Microeconomic Rather than Macroeconomic Inflation/Deflation Concerns are the Real U.S. Challenge
In October 2009, I argued-so far correctly-that hyperinflation concerns in the United States were exaggerated. Now fear of deflation is increasingly in vogue, but there’s a case that those fears are overstated too.
It’s true that the potential for deflation probably was underestimated in some quarters. Conventional wisdom said that mortgage rates would rise earlier this year after the Federal Reserve ended its mortgage‑bond purchase program. Instead they have fallen to an all-time low, reflecting a decrease in the cost of borrowing on top of the collapse of home prices. Weak energy and commodity prices have also caught some financial superstars, like energy trader Andrew Hall, off guard. 1
But over the long term, strong forces can be expected to counter deflation in the United States. Though I continue to believe that hyperinflation is not a likely outcome in the U.S. for the foreseeable future, the sheer size of the U.S. budget deficit provides a check to deflation through the regular inflationary pressure of printing money. Unlike the deflation of the Great Depression-where demand cratered worldwide-emerging economies in Asia will support the price levels of globally traded goods. Even if this has been slow to restart in some ways, today’s lower prices may just allow emerging nations to develop infrastructure and expectations of the good life faster, increasing their demand up the line.
Japanese-style deflation is also not likely to translate to the U.S. Japan borrows over 90% of its debt from domestic investors willing to accept low interest payments. 2 Since 2009, the U.S. has borrowed more from abroad than home, exposing the U.S. to the prospect of foreign investors eventually demanding higher interest rates. 3 In turn, the Federal Reserve would likely charge U.S. banks more to borrow, which banks would pass on to businesses and consumers by raising their interest rates, ultimately raising prices.
That’s not to say that all is well, but just that the dysfunction that could impede a robust recovery is not macroeconomic. In other words, right now inflationary or deflationary pressures are more of a symptom than a cause of the real challenges, and the Federal Reserve’s current monetary policy is apparently not doing anything to aggravate either one of them. Arguably, the real long-term question for the U.S. economy is the aggregate of many smaller microeconomic questions: Are American businesses making products that can beat out foreign competition both domestically and abroad, generating profits that create U.S. jobs. When the financial crisis broke, the strongest U.S. sector relative to foreign competitors was investment banking-now three of the five big independent players in that sandbox are gone, with Goldman Sachs (GS) and Morgan Stanley (GS) the lone survivors.
This means that investors who dump their assets into long-term low interest rate Treasuries to guard against deflation risk being disappointed. But the shocks that the equity markets have absorbed since 2008 also mean that positive sentiment is less likely to spill over to the share prices of “weak sisters,” companies in sectors with strong demand that are doing well because of a windfall rather than good management. If this holds true, the broader markets may find it harder to sustain the rapid upswings of the pre-2008 era, but long-term investors who are able to pick well-run companies before their demand upswing can do well.
Disclosure: The author does not hold a securities position in Goldman Sachs (GS), Moody’s (MCO), or Morgan Stanley (MS).
- “Commodities Star Absorbs Loss,” Gregory Zuckerman, Wall Street Journal, June 25, 2010, http://online.wsj.com/article/SB10001424052748704227304575327252693597316.html. [↩]
- “Japan’s Deficit May Spark Next Sovereign Debt Crisis, Kusano Global Says,” Yasuhiko Seki & Yumi Ikeda, Bloomberg.com, June 3, 2010, http://www.bloomberg.com/news/2010-06-04/new-leader-must-address-deficit-to-avert-debt-crisis-kusano-global-says.html; “How Far Can Aaa Governments Stretch Their Balance Sheets?,” Moody’s (MCO), February 2009, p. 12, http://www.docstoc.com/docs/4808646/Moodys-How-Far-Can-Aaa-Governments-Stretch-Their-Balance-Sheets-February-2009. [↩]
- See “Foreign Ownership of U.S. Debt Continues to Grow,” Veronique de Rugy, Mercatus Center, George Washington University, April 5, 2010, http://mercatus.org/publication/foreign-ownership-us-debt-continues-grow. [↩]
