Saving the bubble…with inflation!

Those readers old enough to remember the oil shock of the early 1970’s and the resulting surge in inflation across most of the world’s economies will greet with skepticism the notion of inflation as a solution to the international economic crisis.  In reality, we are already well on our way to inflation with the injection of trillions of dollars worldwide into the banking system to prevent it from seizing up – every dollar created by central banks to cover massive financial losses on the banks’ balance sheets debases the value of the issuing currency, and that’s the road we’re on.

According to Reuters News Service, since late September the US Federal Reserve has injected over $630 billion in new liquidity into the financial system to get the banks lending again – and this is NOT the $700 billion mortgage bailout package approved by the US Congress.  Every dollar issued by a central bank that is not backed by a hard asset (like the old Bretton Woods Gold Standard, abandoned by the US in 1973) reduces the value of the currency in circulation.  Holding the currency of a country is a confidence game, and eventually the market figures out that too many US Dollars floating around means that its purchasing power is reduced, and inflation takes hold of the economy as sellers begin demanding more of these dollars in exchange for goods and services.

Why should the US welcome inflation?

So why is inflation a savior in this case?  The alternative to inflation is deflation, which is much worse in the long run for consumers and governments alike.  Deflation is defined as falling prices, the practical result of which is that consumers hold on to their dollars in anticipation that the trend will continue – there is no incentive to purchase, and that goes for hard assets as well, like housing.  As one mergers and acquisitions expert summed up deflation; “hey, if the price is lower tomorrow, then I’m not buying today!”  Ben Bernanke, Chairman of the US Federal Reserve, is an expert on the deflationary spiral of the Great Depression as well as the 1990s in Japan - the “Lost Decade.”  Japan’s own banking crisis of the late 1980s resulted in a deflationary vortex that decimated real estate values and consumer confidence in that country.  Bernanke wants to stop falling house prices as soon as possible because housing is the US consumer’s piggy bank.  For the last 10 years, US consumers have refinanced their houses to purchase cars, take vacations, pay off credit card debt and send their children to college; all this was possible because home values were rising.  If home values fall in a deflationary economy, then consumers will never be able to use the equity in their homes to finance other economic activity because the banks will not know where the pricing floor will be.  Without rising home prices, the US could face its own decade of economic stagnation.

George Jonas wrote in the National Post last weekend that there is evidence that US consumers are starting to buy houses again, benefitting from drastically lower prices in many markets.  The long-term key to wealth creation for these new buyers will be increasing home prices, which is what happened after the inflationary period of the 1970s.  Consumers dumped their dollars, which were falling in value, and purchased houses, whose values were keeping pace with or exceeding the US inflation rate.  The same was true in Canada.  The typical home today is worth 4-5 times, if not more, than what it was worth in the 1970s; just look at the old deeds of sale you received from the notary if you are a current homeowner.

Astute readers will notice that the US dollar has strengthened against the Canadian and other currencies over the past week, rather than the reverse.  This is only true in the short run, as the major European governments posted delayed reactions to their own banking crises that motivated currency traders to sell the Euro and the British Pound.  The amount of money “printed” by the European and UK central banks was proportionately far less than the US cash infusion and in the long run does less damage to the intrinsic value of those currencies.

Inflation: Managing the Beast

The US has to make sure that they do not create a hyperinflationary environment the likes of which was experienced by the German Weimar Republic between the world wars, or more recently some South American economies.  The challenge will be to allow inflation to rise to a controlled rate in the 6-7% range for a decade or so, in place of the 3% target that most first-world economies had set for themselves over the past 15 years.  Not only would this reflate real estate prices, it would also debase the value of the accumulated US federal debt, now at $10 trillion in 2008 dollars.  Ten years of US inflation at 7% would cut the “real” value of that debt in half – the debtholders would be the losers in this equation.  If the US government can bring its budget into balance over this period and stop the debt growth, the result would be that the debt would be much more manageable because government revenues would also swell along with the inflation rate.  Wage and price increases would result, but, frankly, the economy would get used to it.  There are many economists who argue that the real US inflation rate is already at least 6% once you consider the price effects of oil and food, but the US government keeps playing with the way inflation is calculated in order to hide the magnitude of the problem.

Can Canada avoid the inflation contagion?

Canada entered the current financial crisis in a much stronger position than the United States.  Our banking system is much more solidly capitalized, we had high employment ad a growing natural resource sector for which the world is our market.  Falling commodity prices are a short-term phenomenon – growth will return to India and China, and higher oil, potash and precious metal prices will result.  Indeed, the Canadian currency will face pressures to increase in value relative to the US and other currencies due to our solid economic fundamentals and the need to pay us for our natural resource products.  Canada’s inflation rate will be lower due to our stronger currency – but Canadian manufacturing will be decimated if the Bank of Canada allows the Canadian Dollar to sustain $1.10 or more for an extended period of time.  Indeed, one economist predicted that the Canadian Dollar could rise to $1.50 US over the next few years due to rising commodity prices.  While this pressure has been temporarily interrupted, long term bull market trends in commodities are still intact and the upward pressure on the Canadian Dollar is scheduled to resume.

Conclusion: Choose your poison

Inflation and deflation are both undesirable economic phenomena, each with their own potential to do long term damage to any economy.  However, given the current problems in the US, its massive federal debt and dysfunctional housing and credit markets, inflation is the preferable poison.  If managed correctly, inflation can resolve the equity crisis facing the US consumer, reflate home values and entice then to spend anew.  Given that consumer spending is responsible for two thirds of US and Canadian economic activity, we must all collectively hope that the trillions of dollars injected into world credit markets over the past several months begin to work their magic very, very soon.