Inflation or Deflation?
Dr. Hans F. SennholzMost American economists are singing "Happy days are here again." The stock market is up, business profits are rising, and commodity prices are going through the roof. They are convinced that stock prices will continue to rise, the economy will boom, and business spending and industrial employment, which presently are trailing other indicators, will soon follow suit. Government politicians and officials happily are joining the tune - after all, it's a Presidential election year.
A few economists are marching to a different drummer. They are certain that stocks are greatly overvalued and prices are bound to fall soon, and that we must brace for deflation leading to recession and even depression. They are the deflationists who envision and observe a gradual reduction in the stock of money or substantial declines in spending, which will depress the economy. They fault several economic and political forces that will cause a deflation despite the apparent present expansion and recovery of stock prices.
During the 1990s, they contend, the American economy enjoyed an unprecedented boom that generated a huge bubble of excess capacity; it is bound to deflate soon and depress economic production for years to come. Moreover, the new computer technoloy has been contributing to this excess capacity, as has an entirely new factor, the globalization of trade and commerce. Relentless competition by industrial newcomers, such as China and India, together with the new technology and the old bubble, are bound to leave their painful mark. The official guardian of progress and prosperity, the Federal Reserve System, will be unable to bail out failing banks and businesses because the deflation will affect the entire world economy and render failure systemic. Surely, the Fed will load the banks with money, but they will prefer to invest their funds in U.S. Treasuries rather than lend them to failing businesses. The stock market, according to the deflationists, will be the key and gauge of the deflation and depression to come.
Deflationists do not tire likening present economic and financial conditions to those of the 1920s that led to the Great Depression of the 1930s. They may point to a precarious real estate market based on exaggerated real estate prices; it crashed in 1931 and 1932 and spread its gloom throughout the economy. Or they may frighten their readers with horror tales about the stock market crash of October 24, 1929, which signaled the beginning of a new era. The stock market rallied thereafter, just as it has after the 2002 decline. Early in 1930, most investors believed that they were on the way of recovery and turned bullish again, as they have now. Actually, the worst was yet to come, as it is now.
Deflationists also seek to prove their case pointing to the decade-long recession in Japan. During the 1980s the Japanese economy was the envy of the world, reporting expansion rates that exceeded all others. Actually, it was blowing bubbles that were bound to burst. When they began to deflate in 1990, the Japanese government chose to fight the needed readjustment. Yet, no matter what the authorities would attempt and undertake, deflation and recession have kept the people in their grip ever since.
This writer readily concurs with the deflationists' analysis of economic bubbles. In contrast to mainstream economists, they correctly perceive the gross overvaluation of corporate stock, the economic maladjustments which they call "excess capacity," and the market pressures of readjustment. They observe the changes in technology and international competition but draw conclusions that differ radically from those of this writer. They plan the future by the past, by the Great Depression and the Japanese receession. This writer braces for more inflation and stringent government controls to come. In his judgment, the future will be different from the past.
In just two years the U.S. dollar has fallen some 30 percent of its value in money markets of the world. Federal Reserve inflation, credit expansion, and government deficits have caused the U.S. dollar index to plunge from 120 to 85. Many foreign holders of dollars, Treasury securities, agency paper, corporate stocks and bonds, etc. have lost equivalent amounts. As U.S. authorities are determined to continue their easy-money policies, and even accelerate them as they deem fit, U.S. deficits on trade or current account are bound to grow; ever more dollars will flow to the rest of the world and swell the debt.
If it were not for Asian central banks, mainly in Japan and China, which are absorbing the rapid outflow of dollars and investing them in U.S. Treasury securities, the U.S. dollar would plunge even deeper. But how long can they keep up their valiant support sending their goods in exchange for American paper? Sooner or later, they may tire boosting American levels of living at their own expense. Or, they may decide to retaliate for new trade restrictions which all Democratic contenders for the U.S. Presidency so ardently advocate and President Bush may finally impose; they may cease to support the dollar, or even dump it. The dollar would fall precipitously, interest rates would soar, and financial markets would crash. It would present the Fed with two possibilities of courses of action. The Fed could choose to continue its policies, even accelerate its accommodations, increase its open-market purchases, and lower its one-percent discount rate even further. Or it could step aside and allow the economy to readjust to the calls of the market. No matter what it should choose, allowing interest to rise to market levels or embarking upon super expansion, the American people would be dazed and stunned by the sudden upheaval. Many would be frightened and prompted to forsake their easy-spending ways, even to reduce their debts, and increase their savings. They would reinforce the very forces of deflation foreseen by the deflationists.
