Usually the best way to describe a certain system is to look at a model and see how it works on a micro level. One can compare it with model planes or cars being tested in a wind tunnel. In this case Nobel prize winner, Paul Krugman, explains the complex mechanics behind recessions and their deflationary pressures by referring to an example in history which is known as the Capitol Hill Baby-sitting Co-op.
This was a project, which started in the late 1950s, with the intention to give young families, who were living and working in Washington, a network of responsible, experienced adults to take on babysitting duties on a sit-for-sit basis. The experiment grew out to become a micro economy and would be highly representative in explaining how recessions take place and the pressure on prices it can have.
The project would work as follows:
Each member family is given a coupon – pieces of paper worth one half-hour of sitting time. That allowance is to be paid back within a year, in order to keep everyone sitting and everyone going out. A scheduling system is in place to organize sits each month, as well as a payment plan that includes time and a half for things like later hours.
In this system everything is based upon the belief that every couple goes out regularly and some others fit in to do baby-sitting. By doing so one part of the population could earn or save coupons which could be spent in turn when they decide to go out for an evening dinner.
However in the mid 1970s, the co-op experiment experienced something of a recession. There was a shortage of coupons, which led people to panic and hoard their shares. Because there was no regular circulation, the system was falling apart. When a rule requiring that couples go out at least once every six months ended up falling flat, the powers that be decided to create more coupons to alleviate the problem and encourage people to spend.
The shortage of coupons was created due to a lack of effective demand as households wanted to accumulate their cash (coupons). As is the case in a real economy the problem was located on the demand side and not on the supply side. Or in the words of the late Milton Friedman, too many people were chasing too few coupons.
In order to solve the problem the governing board of the co-op decided to put more coupons in circulation and the short term result was that couples were more willing to go out. This in turn created more opportunities to baby-sit, which in turn again stimulated young families to go out more regularly. In other words the vicious circle was broken by printing new coupons.
The latter is a text book recipe used by central banks to fight recessions; that is printing money.
In this respect one can wonder why for instance a nation like Japan could not get out of the deflationary spiral as the authorities used every tool available to break the vicious circle. They lowered short term rates to zero and kept them there for a considerable period of time. They did substantial amounts of quantitative easing. Last but not least there was public spending up to more than 170% of their GDP. None of the above was able to break the deflationary spiral.
Returning back to the micro economy of the baby-sitting co-op we can detect similarities. In order to get the system running again the governing board created the opportunity to borrow coupons and pay them back at a later stage with coupons earned from baby sitting. Of course to keep the system fair there was a penalty imposed where couples who borrowed coupons would have to pay an extra coupon back.
This gave the governing council a tool to boost demand, by changing the conditions of borrowing in times when demand was lagging. This is exactly what central banks are doing in general. However in the example of Japan interest rates were cut back to zero and nevertheless the economy did not kick back into gear.
The explanation for that: seasonal effects. Like in every economy, the baby-sitting co-op experiment experienced cyclical effects as well. Intuitively one can expect that couples were less motivated to go out during winter compared to the summer season. People would accumulate coupons for the summer when they would go out more frequently. When this seasonal phenomenon is not too strong the governing council could still make adjustments on the coupon borrowing in order that supply and demand returned to an equilibrium.
However it is perfectly possible when for example the winter would be very long and cold that even at no penalty to borrow coupons (zero interest rates) households would not be motivated to go out.
This is the situation where Japan has been in for the last 1.5 decades. Most probably due to demographic factors the Japanese population is not willing to spend anymore. An aging population is by definition more savings and less investing oriented. Furthermore an older society is more afraid for challenges of the future. This is why Japan’s economy will underperform significantly even with interest rates a zero.
This is what economists also call the liquidity trap.
The major reason Japan was/is stuck in a liquidity trap is due to the fact that the liquidity provided by the central bank was not passed on to the consumer or the industry. Banks used the extra liquidity to clean up their balance sheets. This is happening right now as well. One could argue, like Milton Friedman, that the solution to this problem would be that the central banks start lending directly to corporates and/or consumers. In theory this is possible, however central banks do not have the infrastructure to do this. Secondly this would not resolve the balance sheet problems of the banks either.
This is however the price one has to pay when a system built up excesses over many years and has to go through a deleveraging process. During this process the available credit is erased at a much faster pace than a central bank can print money. At this moment the amount of credit that is lost is approximately USD 14 tln versus USD 2 tln coming from the Fed and US government. This can be illustrated by looking at the gap between broad and narrow money (Figure 1). Broad money is reflected in M2. Narrow money is what the central bank is injecting into the system.
Figure 1 Broad versus narrow money
Source: John Mauldin OTB newsletter
Figure 1 describes the situation in the US however the picture is very similar in the Euro-zone and the UK.
As long as the gap remains very high it is unlikely that inflationary pressures will return. Even the argument that commodity prices sooner than later will automatically re-ignite inflationary pressures does not pass the test. This for the simple reason that commodity prices are inelastic. Elasticity is the degree to which a demand and supply curve reacts to a change in the underlying price of a product. In case a product is inelastic it means that it would be insensitive to price changes because the consumer has to buy it anyway even when the price would rise considerably.
Products such as oil and food are inelastic products. If prices would rise substantially people would look for alternatives to cut in their household budget. As a consequence demand for other products would fall and still create a deflationary environment.
Further taking into account that the industrial production apparatus is facing overcapacity (the aftermath of the excesses of cheap credit) and as a consequence a very weak labour market which keeps wages contained. This might be the ultimate reason why deflation is a much bigger threat than inflation right now, and for the next foreseeable future.
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