Sunday, August 9, 2009

Ask your doctor about indeflation ...

(Perhaps the most challenging prognostication one can make today : Inflation or deflation?

As I posted on November 25, 2008
Remember the movie, 'It's a mad,mad,mad, mad, mad world'?
At the end of the movie that generation's inglorious bastards were all gripping a fire ladder as the motor blew up and the ladder lurched viciously throwing them 'akimbo'.
The vicious movements from left (inflation) to right (deflation) best mirror our market action.
We are at the cusp of being at the most volatile period (per volatility indexes) ever. As in ever since we've had a stock market.
This volatility is mostly driven by shifting perceptions of inflation and deflation.
The compression of time frames within which this inflation/deflation switch gets flipped on and off can only result in one name for our current economic malaise : Indeflation.

Now about 9 months later my gut feeling is still yes to both. In the absence of any meaningful 'reform' , which of course we will recognize once we, like pornography, 'see it' ... it is likely we will lurch from deflationary scares (Great Recession or Late Depression?) to inflationary bullishtness (pay no attention to the value of the dollar in your pocket).

Every member of the bloggenklatura has a few voices they follow on a regular basis. My list includes Marc Faber, James Grant, Bill Fleckenstein, David Rosenberg, Kevin Depew, Bill King and Todd Harrison.

Of these folks perhaps the most adamant in suggesting that we face a hyperflationary future is Faber. Grant is unsure whether we have deflation first but is confident inflation will follow. Fleck is convinced the deflationary shock is over and inflation is inevitable. Rosenberg, King, Depew and Harrison all articulate the
balancing act between these forces : Rosenberg and King sticklers for facts over market fantasy and cognizant of lessons from previous cycles with Harrison and especially Depew anticipating a 'point of recognition', i.e., this ain't your fathers' recession before the bonds and/or the dollar get smashed.

Present within all of these worldviews is the argument that the U.S. government will default on their obligations either through selective default perhaps (lookin' at you Franron), a seismic shift (dragon bonds et. al) or the 'pernicious' default of inflation.

Below however is a counter-argument to the debt-inflation gospel from UBS economist Paul Donovan. As mentioned Faber is the most adamant that we face a hyperflationary future ... a conclusion that seems less preposterous when considering Donovan's note below: -AM

Via FT Alphaville:

While most investors today acknowledge that deflation is likely to be a feature for the OECD economies during the second half of 2009, inflation pessimists cling resolutely to the belief that inflation will inevitably return. “Fiscal deficits are rising dramatically” goes the argument. “Governments will have to create inflation to reduce debt:GDP ratios, as they have done in the past.”

The problem with the idea of governments inflating their way out of a debt burden is that it does not work. Absent episodes of hyper-inflation, it is a strategy that has never worked.Government debt: GDP burdens tend to be positively correlated with inflation. Market mythology has created the idea that inflation will help reduce government debt ratios. The facts do not support the myth. OECD government debt rises as inflation rises. Meaningful reductions in government debt will require a low inflation future.

The fundamental obstacle to governments eroding their debt through inflation is the duration of the government debt portfolio. If all outstanding debt had ten years before it matured, then governments could inflate their way out of the debt burden. Inflation would ravage bond holders, and governments (with no need to roll over existing debt for a decade) could create inflation with impunity, secure in the knowledge that existing bond holders could do nothing to punish them. In the real world, of course, governments roll over their debt on a very frequent basis. As a result, governments are vulnerable to higher debt service costs if market interest rates change. If markets move to price in the consequence of higher inflation by raising nominal interest rates, then the debt service cost will rise and increase the debt. Thus a period of high inflation will tend to raise both the numerator and the denominator of the debt:GDP ratio.

The idea that governments can readily inflate their way out of their debt problems is a misnomer — arising, perhaps, from confusion between the fate of the individual bondholder and the response of the collective market. An individual holder of a long duration bond will lose out as a result of inflation. However, modern governments can not rely on markets to remain collectively indifferent to inflation. Inflation will raise the nominal cost of borrowing (of course) but through the inflation uncertainty risk premium it will also add to the real cost of borrowing.

The higher debt service cost becomes a problem for a government that is pursuing an inflation strategy because government debt does have to be rolled over. Unless a government is willing to pursue hyper-inflation as a strategy, raising inflation will not reduce the government debt burden. Indeed, history indicates that the reverse result will be achieved.

(Hence the Faber thesis that they will ultimately end up hyper-inflating ... -AM)

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