Posted by Joseph Y. Calhoun, III

A number of people (HT: Doug Terry) have sent me the most recent Outside the Box commentary from John Maudlin. The commentary is written by Van Hoisington and Lacy Hunt. While I agree with a lot of what they have to say, I disagree with the main thrust of the article which is essentially that the outcome of current policy will be deflation. They contend that our large debt load and excess capacity in the US economy means that deflation is inevitable.

They do make some good observations with which I agree. For instance they shoot down the idea that government spending, through the wonders of the money multiplier, increase GDP:

Interestingly, the term “federal stimulus spending” is an oxymoron. Many assume that the act of sending checks from the federal government sector to the private sector helps the economy through so-called spending multipliers. Multipliers take into consideration the second, third, fourth, etc. round effects from an initial change. Thus, multipliers capture the unintended consequences of policy actions. Although the initial spending objectives may be well intended, the ultimate outcome becomes convoluted. Over the past several years, multipliers have been intensively examined by leading economic scholars. Robert Barro of Harvard University calculates in Macroeconomics a Modern Approach (Thomson/Southwestern, 2008, p. 307) that the government expenditure multiplier from 1955 to 2006 was negative .01, not statistically different from 0. The highly respected Italian econometrician Roberto Perotti of Universita’ Bocconi and the Centre for Capital Economic Policy Research has also done extensive work on this subject while visiting the fiscal policy division of the ECB. In October 2004, in his Estimating the Effects of Fiscal Policy in OECD Countries, Perotti calculates that the U.S. expenditure multiplier is also close to 0. Thus Barro and Perotti are saying that each $1 increase in government spending reduces private spending by about $1, with no net benefit to GDP. All that is left is a higher level of government debt creating slower economic growth. There may be intermittent periods when government spending will lift the economy, but offsetting episodes will follow. The best available empirical research suggests that the current federal policy of expanding spending will retard, not improve, the performance of business conditions.

I opposed the stimulus package for these exact reasons and much preferred tax and spending cuts as a form of stimulus. Taxes have a large multiplier effect and would have been much more effective. They also point out that those tax multipliers will work in reverse when taxes are raised. That does not bode well for future real growth. 

Like many in the deflation camp, they use Japan as the example to prove that our excessive debt load will cause deflation:

Contrary to many evaluations of Japan’s problems, traditional monetary policy was actually working. This is evidenced by the enlarged Japanese debt ratio in the early years after 1989 which was not merely due to increased government debt. Private debt as a percent of GDP also rose from 219% in 1989 to its peak of 274% in 1996. However, private debt as a percent of GDP turned down in 1997 as government debt absorbed a rising proportion of Japan’s credit resources. The greater private debt load, from 1989 to 1996, as well as the massive increase in the government debt from 1989 to the present, coincided with two lost decades, not with prosperity. This template of increasing debt, combined with decreasing asset values, is a warning to investors of the efficacy of our current fiscal and monetary postures.

The combination of an extremely overleveraged economy, ineffectual monetary policy and misdirected fiscal policy initiatives suggests that the U.S. economy faces a long difficult struggle. While depleted inventories and the buildup of pent-up demand may produce intermittent spurts of growth, these brief episodes are not likely to be sustained. In several years, real GDP may be no higher than its current levels. However, since the population will continue to grow, per capita GDP will decline; thus, the standard of living will diminish as unemployment rises. These conditions will produce a deflationary environment similar to the Japanese condition.

Investments in long term Treasury securities are motivated by inflationary expectations. If fixed income investors believe inflation is headed lower, they will invest in long-dated securities, while they will invest in Treasury bills, or inflation protected securities if they believe inflation is headed higher. In the normal recessions since 1950, the low in inflation was, on average, 29 months after a complete economic recovery was underway, and bond yields moved in a similar fashion. If this recession were normal, then the low in inflation would be in late 2011, at which time investors would begin to consider shortening the maturity of their Treasury portfolios. However, because of our highly-indebted circumstances and the movement of private sector resources to the public sector, the trough in inflation will be moved out, meaning that the low in Treasury bond yields is a distant event. The path there will be bumpy, as it was in the U.S. from 1929 to 1941 and in Japan from 1989 to 2008. Presently the 10-year yield in Japan stands at 1.3%. Ultimately, our yield level may be similar to that of the Japanese.

The problem I have with this analysis is that Japan’s lost decade(s) is only superficially like our current condition. Despite the high levels of Japanese debt, the country had a large amount of net savings, particularly at the private level. The BOJ always had the means to inflate but I believe politics prevented them from pursuing that course (remember the BOJ until recently was not particularly independent). The majority of voters were savers and inflating would have meant losing elections. There was no way the LDP would tolerate inflation. The situation here is different with the majority of voters in debt. Inflation will benefit the majority of voters and that is the course I expect the Fed to take.

Despite my difference with Hoisington and Hunt on inflation/deflation, their overall message is correct. Current policy will reduce living standards over time and will not result in sustainable growth. Read the whole thing.