literally the power that money has to purchase. The larger the quantity of goods that a unit of money can buy, the greater is its purchasing power; and the better off the consumer will be.

It is not the quantity or number of units of money that is important. What is important is the quantity of goods the unit of money can purchase. It is the quality of money (purchasing power) that is important. The greater the value of money the more goods it can buy.

The loss of purchasing power is better known as inflation. Inflation is a hidden tax that comes like a thief in the night and steals one's wealth or power to purchase. It is more lethal than any form of direct tax such as income tax. If you were taxed 96% of your income you would be up in arms. Yet, inflation has stolen the same amount of purchasing power from you over the years.

A financial crisis is occurring around the world. What caused this crisis? The answer is simple: monetary inflation of epic proportions created by excess credit and debt issuance. The tons of paper money created fueled unsustainable bubbles in real estate, stocks, bonds, and commodities - a crack up boom, which has now gone bust...>

http://www.gold-eagle.com/editorials_08/gnazzo112108.html

[Dover]

6. Are we killing off the dollar?

Moving to a new currency? If so, how much of this 'crisis' is intentional?

While the following article seems a very good and understandable explanation of Deflation and Hyperinflation, I don't agree with the proposed solution at the end, as I think we are headed
for something new/different rather than a return to an old standard. Other areas of the world
have been busy working on the creation of their own currency, and I don't think we are any different. Perhaps a currency defined by 'trading blocs' or geographical realignments...

-------

History is replete with bouts of deflation and hyperinflation. One distinction that history shows, however, is that hyperinflation ends the life of a currency - it no longer is accepted as the medium of exchange. Although deflation is wrought with pain and suffering, defaults, bankruptcies, job losses, depressions, etc.; the currency is not destroyed. The slate of debt is wiped clean and the game begins anew. Deflation prolongs the life of the currency; hyperinflation destroys the currency. The first allows the game to continue. The second ends the game.

http://www.gold-eagle.com/editorials_08/gnazzo112108.html

[barb162]

9. No; other currencies like the pound and euro are also taking beatings.

Still the dollar is in terrible shape but it's been headed that way a long time.