The Bush Legacy: Deflation or Inflation?

This article appeared in Globe Asia on September 24, 2008

Since 2001, the Bush administration has entangledthe United States in a war that is undefined in terms of itsscope, scale and duration. It has also been interventionistin the domestic economy, overseeing what the U.S.Congressional Budget Office terms a “substantial increase inspending” which has put the economy “on an unsustainable path.“Indeed, according to the CBO’s baseline budget projections issuedin September 2008, the federal debt held by the public will grow to$7.9 trillion (in 2008 dollars) over the next decade, a 46% increaseover this year’s $5.4 trillion estimate. And that’s only the tip of whatcould be a huge debt iceberg. The trustees of the Social SecuritySystem estimate that the present value of the system’s unfundedliabilities is $13.6 trillion. A similar present value calculation bythe trustees of the Medicare System results in a whopping $85.6trillion estimate. To put these numbers into perspective, keep inmind that last year the United States generated a GDP of $13.8trillion.

The Bush administration's most recent economic intervention--the nationalization of Fannie Mae and Freddie Mac,two giant government-sponsored mortgage finance companies--could cost U.S. taxpayers hundreds of billions of dollars. Fannieand Freddie were not really private nor purely public--perhaps theworst type of hybrids imaginable. Indeed, both followed a classicpublic-private partnership (socialist) business model--one thatprivatizes profits and socializes losses. This was a train wreckwaiting to happen. Not surprisingly, the Cato Institute's EconomicFreedom of the World, 2008 Annual Report records a significantfall in the economic freedom index for the U.S.

Given these developments and the squeeze that the creditcrunch has put on the U.S. economy, some people have beenshocked that the U.S. dollar has staged a spectacular rally againstthe euro. But in the world of exchange rates, it takes two to tango.Expectations about Europe's economic prospects have turnednegative. Super-negative European expectations, relative to thosein the U.S., have pushed the dollar up by over 14% from July 15to September 11, 2008. And not surprisingly, commodity prices(measured by the Commodity Research Bureau's Spot Index)have tumbled by 9% over the same period. But consumer price and producer price indexes remainedat elevated levels, registering year-overyearincreases in August of 5.4% and9.6%, respectively.

Now the U.S. is on a razor's edgebetween deflation and inflation. Thisrequires one to think through how eachof these scenarios might unfold.

The prospect of a debt deflationbegins when a central bank pushesinterest rates below where the marketwould have set them. This is exactlywhat the Federal Reserve did. In July2003, the Fed funds interest rate targetwas pushed to a record low of 1%, whereit stayed for a year. This set off a creditboom which fueled a massive increasein leverage. Over the past year, we havewitnessed financial stress, a stampedeto deleverage and an economic slowdown.

These events could be the precursorsof a classic debt deflation. It would takethe following course:

  • Debt liquidation would lead to distress selling.
  • As loans are paid off, a contraction in demand deposits would ensue.
  • This would slow down the velocity of money circulation.
  • This would cause a fall in the general level of prices.
  • This would lead to a further fall in the net worth of businesses and an increase in bankruptcies.
  • A fall in profits, often resulting in losses, would also occur.
  • This would lead to a reduction in output, trade and employment.
  • These losses, bankruptcies, and unemployment would generate pessimism and a loss in confidence.
  • These waves of pessimism would result in more hoarding and further reductions in the velocity of money circulation.
  • The debt deflation process would eventually run its course, but only after asset prices have hit bargain basement levels.

Economists of the Austrian school of economics term thistype of debt deflation a "secondary deflation". If the forces of asecondary deflation are strong enough, a central bank's liquidityinjections are rendered ineffective by what amounts to privatesector sterilization. When people expect prices to fall, theirdemand for cash increases and soaks up central bank liquidityinjections. This phenomenon characterized Japan's economyduring most of the 1990s.

But what if the Federal reserve--fearing a secondary deflation,as they feared (incorrectly) a mild deflation in late 2002--pushed the Fed funds rate lower (now it's 2%)and turned on the inflation switchby monetizing more debt? Given thegrowing mountain of government debt,there is virtually an unlimited potential.It's a scenario worth thinking about.

To appreciate how the processwould work in the extreme, considerwhat's happening in Zimbabwe, the firstcountry to realize a hyperinflation (aninflation rate of 50% or more per month)in the 21st century. The government ofZimbabwe issues debt and the ReserveBank of Zimbabwe monetizes it byprinting Zimbabwe dollars. Whilethe RBZ produces a lot of currency,statistics on the quantity of currency incirculation and the inflation rate are inshort supply. The most recent officialdata for currency in circulation were forJanuary 2008, and inflation data werelast released for June 2008. To remedythat shortcoming, I have developed ahyperinflation index for Zimbabwe.As indicated in the accompanyingtable, the monthly inflation rate onSeptember 5, 2008 was 9,914%. That'sa whopping annual inflation rate of 36billion percent.

Figure One
Zimbabwe: The HankeHyperinflation Index

Zimbabwe: The Hanke Hyperinflation Index

To effectively trade currencies,commodities, or for that matter, anyassets, traders must build alternativescenarios--like those for deflation orinflation. To give the scenarios life, probabilities must be attachedto each of them. The resulting array can then be used to inform, inpart, one's trading activities.

Fortunately, three books are hot off the presses that willgreatly assist all traders who wish to engage in the necessary taskof scenario building. The authors are all market-tested veteranswith first-class minds and experienced hands.

  • Brendan Brown, Bubbles in Credit and Currency: How Hot Markets Cool Down. New York & London: Palgrave Macmillan, 2008.
  • Mohamed El-Erian, When Markets Collide: Investment Strategies for the Age of Global Economic Change. New York: McGraw-Hill, 2008
  • David M. Smick, The World is Curved: Hidden Dangers to the Global Economy. New York: Portfolio/Penguin Group (U.S.A.), 2008.

Steve H. Hanke

Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute.