The Looming Deflation Crisis

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The Looming Deflation Crisis

By Donald Luskin August 15, 2001

REMEMBER ALL THOSE books in the 1980s "kaizen," "kanban," "keiretsu" and all the other secrets of Japanese management that were supposed to save American industry? Well, it must have worked — and perhaps too well. American industry is back on top of the world, while Japan has been mired in a decade-long recession.

Now there's a new secret from Japan that we'd be wise to learn — even though it doesn't begin with a "k." It's "quantitative easing."

It's a tool of monetary policy that the Bank of Japan — Japan's equivalent of our Federal Reserve — is starting to use to spark its once-great economy back to life. And if Alan Greenspan doesn't start using it here in America pretty soon, our post-boom economy is going to slip into a long recession just like Japan's did after its boom busted.

Quantitative easing is fundamentally different from the easing that the Fed's been doing all year by lowering interest rates. To keep these two kinds of easing straight, let's call the Fed's type "qualitative easing."

In qualitative easing, the Fed lowers overnight interest rates until people start borrowing more money, or taking funds out of their now low-yielding bank accounts and money-market funds, and use it to buy things or make investments. This is supposed to put more money into circulation — to expand the so-called money supply.

There are two reasons the Fed might want to expand the money supply. One would be if it believed that the economy was headed for recession, and needed the stimulus of new business activity made possible by having more money around to spend or invest. Another would be if the Fed wanted to combat deflation — the opposite of inflation — a decline in the price level of goods, services and assets.

Japan has had both reasons to increase its money supply over the last recessionary, deflationary decade following the crash of its stock market and real-estate market in 1990. After a boom in the 1980s, in the 1990s Japan has busted, with continuing drops in industrial production, exports and consumer spending. And for the past two years, Japan's consumer price index has declined every single month.

Japan has fought its economic contraction and its monetary deflation in all the traditional ways, including massive government spending on useless public works that have resulted in paving just about every surface in Japan except the slopes of Mount Fuji. And they've tried good old-fashioned qualitative easing, with interest rates effectively at zero for most of the past four years.

But the problem with qualitative easing is that sometimes, no matter how low you make interest rates, nobody wants to spend or to borrow. Even with interest rates at zero, when you expect more economic contraction, you'd rather have your money in the bank than in stocks. And when you expect more deflation, you'd rather keep your money in the bank than buy consumer goods that will just be cheaper next year.

That's where quantitative easing comes in. With quantitative easing, the Bank of Japan expands the money supply by, in essence, cranking up the printing press — and using freshly printed money to buy up government bonds. The BOJ has already been buying 400 billion yen in bonds each month; on Tuesday, it announced that it's throwing the printing presses into high gear and buying 600 billion yen's worth. (A dollar's worth about 122 yen.)

If you're like most people, the very thought of the government printing money raises the dreaded specter of hyperinflation — images of interwar Germany come to mind, where it took a wheelbarrow of inflated paper money to buy a loaf of bread. But after years of deflation — in which just a little money would buy a wheelbarrow of bread — a little remedial inflation is exactly what the doctor ordered. Like any treatment, it has its own risks and a little bit goes a long way. But left untreated, deflation is a deadly disease that eats away at the value of all goods, services and assets in the economy.

Wait a second — why not leave well enough alone? Wouldn't it be wonderful to be able to buy a wheelbarrow of bread with just a little money? Well, no...not if you're the guy who makes and sells the bread. Or the steel. Or the semiconductors. Or the stocks. When a spiral of falling prices gets started, everyone is a loser, because everyone has to make or sell something to earn his living. The only winners are the wealthy who are sitting on cash in the bank.

When consumers get the message that the printing presses are running, the psychology of deflation gets broken because they'll stop anticipating ever-lower prices. With the risk of higher prices in the future, consumers will start buying again.

And that's where quantitative easing comes in. If inflation means too much money chasing too few goods, then deflation is the opposite: too little money chasing too many goods. Quantitative easing restores the balance by pumping more money into the system. When consumers get the message that the printing presses are running, the psychology of deflation gets broken because they'll stop anticipating ever-lower prices. With the risk of higher prices in the future, consumers will start buying again.

