Europe and US may have caught the Japanese disease

Before things get better, they get worse.

The Federal Reserve of the United States has been on a money printing spree over the last few years. Currently it prints $85 billion every month to buy bonds from banks and financial institutions and thus pump ‘’new" money into the financial system.

The hope and the economic theory behind this is that banks will lend this new money to ‘prospective’ borrowers, who will spend it to buy things ranging from homes to cars to consumer goods. This in turn will revive the stagnating American economy.

The money that the Federal Reserve puts into the financial system every month also ensures that there is enough money floating around, and thus interest rates continue to remain low. People are more likely to borrow and spend money at low interest rates than high.

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The money printing will also create some inflation - and that is the hope. As this ’new’ money chases the same amount of goods and services, prices will start to rise at a reasonably fast rate. In a scenario where prices are rising or are expected to rise, people are more likely to buy goods and services, rather than postpone their purchases since things will get costlier later.

All this buying will give a fillip to businesses and that in turn will help the overall economy grow faster. And this is how things will get better.

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As things stand as of now, this economic theory doesn’t seem to be working. In fact, inflation instead of going up, has been falling in the United States. The Federal Reserve’s preferred measure of inflation is the personal consumption expenditure (PCE) deflater. This, for the month of March, stood at 1.1 percent, having fallen from 1.3 percent in February. The number stood 1.92 percent in March 2012.

What this means is that the rate at which the personal consumption expenditure is growing has been coming down over the last one year.

A similar situation seems to be prevailing in Europe as well. As Ambrose Evans Pritchard recently wrote in a column in The Daily Telegraph, “The region’s core inflation rate - which strips out food and energy - fell to 1 percent in March. This is far below expectations and leaves monetary union with a diminishing safety buffer.”

What this tells us is that attempts by the Federal Reserve and the European Central Bank to get inflation and consumption going by keeping interest rates low haven’t yielded the results that had been hoped for. People are not interested in borrowing and buying things even though interest rates are at very low levels. But that didn’t stop the ECB from cutting rates further to 0.5 percent yesterday.

[caption id=“attachment_751387” align=“alignleft” width=“380”] People are not interested in borrowing and buying things even though interest rates are at very low levels. AP[/caption]

In fact now there is an inherent danger of inflation getting into negative territory - or what economists calls deflation. “Over the last 15 years most investors have refused to contemplate that events in the West are playing out in a similar fashion to Japan in the 1990s. But the latest inflation data out of both the US and the eurozone should ram home the fact that we are now only one short recession away from Japanese-style outright deflation,” writes Albert Edwards of Societe Generale in a report released on 2 May 2013.

“The eurozone is tracking the experience in Japan in the mid-1990s. There is a very high risk of a slide into deflation,” Lars Christensen, a monetary theorist at Danske Bank, told Evans Pritchard.

Japan had experienced a huge real estate bubble and a stock market bubble in the mid- to late 1980s. After these bubbles cracked, the country experienced a deflationary scenario, where prices were falling. The falling prices had a huge impact on economic growth. When prices are falling, or are expected to fall, people tend to postpone purchases of goods and services in the hope of getting a better deal. This means lower revenues and hence lower profits for businesses. It also leads to slower economic growth.

Such an economic scenario is now expected to hit both the United States as well as Europe.

Some of this has already started to play out. As a news report in USA Today points out, “The reports also show evidence of an economy weakening – a hiring pullback, a drop in construction spendingand slowing manufacturing growth, among others.” So the American economy already seems to be entering the slowdown mode.

Suggestions have been made in the recent past that the Federal Reserve will wind down its money printing in the days to come. Patrick Legland and Dr Michael Haigh of Societe Generale, in a report titled The End of the Gold Era that wasreleased around one month back, wrote that “the Fed’s balance-sheet will continue to expand at $85bn/month through September, at which point purchases may be tapered modestly to $65 bn/month until being fully terminated at the end of the year.”

But with a deflationary scenario looming that doesn’t seem to be a distinct possibility. The Federal Reserve hinted at this in a statement released on 1 May where it said, “To support a stronger economic recovery and to help ensure that inflation, over time is at the rate most consistent with its dual mandate…the (Federal Open Market) Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.”

In short, the Federal Reserve plans to continue printing money and use it to buy $85 billion worth of bonds (mortgage bonds worth $40 billion and American government bonds worth $45 billion) every month. As Edwards puts it, “With inflation now massively undershooting the Fed’s own 2-2½ percent target range, there is nothing to stop the Fed keeping their foot pressed down hard on the gas pedal.”

As pointed out earlier the hope is that money printing will lead to some inflation and that in turn will get people to start consuming and drive economic growth. If it doesn’t there will be trouble. As USA Today points out, “if consumers and businesses are convinced prices of goods and services are falling, they tend to delay spending if possible. They want to wait and get the lowest price they can. That sentiment would snuff out the bull market, likely in an alarming sell-off.” And once deflation sets in, it becomes very difficult to break out of it, as has been proved in Japan’s case.

The trouble, of course, is that this new money may not reach the people it is intended for, simply because they are no longer interested in borrowing and consuming.

Instead this money will be used for speculation. As economist Bill Bonner wrote in a recent column, “The Fed creates new money (not more wealth… just new money). This new money goes into the banking system, pretending to have the same value as the money that people worked for. And people with good connections to the banks take advantage of the cheap credit this new money creates to aid financial speculation.”

The difference will be that instead of the money going into the stock market this time around it will go into bonds. Edwards says: “Quantitative easing (a sophisticated name for money printing) seems, in large part, to be bypassing the real economy, liquidity will evaporate from equities if we dive into a deflationary recession. Where will all the liquidity then go as quantitative easing is ramped up still further? It will go into ridiculously expensive bonds.”

But that doesn’t make bonds a safe investment bet. The American government is largely broke and not in a position to repay these bonds. “We remain of the view that on a three-to-five year time horizon, bonds will prove to be a toxic investment and rapid inflation is the likely longer term outcome,” writes Edwards.

As the old Chinese curse goes “may you live in interesting times”. These surely are interesting times.

ivek Kaul is a writer. He tweets @kaul_vivek