Quite a lot has been written about it already and this debate will surely dominate the economic agenda in the years ahead. Lately we have been criticized over this exact issue as well as we have been talking about the risk of deflation for more than 10 months now. Until last week, especially in the UK, we were being questioned that despite our negative outlook pure deflation had not yet crystallised compared to three or four Eurozone countries and the US. A major explanation for this is that the UK could ease the deflationary pressures over the last six to eight months due to a devaluation of its currency.
However if we take a look at the pace of inflation dropping from nearly 5% a year ago to 0% in February this would fit well into the definition of the Australian School of Economics as deflation as well. Figure 1 illustrates the deflationary pressures in the UK very well. How much more do you need? In the meantime from the month of March onwards the UK has joined the other countries as well. The Retail Price Index (RPI) showed a contraction by -0.4%.
Bear in mind, deflation is a slow process comparable to the interest rate policy of a central bank. When for example the Fed would hike or cut interest rates, the effects of this move will only show up in the economy the earliest nine months down the line if not longer. The same argument goes for a deflationary process, and having a look at the chart this process still went pretty fast if you are asking us.
Figure 1 UK Retail Price Index
© Bloomberg L.P. Used with permission. Visit www.bloomberg.com
Going forward the debate will be whether the substantial quantitative easing and build up of public debt by governments all over the world will have inflationary consequences. Sooner or later that may well be the case. This is also the ultimate objective of central banks, to inject inflation into their respective economies by quantitative easing.
But if we have a look at what happened in history or go back to our elementary textbooks of economics we get indications that inflation will be more something for later on. The latter will be a topic we will discuss in one of our next newsletters as there is a lot to be said about the over/under shooting of central banks’ monetary policy.
Let us assume for a moment that inflation would start rising again during the ongoing recession or let’s even for a while join the camp of the optimists and assume we are in the early phase of an economic recovery. If so this would automatically hamper the economic expansion and push the economy back into recession. The reason for that is unemployment and manufacturing capacity utilisation. Both have been dropping to historic lows, which is a logic phenomenon in severe recessions. (Figure 2)
Figure 2: US Manufacturing Capacity Utilisation on a monthly basis
Source: Federal Reserve, March 2009
Let us further assume that inflation would start to rise from this point onwards. Given the high level of unemployment, wages would be lagging inflation substantially. As a consequence real household income would decline and further depress consumer spending. This is the ultimate feature of deflation.
Also basic economics support this intuitive thinking. The mechanics of excess labour and production can be explained by looking at the Aggregate Supply and Demand Curve. (Figure 3)
Figure 3 Aggregate Supply and Demand Curve in periods of over capacity
GDP in Trillions
Source: Van R. Hoisington and Lacy H. Hunt
Inflation will not commence until the Aggregate Demand (AD) Curve shifts outward sufficiently to reach the part of the Aggregate Supply (AS) curve that is upward sloping. The AS curve is perfectly elastic or horizontal when substantial excess capacity occurs. Excess capacity puts pressure on companies to lay off staff, cut wages and other costs. Since wage and benefit costs are approximately about 70% of the cost of production, the AS curve will shift outward, meaning that prices will be lower at every level of AD. Therefore, multiple outward shifts in the Aggregate Demand curve will be required before the economy encounters an upward sloping Aggregate Supply Curve and as a consequence creating higher price levels. And this can only take place when household incomes start to rise again. In our opinion such a process will take a lot of time. If we look at what happened to Japan, they had a similar problem which turned into ... The Lost Decade.
Then there is the mainstream argument that the monetary efforts by central banks in general and the Federal Reserve more in particular will raise the risk of inflation considerably. One cannot deny that for example the Fed is expanding its balance sheet to unseen levels in an attempt to push the money supply M2 back up to acceptable levels. Unfortunately until now these efforts did not have any effect on new lending efforts by banks or economic growth.
The problem with this is that M2 is influenced by a number of factors which lay outside the power of a central bank. For instance the public's preference for checking accounts versus their preference for holding currency or time and saving deposits and the bank's needs for excess reserves have an impact on M2. This is also known as the multiplier of money and a central bank has hardly any grip on these parameters.
Having a closer look at the data from the Fed, the total money reserve increased by approximately $ 736 bln. However the excess of reserves went up almost as much, which is $ 722 bln. This caused a significant drop of the money multiplier. (Figure 4)
As a consequence only $ 14 bln of the increase in money reserves was available for lending. This in turn explains in part the significant drop in bank lending over the last two quarters.
Figure 4 M2 Money Multiplicator and Excess Reserves
Source: Federal Reserve Bank
The point we are trying to make here is that sometimes it is naive to assume that considerable expansion of reserves by a central bank (in our example the Fed) is inflationary.
Economic activity can not move forward unless credit expansion follows reserves expansion. This is not happening. Too much and poorly financed debt has rendered monetary policy ineffective.
The Fed did succeed until now in moving up the absolute amount of M2. They had to as M2 was created by the official and shadow banking system over the past couple of years. The latter though is in the midst of a deleveraging process and as a result the Fed has to take over this role.
But only printing of money will not be enough to generate new economic growth. Economic growth represented by GDP can be formulated as follow:
GDP = M2 * V ( )
A central bank will only manage to generate extra growth by increasing the amount of money in case that V remains stable. However if we look at the behaviour of V in times of recessions we see a substantial drop in frequency. (Figure 5) The reason for that is that V is determined by the amount of leverage the banking sector is able to use. This in turn is influenced by financial innovation. We know by now that financial innovation is put back in to the refrigerator and will not come out of it for the next couple of years.
