The UK is now facing a severe economic contraction. While we chose to ignore the comments of politicians and bankers on both sides of the Atlantic, who routinely alluded to the strength of the global economy, there is no question that, economically speaking, we are now in uncharted territory. Governments have attacked the problem by borrowing and assuming liabilities at an unprecedented rate. In short, as economic dislocation causes the supply of money to contract, Governments are preparing to do all they can to expand it.
There is no doubt that economic slowdowns are naturally disinflationary and the fall in asset prices we are now witnessing carries more than a whiff of cordite. However, looking a little further ahead, it is our view that the deflation argument is not as clear cut as many would have us believe. While the future tends to be somewhat difficult to predict, we would be surprised if the past 60 years of constant inflation were to be followed by a sustained period of deflation.
It is our contention that modern western style economies cannot survive an extended period of genuine deflation. In the 1930’s most people didn’t own their own home and only the wealthy could obtain any meaningful level of credit. Today, that’s not the case and a lengthy period of outright deflation would result in far too many citizens falling into semi-permanent negative equity with soaring home repossessions. It would make the problems of the early 1990’s look very tame indeed.
Of course, governments have the ability to expand the money supply as much as they wish. The Gold Standard is long gone and they can create unlimited amounts of paper money. Furthermore, the greater government debts are then the greater the temptation to reduce their real value by de-basing the currency. Deflation is a killer for debtors because it increases the real value of liabilities. As such, whether it is the national debt or the mortgage on 26 Acacia Avenue, money supply expansion will likely be the favoured antidote. So, governments can reduce the real value of their liabilities and the occupants of Acacia Avenue have votes. We don’t have much faith in politicians at the best of times but we doubt that background is likely to produce an outbreak of either fiscal or moral rectitude.
Several years ago, current US Federal Reserve Chairman, Ben Bernanke, said “if we do fall into deflation, we can take comfort that the logic of the printing press must assert itself and sufficient injections of money will ultimately always reverse a deflation”. Well, we can’t say we weren’t warned. The market remains concerned that deflation is lurking. However, as George Soros says, the market consensus is almost always wrong, which doesn’t mean whatever he says is automatically correct but we were interested to note he was recently short selling US Treasury bonds because he believes future levels of inflation will be higher than expected.
John Newsome can be contacted on: 01423 705123 or email:john.newsome@williams-im.com
