Inflation? Not.
December 3rd, 2007 by 
reality
Mish asked Paul Kasriel of Northern Trust about the prospects of inflation versus deflation and got the following email in response (and a follow-up interview). Very succinctly, it describes the situation in which, I believe, we find ourselves:
Japan experienced a deflation in recent years because the bursting of its asset-price bubble in the early 1990s created huge losses in its banking system. The Japanese banks had financed the asset-price bubble. When it burst, the debtors could not keep current on their loans to the banks and therefore were forced to turn back the collateral to the banks. The market value of the collateral, of course, was less than the amount of the loans outstanding, thereby inflicting huge losses of capital to the Japanese banks. With the decline in bank capital, the Japanese banks could not extend new credit to the private sector even though the Bank of Japan was offering credit to the banks at very low nominal rates of interest.Banks are an important transmission mechanism between the central bank and the private economy. If the banks are unable or unwilling to extend the cheap credit being offered to them by the central bank, then the economy grows very slowly, if at all. This happened in the U.S. during the early 1930s.
U.S. banks currently hold record amounts of mortgage-related assets on their books. If the housing market were to go into a deep recession resulting in massive mortgage defaults, the U.S. banking system could sustain huge losses similar to what the Japanese banks experienced in the 1990s. If this were to occur, the Fed could cut interest rates to zero but it would have little positive effect on economic activity or inflation.
Short of the Fed depositing newly-created money directly into private sector accounts, I suspect that a deflation would occur under these circumstances. Again, crippled banking systems tend to bring on deflations. And crippled banking systems seem to result from the bursting of asset bubbles because of the sharp decline in the value of the collateral backing bank loans.
Hope this helps,
PaulPaul L. Kasriel
Sr. V.P. and Director of Economic Research
The Northern Trust Company
50 South LaSalle Street
Chicago, IL 60603
Posted in Fixed Income, Inflation & The Dollar, Manias, Paul Kasriel, Real Estate, Strategy & Scenarios, The Economy | 
December 3rd, 2007 at 8:32 am
One point I would like to make is that there is one MASSIVELY important difference between Japan’s experience and the one unfolding in the US. The massive amount of Japanese debt was largely held internally. The deflationary bust was largely contained within Japan (there level of cross ownership was huge). However, the US does not have the same situation. A large amount of US debt instruments and other assets are held by foreigners.
If the US gov’t (and in my opinion it is just a matter of when - not if) decides to get aggressive in trying to address the problem, the dollar could fall into a major crisis. I have long argued with colleagues and friends that we are not Japan - we are Argentina. I always get the “yeah right” look back, but if foreigners begin to flea the dollar en masse, the dollar will tank and interest rates will explode higher. That is NOT Japan.
December 3rd, 2007 at 8:54 am
I agree, the US is not Japan. But the credit bubble is not limited to the US, either. Europe and Asia have their own pieces of the bubble and the deflationary bust will be global. The impact of the bubble burst in Japan has been substantially mitigated by the existence of a strong export market for their manufactured goods. The US does not have that luxury, nor does it have the luxury of the high savings rate that Japanese consumers still maintain (although not as high).
Foreigners can’t flee the dollar en masse - the dollars can be passed from one foreigner to another, certainly, and their price will change in one foreign currency or another, but they can only “flee” if the US deficits reverse themselves and cause dollars to be repatriated. That will happen, but quite a way down the line. Research says that short term exchange rates cannot be forecast by any analysis based on economic factors, like deficits, but longer term they converge on PPP - purchasing power parity. The euro is very overvalued on that basis, although the yen is very undervalued. The long term tendency will be for the dollar to strengthen against the euro, and decline against the yen.
December 3rd, 2007 at 9:21 am
If I understand these 2 predictions, either:
#1 - Deflation across the board or
#2 - Stagflation. Slow economy with high interest rates.
Neither sound very appealing.
December 3rd, 2007 at 8:35 pm
I agree with your statements except one. Just because the US is creating debt via budget deficits does not de facto mean that foreigners will be willing to finance them via dollar holdings at low interest rates. Perhaps my language was sloppy by using “flee”. How about only willing to finance at significantly higher interest rates? The US savings rate surely means that we cannot finance it internally as the Japanese have done.
December 3rd, 2007 at 9:05 pm
Well I think it is very hard to predict, because there are so many “non-economic” players out there, central banks and so-called sovereign wealth funds.
The dollar is unique because of its reserve currency role. Foreign central banks are willing to hold US dollars as foreign exchange reserves, and net flows between countries are settled in dollars. This is the role that was played by gold and sterling in the past. This provides an important support for the credibility and value of the dollar, and means that sovereign dollar debt should be easy to place, and the Fed will keep rates low. I’ve said elsewhere that I expect to see a ZIRP in the US.
Private debt is another question entirely. At what spreads will foreign creditors relinquish the perceived safety of Treasury debt? Only the Shadow knows…