Here in the U.S., the Fed has been doing nothing of the sort. Interest rates keep getting lower and lower, but the Fed has done little to actually inject fresh money into the economy. Sure, so far this year the Fed has lowered interest rates further and faster than ever before. And there's a lot of uninformed talk in the media about a supposed explosion in the growth rate of the money supply, as measured by M1, M2, MZM or M-whatever. But don't be fooled: It just isn't true. The way to tell if the Fed is actually creating money is to look at numbers the media generally ignores: the Fed's own balance sheet. That reveals that the "monetary base," the liability side of the Fed's balance sheet, is hardly growing at all. It has grown only 4.6% since year's end, after actually contracting 2.7% in 2000.

The manufacturing-led recession just keeps deepening, and unemployment just keeps creeping higher. And while we're all historically conditioned to focus on inflation and ignore deflation, the evidence of a mounting Japan-style monetary deflation is all around us if we will only have the courage to look. The CRB/Bridge index of industrial commodities is at a 15-year low. The producer price index reported last week showed a drop of 0.9% in a single month. And the U.S. dollar has been skyrocketing against most foreign currencies, prompting the chief financial officer of General Motors to petition the government last week to do something to weaken it, or threaten the international competitiveness of U.S. manufacturers.

So it's time, once again, to learn from Japan. To learn from their mistakes, and learn from their solutions.

After all, truth be told, they got the idea of quantitative easing from us! We used it right here in August 1982 when Fed Chairman Paul Volcker printed billions to buy peso-denominated bonds to bail out U.S. banks from the Mexican debt default crisis. That ended a deflation threat as severe as the one we're facing now, and — in hindsight — can be seen as the shot of the starter's pistol that set off the great bull market of the 1980s and 1990s.

It worked then, and it will work now. In Japan, and here in America.

http://www.smartmoney.com/aheadofthecurve/index.cfm?story=20010815

-- CAkidd (CAkidd_94520@yahoo.com), August 15, 2001

Answers

And there's a lot of uninformed talk in the media about a supposed explosion in the growth rate of the money supply, as measured by M1, M2, MZM or M-whatever.

Someone is miss informed here, either all the other financial gurus or this fella. M-whatever is the TOTAL amount of money, not just what the Fed cooks up -- He's only looking at the Febs numbers, which is like; looking at the lint in your navel [well, ok, not quite].
This fella is not taking the money created and lost in the stock mainia, er uh, I mean the stock market. And the money made by the banks by 'lending' aka reserve banking.

-- (perry@ofuzzy1.com), August 16, 2001.


Here's his bio:

Donald L. Luskin

Don Luskin has devoted over 20 years to the investment management profession as an investment firm chief, portfolio manager, market maker, author, columnist, and pundit. Prior to co-founding MetaMarkets.com, Don was Chief Executive of Barclays Global Mutual Funds, and Vice Chairman of Barclays Global Investors (formerly Wells Fargo Nikko Investment Advisors), one of the world's largest investment management organizations. Before joining Wells in 1987, he was Senior Vice President of Jefferies & Company, where he developed the innovative POSIT electronic communications network (ECN) and founded its Investment Technology Group division (spun off as ITGI, NASDAQ-listed with a market value in excess of $1.5 billion). Don was previously a hedge fund manager, and a market-maker, on the Chicago Board Options Exchange and the Pacific Stock Exchange. He is the author of Index Options & Futures: The Complete Guide (Wiley: 1987); and the editor of Portfolio Insurance: The Guide to Dynamic Hedging (Wiley: 1988). Don attended Yale in 1974 and dropped out after one year to pursue his career. He is a die-hard libertarian and devotes a great deal of energy to staying uninvolved in politics. Don appears weekly on CNNfn's "N.E.W. Show" and regularly on CNBC and TechTV, and he is frequently quoted in publications such as The Wall Street Journal, Barron's, The Financial Times, BusinessWeek, Smart Money, Fortune, Worth, Institutional Investor, InteractiveWeek, US News & World Report, Industry Standard, The New York Times, The Washington Post, TheStreet.com, and CBS Marketwatch. His columns appear regularly in SmartMoney.com and the Industry Standard.

-- CAkidd (CAkidd_9450@yahoo.com), August 16, 2001.


In other words, regarding his resume, he is guilty as charged of being a liar and a thief from the get go. He's not worried about the little guy, he's worried about the world of big finance.

one of the rumors going around the net in certain circles is that one of the reasons Japan's economy is in such doldrums is that many people there have adopted a frugal lifestyle as a matter of philosophical/environmental choice. Maybe what's happening is a slow contraction to a more sustainable level of enterprise. Perhaps we need some of that same contraction here, to bring us to a more sustainable way of living, especially since the alternative to a slow decline is a hard crash.

-- robert waldrop (rmwj@soonernet.com), August 16, 2001.


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