The following article was reprinted with permission from the author, George Athanassakos. George Athanassakos is a professor of finance and Ben Graham Chair in Value Investing at the Richard Ivey School of Business. This article first appeared in the Globe and Mail on November 6, 2008, p. B11. The article also appeared in Globe Investor Magazine Online.
The global financial market is a confusing place these days. A battle is raging between concern about deflation in the near term and inflation in the longer term. As a wave of pessimism about capitalism sweeps around the world, investors are searching for reassurance from monetary authorities that this time they won't overreact in their bid to defeat deflation and unwittingly create a more severe problem in the future.
Here is the conundrum in the balance between deflation and inflation.
There is a lot of money to go around and high levels of liquidity. Money supply (M1) has been rising at a rate of close to 9 per cent over the past year in Canada, compared with an annual average of about 6 per cent in the past 15 years. In the United States, M1 has been rising at a 19.5-per-cent annualized rate the past three months and at 11.4 per cent over the past six months to September. And the numbers are getting higher. Central banks around the world, including emerging economies, have also embarked on an unprecedented loosening of monetary policy, with co-ordinated interest rate reductions. Moreover, large amounts of capital and liquidity have been injected in the economies around the world. Strictly speaking from a monetary perspective, this is highly inflationary.
But despite the global co-ordinated easing of monetary policy, and the massive liquidity injections into the system, banks and other investors are increasingly unwilling to lend money. The rates at which banks lend money to each other remain extremely high by historical standards and mortgage rates are rising, despite global interest rate cuts by central banks. Banks are not facing a liquidity problem as they have ample reserves. The problem is that they are unwilling to lend for fear that they will not get their money back.
Banks are hoarding cash, and so are consumers. For example, “currency in circulation” has increased sharply in recent months, according to a report from the U.S. Federal Reserve, to a level not seen since 1999, when Y2K raised consumers' fears about bank computers. In related evidence, Home Depot recently reported a double-digit increase in the sale of safes in the United States as consumers keep cash closer to home.
What happens when there is a lot of money around, but no one wants to lend (invest) it? The answer is: We have a credit crisis.
Credit is the fluid that oils the economic machine. Without credit the economy stalls and the engine of growth sputters. Even healthy companies starve when credit is tightening, as they cannot pay their suppliers and employees. If demand collapses, and goods start to pile up, prices fall. Deflation ensues. We have started to experience falling prices in many sectors of the economy, including housing, furniture, appliances, tools and hardware.
Current conditions are consistent more with an increase in deflationary rather than inflationary pressures. The spectacular de-leveraging we have witnessed over the past few months has led to a buildup of deflationary forces, and this, over a short few months, has led to the collapse of commodities and gold prices and the prices of other investments that are considered good hedges against inflation.
Major producers, like India and China, over-expanded capacity over the past 10 years and overproduced. The fear that all these products will be dumped onto world markets is reinforcing the expectation of lower prices down the road. Excess production in the face of falling demand for an array of products from building materials to laptops, chips, and flat panel TVs increases the expectation of a glut and lower prices even further.
Central banks around the world are trying to deal with deflation by flooding the system with liquidity, while at the same time guaranteeing bank loans and other investments, such as bank deposits, in an attempt to deal with the fear of default.
Currently, in the battle between inflationary forces (too much money floating around) and deflationary forces (the unwillingness to lend/invest), the deflationary forces are winning in the economies around the world as the severe credit squeeze and de-leveraging that has been taking place are working their way through the system. But inflation lurks in the background.
In my opinion, the co-ordinated actions of the central banks and governments around the world will prevent this panic and credit problems from developing into a depression with its requisite deflationary consequences. But central banks and governments tend to overact based on past experience. When the credit problems are resolved, and banks and consumers start to feel more confident, all this accumulated (hoarded cash) liquidity and money supply surge may find their way back to financial and real assets, bid their prices up and in so doing take us back to square one, and a severe inflationary situation two to three years down the road. That is why it is critical for central banks around the globe to monitor the situation carefully and not be complacent as they were in the past. The markets may already demonstrate an implied fear of complacency, as the spread between the yields on the 10 year U.S. Treasuries and three month T-bills has turned up sharply in recent months.
Inflation may be a long-run problem to the short-term credit crunch. And it may bring us back to square one.