Inflation-Deflation Tug of War

Amidst the conservatorship of Fannie and Freddie, the rescue of Bear Stearns AIG and the bankruptcy filing of Lehman Brothers, credit markets continue to seize up on a global scale in manifestation of the rapid tightening credit conditions, aside from mounting loss recognition and forcible “deleveraging” liquidation as part of capital raising and shrinking of balance sheets by affected financial institutions which has resulted to the current downside volatility and staggering losses in global equity markets.

Courtesy of Danske Bank

A symptom of credit shortage can be found in the chart above courtesy of Danske Bank, one of the interbank rates used for stress testing (the Euribor-Overnight Indexed Swap). Importantly, the problems are obviously manifest in US Dollar denominated money markets, which of course, has been the epicenter of today’s crisis episode. Such dearth of “US dollars” available for credit have lent to the recent spike of the US dollar’s value which deflation proponents label as funneling to the “center”, aside from of course, the repatriation of US dollars to shore up foundering balance sheets of US financial institutions.

This very fitting quote from Bloomberg, ``“There’s a complete lack of faith in the markets,” said Jim O’Neill, chief economist at Goldman Sachs Group Inc. in London. “There’s a lot of cash hoarding and people losing trust in banks, so the central banks are acting to relieve that. This might not be the last time they have to act.”

Such activities characterize deflation.

So on one hand you’ve got market forces unraveling the malinvestment from the previous credit bubble, which left leaning ideologues describe as “market failure” (which has actually been more government induced-via monetary policy and special privileges; besides capitalism includes profits and losses and not only profits).

On the other hand, global governments fearing a collapse to outright deflation have worked double time to reflate the world markets.

First, by massive bailouts-despite the overextended balance sheets of the US Federal Reserve.

courtesy of the New York Times

According to the New York Times (highlight mine),

``The Fed’s balance sheet, moreover, is being stretched in ways that seemed unimaginable one year ago. As recently as last summer, the central bank’s entire vault of reserves — about $800 billion at the time — was in Treasury securities.

``By last week, the Fed’s holdings of unencumbered Treasuries had dwindled to just over $300 billion. Much of the rest of its assets were in the form of loans to banks and investment banks, which had pledged riskier securities as collateral.

``In a sign of how short the Fed’s available reserves had become, the Treasury Department sold tens of billions of dollars of special “supplementary” Treasury bills on Wednesday to provide the Fed with extra cash. The Treasury sold $40 billion of the new securities on Wednesday morning and will sell $60 billion more on Thursday. More money-raising is sure to follow.’

Harvard Professor and former IMF Chief Economist Kenneth Rogoff estimates that the US would need $1 trillion in rescue package (some say more).

And next, by the unprecedented concerted global central bank actions to provide humungous liquidity to the marketplace in order to hold down interest rates.

courtesy of the Wall Street Journal

This from the Wall Street Journal, ``The Fed boosted its currency-swap lines -- through which it gives foreign central banks access to U.S. dollars -- by $180 billion, to allow central banks to meet fierce dollar demand from commercial banks outside the U.S.

``The Fed added a record daily total of $105 billion in temporary reserves into U.S. money markets, while the European Central Bank injected an extra €25 billion ($35.88 billion) in one-day funds. The Bank of Japan injected the equivalent of $24 billion into the local yen money market, and the Bank of England offered an extra £25 billion ($45.54 billion) in short-term funds. Monetary authorities in Hong Kong, India and Australia also stepped in with cash injections.”

So global central banks are today creating a tsunami of “money from thin air” to keep afloat the global asset markets from their natural reaction to overleverage, oversupply, overspeculation and massive malinvestments.

Of course, treating insolvency with massive liquidity ain’t likely gonna solve the problem as this has not been the first time global central banks have injected liquidity ever since the credit bubble crisis surfaced last July of 2007.

And worst, it could lead to a next problem. The unintended consequences of generating the next bout of inflation.

Quoting CLSA’s Russell Napier (source fullermoney.com),

``Let's get to the bottom line. A deleveraging process is under way. It can happen against a background of bankruptcy, deflation, declining cash flows and bank bankruptcy or in a slower way against a background of inflation. Both reduce the debt burden, but one is socially jarring and led in the past to mass unemployment and arguably WWII. Democracies will choose the inflationary approach. This is not evident today, but it will be more evident soon enough as the BoJ, ECB, BoE and others realise that their current monetary policy is driving them not to slower growth and lower inflation but to deflationary calamity. Today, you can see the calamity of the deflationary disease but what will you see tomorrow, or the day after, if the monetary cure pours from the medicine jars of the global central banks? (emphasis mine)