Mid Term Election & Inflation (Deflation) - Dialog with a (UK resident) Sibling

Leinie:

In partial response to your email question re. next week’s mid-term elections:
> I think that the R’s will win control of the Senate by at least one or two seats.
> I also think that the R's will add to their advantage in the House by 5 to 10 seats.
> I don’t think that this will have a major impact on the markets either up or down.
> I think that the equity markets will trend down over the remainder of the year, but not in a major way.
> I also think that interest rates will remain muted - even trend down marginally.
>
> http://wapo.st/1tiAeW0

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This is an interesting development.
I suppose that the Republicans would then have an imperative to pass legislation in the next 2 years to warrant support in 2016. Without action in a Republican controlled Congress, notwithstanding vetoes from the White House, these swing votes/constituencies will sour on Republicans, as well. Although what the alternative at that point would be, I don't know!
On another topic: there is continuing talk on both sides of the inflation/deflation issue. It would appear to me as a lay'person'(!) that until confidence picks up, demand will not pick up, and therefore, despite QE inflation will be held in check. Do you agree? What will change the current 'balance'?
As the Chinese curse says: "We live in interesting times".
Leinie

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Leinie:

I would expect the R's to introduce a lot of "faux" legislation - legislation that will garner headlines on issues that will energize their base and appeal to swing constituencies that they believe will also be "wedge" issues for the D's (issues that will divide the D's and prompt vetoes from Obama); not sure how much substantive legislation they will introduce. In other words, I would expect that the next Congressional term will reflect a lot of Kabuki theatre in preparation for the 2016 Presidential cycle.

As to inflation/deflation, this is an involved topic, but my short answers are as follows:

(1) Inflation is, in the vast majority of instances, NOT the direct consequence of the expansion of central bank balance sheets (though this may be an indirect consequence ), but rather a direct consequence of a significant expansion of credit. (The exceptions are in the rare instances when governments actually print excessive quantities of currency and issue it directly to the public.) 

(2) It is possible (as we have been experiencing) to have an expansion of central bank balance sheets occurring at the same time that non-central bank credit is declining. (In fact, Bernanke's argument for QE in Japan in the '90's and early '00's and in the US over the past six years was in order to offset the decline in the balance sheets of the financial sector.)

(3) It is also possible to have static central bank balance sheets and expanding financial sector balance sheets. (In fact, virtually all of the historic literature dealing with the interaction of business cycles with financial cycles - eg. Bagehot's primer on central banking, "Lombard Street" - is devoted to this type of phenomenon.)

(4) The Monetarists have so successfully confused economists of all persuasions as to the supposed tight causation between central bank balance sheets and the "money supply" that most economists find the current "disconnect" between the two to be an historic anomaly - it is only an anomaly, however, if one ignores that economic agents spend "credit" in much greater amounts than they spend "currency".

(5) One additional characteristic of credit worth noting - it can be spent on financial assets as readily as it can be spent on goods and services. However, for some reason, most economists regard increases in financial asset values resulting from increases in credit as good (ie. not "inflationary"), but increases in the prices of goods and services resulting from increases in credit as bad (ie. "inflationary"). From my vantage point, increasing prices resulting from increases in credit are good if they are "sustainable" and bad if they are not; and they are "sustainable" if buyers and sellers recognize that increased prices reflect increases in the real demand for the items being purchased rather than merely an increase in nominal (not real) demand and are NOT "sustainable" if either or both of the economic agents misperceive an increase in nominal demand as an increase in real demand. (This is so-called "money illusion".)

(6) I believe that the fundamental debate about the efficacy/advisability of QE can be framed by the following question: When, if ever, is it acceptable to use central bank instruments to induce "money illusion" as a means to stimulating the economy. The Austrians say never - they argue that the intentional introduction of "money illusion" creates distortions that are not sustainable in the long run and that those distortions ultimately result in (potentially significant) mis-allocations of scarce resources. Keynesians say always - they argue that, just as people use caffeine to get going in the morning and other stimulants for other purposes, the economy often needs a stimulant to boost its way out of the troughs of economic cycles and that any resulting distortions are a price worth paying. Of course, there are a myriad of nuanced views between both extremes. Indeed, that is what the FED and the Bank of England and the ECB and the Bank of Japan and the Chinese Central Bank are all debating as we speak.

(7) As to the why credit creation is so weak - in a word, supply and demand. As to demand, there are a number of important factors; in my view, the most important of these is demographic - most of the developed world (including Europe, Japan and China, but less so the US) is aging rapidly. The result is that population growth is slowing (actually declining in Japan, Western Europe and Russia) and the average age is advancing significantly. Declining populations do not need to expand their infrastructure, only to replace that which is fully depreciated; also, older households spend less on virtually everything other than healthcare and financial assets.

As to supply, over the last twenty five years (especially in the US and the UK, but to a lesser extent elsewhere in Europe) the financial sectors have seen tremendous expansion in the infrastructure of extending credit to support the purchase of financial assets and a corresponding decline in the infrastructure of extending credit to the real economy. As a result, it is very easy to buy financial assets on credit and extremely challenging to buy real assets on credit unless you are a large corporation or have significant financial assets that a lender will use as collateral. Just look at where credit creation is concentrated (and where "inflation" is also manifest in consequence) for corroboration - financial assets and luxury goods and services.

In sum, so long as the demographics of the developed world (which represents 80% or more of world GDP) reflect aging and declining populations and so long as the infrastructure of credit creation is biased against extension of credit to the real economy and towards the purchase of financial assets, we will continue to see weak, disinflationary trends in the real economy. To the extent that central bankers continue to seek to offset these trends with QE, we will see inflationary trends in financial assets. The two together will result in continued low interest rates - both because real interest rates are low and because QE is inducing "money illusion" in the pricing of financial assets. If we experience a financial sector meltdown (rapid and significant decline in financial sector liabilities) which is not offset by central bank expansion, we will experience actual deflation - maybe even Fisherian "debt deflation". If/when we see a reversal of demographic trends and a rebuilding of the infrastructure of credit extension to the real economy, we will see an expansion of credit creation directed to the real economy and this will result in inflationary trends in the real economy and in increasing interest rates. 

Hope this makes sense.