Figure 5 Velocity of Money 1900-2008
Source: Federal Reserve
If we assume that the Shadow Banking system will have more deleveraging ahead, we can conclude that V has further to drop. As a result this can only mean one thing, in order to support economic growth (and this is an explicit mandate for the Federal Reserve) the quantitative easing will not be limited towards the $ 300 bln that was announced last month. Similar like the TARP I, II (and perhaps III and IV) we will see QE I and QE II, III in the next quarters ahead.
All this because a central bank can not control the velocity of money. This also means that the balance sheet expansion, which stands at astronomical levels already, has further to go.
There is also a paradoxical thought in this. We all agree the lessons to be learned from the ongoing Great Credit Crisis are the lack of regulation or de-regulation that took place at the end of the latest boom cycle. Policy makers are eager to increase regulation again for the banking industry and preferably also hedge funds. This with the goal to tame the unnecessary or imprudent use of financial innovation.
However if history is right this entails a paradoxical twist to conventional wisdom. Regulation should be the tightest when leverage is increasing rapidly, but lax in the face of deleveraging.
A similar argument can be made about tax policies. During times of prosperity and flourishing economic growth it is more rational to increase taxes. In times of economic downturns or recessions it is more advisable to lower taxes in order to support disposable income.
Taxes in general always have an effect on price development. In our case when we talk about taxes we refer to income taxes. A sales tax or VAT has an upward price effect. A rising income tax however will have a decreasing effect on prices as consumer demand is cut.
Corporate taxes however are a different story but give the same end result. They allow interest rates to be deductable and as a consequence stimulate debt-financing. In the current environment of de-leveraging it would be more appropriate to promote corporate tax cuts to digest the excesses which have been built up over the last decade.
The problem in the current crisis is a massive / structural build up of public deficits among governments around the world. Politicians are usually tempted to increase taxes to get their household finances back under control. Unfortunately these are the wrong tools to get us out of the crisis. In one of our earlier newsletters we already referred to the crucial policy mistakes made during the Great Depression of the 1930s by President Hoover which made the crisis only worse.
What did we see from the UK Government this week when they presented their budget plans for the current and next fiscal year? They announced a revision of their tax system and increased the income tax from 40 % to 50 % and a 10% rise on national insurance for salaries above £ 100,000.
The consequences of this move will be catastrophic for the UK economy. Socialists will argue this will only affect the 5% rich of the population as only the happy few earn £100,000 + salaries. The problem with this initiative however is that this is a hidden agenda to punish the bankers for the turmoil we are in.
Unfortunately one of the side effects of increasing income taxes to astronomical levels, and the UK tax revision can certainly be categorized as one ( salaries above £ 100,000 will have a tax rate of 60%), is tax avoidance. This group that is targeted is highly mobile and will re-locate to other more tax friendly regions. The only result by imposing such tax will be playing in the cards of the likes of The Caymans, Switzerlands and Lichtensteins.
Despite the unpleasant humid climate, the United Arab Emirates, which are also suffering from a burst real estate bubble, are still very eager to build out Dubai as the fourth financial centre in the world as a hub between Europe and the Asian markets. Initiatives from the Brown Administration will only contribute to a further brain drain from the UK to that country.
This is certainly not the way forward to restore the banking / financial services industry, which in the UK represents 20%+ of GDP. Compared to the US, where that number is only 6 to 8 %, this is a number to be reckoned with.
A more sensible and solid way to stimulate consumer spending would be the introduction of a flat tax system. In this case all household incomes (with an exemption of households of e.g. four would not pay taxes until their annual income would rise above $ tbd) would be taxed by a single marginal tax rate of for example 19 %.
A first advantage would be that it simplifies the tax system. Instead of needing a tax advisor helping you through all the exceptions and filling in hundreds of forms, the tax form would be reduced to a simple post card size form, with on the left hand side the labour income and the right hand side business and or capital income.
Secondly it would avoid double taxation of savings. Registration rights, dividends etc. would be cancelled.
The biggest advantage would be the substantial impact on consumer behaviour and economic growth. Economists from the Heritage Foundation’s Centre for Data Analysis, Dale Jorgenson from Harvard, and think tank The Hoover Institute did research on the subject of growth contribution of a Flat Tax system.
Adopting e.g. a 17 % flat tax system would lead to significant improvement of economic activity in the first 10 years:
• 3.8 million new jobs would be created
• $ 550 billion extra GDP (current US GDP is approximately 13,000 billion)
• Increase in personal savings by 50 %
• Nations capital stock would rise by $ 1.3 trillion
All these factors are desperate elements every economy is looking for. A large part of the 5 million jobs that were lost during the current crisis would be recovered. GDP would rise by roughly 4 %. The savings ratio would be considerably boosted for a nation which is currently buried under debt. A small part of the capital destruction would be restored.
Critics argue this is an unfair system because it would further punish the middle class which is carrying the majority of the burden. The question is whether the critics have already wondered how unfair the current system is. Their calculations invariably take the adjusted gross incomes reported by taxpayers as if they were their true incomes. They fail to come to grips with the shocking fact that over half of all business income never shows up in anyone’s adjusted gross income.
Because the critics are unaware of the additional revenue available from effectively taxing business income at a rate of let’s say 17- 19 percent, they examine flat- rate plans that extract excessive revenue from working people and find that those plans put a heavy burden on middle income wage and salary earners. They do not consider the option of raising a suitable amount of revenue from business income; instead, they propose to continue the current practice of generating almost all revenue by taxing wages and salaries. By letting business income continue to go virtually untaxed, they perpetuate the unfairness of the current tax system.
Bottom line, apart from the potential loss of talent, in times of deflationary pressure it is ludicrous to hamper consumer spending and reduce disposable income by increasing taxes. The UK and possibly the US (as President Obama has similar thoughts on this in order to balance their budget deficits again) will pay a very expensive price for this down the road.
