Nipponification?

To pick up on a theme, is American going to go the way of Japan? By this I don't mean xenophobic and robot-obsessed. Rather, will we see continued economic stagnation, zero interest rates, employment only held together through wasteful and purposeless government spending, and long term declines in asset values (i.e., Dow 1000, home values declining another 50-70%, etc.)?

The answer hinges on the following question: what can we do to differentiate our path from Japan's? If you go back to Bernanke's deflation speech (2002), it becomes clear that we have done nearly the exact same things that Japan did to combat their asset catastrophe. As of today, we are in the same liquidity trap that has mired Japan for a decade. To be honest, I do not know what exactly would accelerate economic growth to the point where we could reach escape velocity. We need four things simultaneously: better employment figures, confidence in the market, assets to be priced attractively, and inflation. These four cannot be had at the same time -- or at least, they cannot be engineered by the Federal Reserve to occur in simultaneity.

For now, I would be content if policy makers would just pursue job growth.

For the Record

Just for the record, I gave up on the Administration when they pursued cap-and-trade and health care reform while ignoring the unabated bloodletting of geographically pervasive layoffs.

You can pick your principles and form your own ideals in life, but you don't usually get to pick your challenges and crises.

I really and truly cannot fathom how the Administration failed to see the unemployment crisis as the biggest threat to 1) American prosperity, 2) economic and financial recovery, and 3) Democratic reelection.

More on Deflation - Daniel Gross

I like reading Daniel Gross, but he's been mailing it in for about five months now. Probably fatigue from peddling his book. But, now he's just getting sloppy.

Economists generally agree that deflation is a widespread fall in prices, as measured by the consumer price index (CPI).

That economists generally agree on anything is news to me. Deflation has many definitions. Some would argue that there are multiple species of deflation.

For example, there is the phenomenon of debt deflation -- where credit was extended far and wide without proper risk assessment. Always this leads to creditors chasing too many debtors who cannot pay. Always this chokes the supply of money from lenders to borrowers.

There is also the type of deflation referenced by Gross, whereby prices of things go down in a domestic market. Price deflation can result from innovation (things being made cheaper) or from oversupply. Price declines from innovation are different from price declines from oversupply. For example, precision machining may lead to fewer error rates in a manufacturing process, which benefits the manufacturer's bottom line by reducing the cost of production. Some of that savings is passed on to consumers. Some is gobbled up as profit, depending on the level of competition in the industry. Suppliers to the manufacturer see no net change, unless the lowered price leads to greater demand -- in which case suppliers may see a benefit to the innovation-driven price decline. Maybe jobs will be created.

Price declines from oversupply are a bad deal for the companies selling the product. For example, many areas have too many houses right now. This means homes can be bought for cheap (especially with interest rates set to prevent a worsening of the depression). It also means many sellers are taking a loss. It also means home builders have to build fewer homes than planned. This means the suppliers to the builders will take a hit. People will get laid off.

There are other forms of deflation, too, such as an insufficient level of money printing. Or the decline of derivatives creation.

My guess is that we are in a state of multiple layers of deflation. Debt deflation, price declines from oversupply, and a complete derivatives Armageddon. One could make the case that the printing presses are not running at capacity, either. I know DeLong and Krugman would agree. So would Martin Wolf.

As for price declines from innovation, this is where it gets tricky. A lot of the innovation we have seen in the past fifteen years has actually been a political and economic innovation: globalism. Really, shunting off manufacturing to Asia to take advantage of the low cost of labor. This will reverse itself to some extent as Asian populations demand a chunk of the consumer pie, which will send some portion of their colossal aggregate savings into merchants’ pockets. This increase in demand will lead to price increases for everyone. These price increases, given the tendency for things to fall to shit all at the right time, will hit us just as our debt deflation is the worst. Meaning, just when we can afford it the least.

Indeflation, or Indigestion?

Deflation is still real, thanks to European banks holding sketchy sovereign debt. The poor stock markets are getting battered as the carry trade reverses. How this works is simple: European banks borrow dollars or yen, then trade stocks with the borrowed money. Basically, the banks are playing with free money because the borrowing rates that big players enjoy are close to zero. Well, now the European banks don't trust each other's collateral so they need to be back in cash to fulfill their capital requirements and pay their bills. So, they sell their stocks, using the cash to make payroll or to buy safe US Treasurys (used for collateral for overnight borrowing). Plus, Treasurys and other US guarantees are trading for higher than book value, so banks can trade them out for a greater rate of return than they'd see in this stock market anyway.

Meanwhile the printing presses continue to work overtime. Why would they do that? Again, for a simple reason. Politicians have decided that is is more palatable to inject blood into zombie banks than to let them fail. The story is getting old, but we're not writing any new chapters. So we have simultaneous inflation and deflation. Indeflation.