Inflation and Deflation Revisited

In December 2008 I came off the fence and plumped for deflation as inevitable. Mostly I reasoned that debasement of accounting practice, mismanagement of financial intermediaries, captured regulators that collaborated in perpetuating failure, and extremely poor market pricing of risks and fundamentals meant that there was litte incentive to save and no place safe to invest. I predicted that when the last great bubble in sovereign debt popped, deflation would work its cleansing power to restore fundamentals.

It is now clear to me that policy makers in the West are determined to apply every available resource to underpinning failure, misallocation and executive excess. As this discourages the honest saver from parting with cash, policy makers are ensuring that deflation will wreak its havoc on the financial and real economies of the world. Only when that deflation has played out and rational policies that reward market-based management and returns are restored will it be worthwhile to invest again.

Obviously, I was premature about deflation, but I am not convinced I was wrong. Events this week in Japan, and political upheavals this year elsewhere, have me thinking that we are at a turning point in many ways. When the numbness that follows such a mammoth series of tragedies wears off, the public in Japan is going to be very angry. They have suffered three great catastrophes in one week: the 8.9 earthquake, the tsunami that swiftly followed, and the failure of safety controls at six nuclear reactors. We still don’t know the scale of the final disaster, or what it will mean for the country or the world.

The Japanese state is to be congratulated that strict building codes preserved much of the physical infrastructure from the earthquake, and regular tsunami drills doubtless saved tens of thousands of lives during the tsunami. The most serious failure was in management, risk assessment and regulation of the nuclear industry. The anger will be that an industry critical to the economy, with powerful lobbyists close to government, was able to capture its regulators and erode safety standards until a crisis revealed the tragic short-termism. The anger will increase when the Japanese come to appreciate that the serial depredations of the banking industry have left them over-exposed with few fiscal policy options to meet the financial challenge of rebuilding and resettlement of refugees.

If the government and institutions of Japan are forced to liquidate and repatriate foreign assets, then fears of rising Yen and destabilisation of G7 economies are well founded. I believe it was the collective self-interest in preserving stability that motivated today’s central bank interventions. The Yen appreciated 20 percent in the three months following the Kobi earthquake, and the scale of the current disaster – particularly with the risk of nuclear contamination of some part of the country – is likely to dwarf the Kobi effect.

As radiation reaches California from Fukushima today, we might all consider that regulatory capture places us all at some degree of risk. The crisis in California sub-prime real estate was borne by the currents of international finance to the pension funds of Norway and the savings banks of Germany. Both the nuclear energy industry and the banking industry had parallel patterns of political influence leading to regulatory capture and debasement of best practice, and ultimately ruination for a suffering public. It will be interesting to see how much accountability is demanded of management and regulators in the nuclear industry in Japan, and compare this with the lack of accountabiity for serial financial failures and bailouts. After all, Japan has 20 years more experience of financial sector abuse and bailouts than the rest of us.

And the result was almost continuous deflation – even in the face of mounting deficits and quantitative easing.

Another factor that leads me to fear deflation over inflation is the popping of the great China bubble. My view is that the Chinese economy slowed markedly in Q4 2010 as monetary tightening and administrative regulation of bank lending began to bite, and that the slowing has accelerated in 2011. This view has been confirmed by Gavyn Davies on his FT blog. With another rate rise today by the PBOC, and the supply chain shock of Japan’s industrial disruption and power shortages, we could be in for a sharp, deflationary global contraction in the next few months.


Originally published at London Banker and reproduced here with permission.