No matter how the American people would react, the inflation forces would reign supreme in international money markets and beseige the dollar. They soon would follow it to American shores and overwhelm the deflationary tendencies in the end. Rising prices of essential foreign energy and many imported consumers goods as well as newly protected domestic products would determine the outcome. However, if the Federal Government should decide to follow the pattern of the Hoover and Roosevelt New Deals or the Japanese deal of the 1990s, it would constrain and retard economic activity and give rise to an admixture of inflation and stagnation, commonly called "stagflation."
Most American economists misjudge the very causes of the Great Depression, which may mislead them in their analysis of the present situation. Many fault the Federal Reserve for not expanding its credits in the fall of 1931 and the winter of 1932. Others lay the blame for the Depression on the credit bubble of the 1920s and the 1929 crash which finally burst it. Actually, the credit expansion merely called for a year or two of readjustment with some redirection of capital and labor, similar to the 12-month recession of 1920-1921. It did not give rise to the Great Depression, which was the tragic handiwork of the Hoover-Roosevelt New Deals. In June 1930 the Republican Congress passed the Smoot-Hawley Tariff Act which practically closed U.S. borders to foreign goods and led to foreign borders being closed to American goods. Rapidly growing trade restrictions, including tariffs, quotas, foreign trade controls, and other devices, soon generated a world-wide depression. Moreover, in the dark hours of 1932, the Hoover administration struck another blow - it doubled the income tax. The Revenue Act ordered the sharpest increase in American history. When state and local governments faced shrinking tax collections, they, too, joined the Hoover team and imposed new levies and raised the rates of old.
Marching in President Hoover's footsteps, President Roosevelt's exactions and demands on business were unrelenting. Revenue legislators in 1933, 1934, and 1935 again raised tax rates on higher incomes. Estate taxes were raised to the highest levels in the world. The Farm Relief and Inflation Act of 1933 sought to raise farm income by reducing output. Crops were burned in the fields, livestock destroyed, and the expenses were covered by a new "processing tax." In 1935, Congress passed the Wagner Act, taking labor out of the courts of law and lodging it in a newly created federal agency, the National Labor Relations Board. Soon, labor unions engaged in numerous boycotts, strikes, seizures of plants, and outright violence which depressed business even further. With unemployment above the 10 million mark, the American economy just would not rise from the depths of depression into which it was cast by the Hoover and Roosevelt Deals.
Japanese governments during the 1990s were marching in the footsteps of the American New Deals. When Japanese financial markets began to break after many years of unrestrained credit expansion, the government decided to support and sustain high-cost unprofitable banks and businesses. It ran budget deficits amounting to one-fourth to one-half of its annual budgets which, in time, boosted the national debt to more than one and a half year's gross domestic production. The Bank of Japan even lowered its rates below the yen inflation rate, offering its credits without cost. In short, the Japanese government labored strenuously to prevent a needed readjustment to true market conditions; it succeeded in protecting the maladjustments and prolonging the recession.
Deflationists observing booms and depressions correctly recognize and analyze the harmful policies of national treasuries and central banks. They perceive the cyclical instability of a hampered market order but blithely overlook and ignore all other forms of government intervention that impede, thwart, shackle, and curb economic activity and lead to deep depressions. And they pass over the peerless position of the U.S. dollar as the world's primary reserve currency, which allows the Federal Reserve System to inundate the world with U.S. dollars - until the principal creditors, China and Japan, call a halt to the delusion. At that time, the U.S. government may contrive a Bush or Kerry Deal, similar to the Hoover-Roosevelt Deals. We are bracing for fervent controls and dreary stagflation to come.
Dr Hans F. Sennholz
3 March 2004
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