The Bear’s Lair: What happens if we get real deflation?

Ben Bernanke spent his entire Fed career wittering about deflation, from his initial “helicopters” speech of 2002 on. Yet we never got it, or even close to it. Ironically, a year after Bernanke’s replacement by a like-minded successor, we finally appear close to genuine deflation. The balance of probabilities must still be against it, but if it does occur in force, it may provide the battered American public with some highly salutary lessons about the drawbacks of recent Fed management.

During the decade when he held major influence over U.S. monetary policy, Bernanke’s deflation obsession was sheer folly, and the policy it produced was highly damaging. Even by the doctored “hedonic pricing” official statistics, which are close to 1% per annum short of representing the true price increases faced by consumers, from November 2002, when he gave the notorious speech “Deflation: Don’t let it happen here” to his retirement in January 2014, the U.S. Consumer Price Index (CPI-U) rose 29.2%, or 2.3% per annum, above the Fed’s current 2% target, never falling below zero in any calendar year, even though commodity prices collapsed in the financial crash of 2008.

That may now be changing. The weakness in commodity prices since 2011, the collapse in oil prices since July and the consequent declines in the consumer price index, suggest we may actually see deflation on a year-on-year basis for a few months. If as is likely there is a massive credit crisis later this year, as energy sector investment is proved to have been excessive and the banking system totters, this deflation could even persist for a more extended period. Experience within our lifetimes, knowledge of the Fed’s determination to prevent deflation, and observation of the normal effects of fiat currencies in a politicized world all suggest that significant deflation is unlikely. Still, examination of earlier periods suggests that it is not impossible.

There have been no fewer than four periods of significant deflation in U.S. history. The first, in 1819-23, comprised about a 40% decline in agricultural prices, which coincided with a moderately severe financial crisis that required the recapitalization of the Second Bank of the United States. The trigger for the crisis was the British return to the Gold Standard in 1819, which produced a similar but earlier (1816-20) decline in prices in that country.

Britain’s return to the Gold Standard involved short-term hardship and was opposed by Whigs like Henry Brougham as well as by the banker Nathan Rothschild, who was making a fortune in FX profits off the floating-rate system. It was thus a decision of exceptional courage by Lord Liverpool’s government, made the more difficult by Britain’s huge load of government debt, probably the highest in its history. In the event, the British economy after 1820 swung into a period of sustained prosperity such as had never before been experienced, and the U.S. after 1823 followed suit. The deflation, while severe was thus overall highly beneficial in its long-term effects.

The second deflationary period was much less benign. Andrew Jackson’s foolish and vindictive removal of government deposits from the Second Bank of the United States in 1834, and the bank’s de-chartering in 1836, removed the mechanism by which money had been transferred across the growing United States and greatly increased the cost of borrowing outside the major financial centers. The result was the Panic of 1837, and a deflation that caused prices to decline by a third in 1837-43. This produced a severe double-dip recession, with a second wave of bankruptcies occurring in 1841, although GDP overall continued to increase by about 16% in 1839-43.

The third deflationary period, from 1875-96, in which according to Milton Friedman prices declined at an average of 1.7% per annum, was almost wholly benign. In the U.S. this followed the withdrawal of Civil War greenbacks, in Britain, where the Gold Standard reigned throughout, deflation was only 0.8% per annum. While farmers, especially highly indebted farmers, suffered during this period, industrial workers did very well indeed and overall GDP advanced at a faster rate than had ever been seen before. In the U.S., a final deflationary burst in 1893-96 was painful, and led to a major leftward movement with William Jennings Bryan’s 1896 “Cross of Gold” speech, but thereafter with sound policies prosperity returned rapidly.

The final deflationary period, in 1930-33, was a malign one that saw prices decline by 30% and one third of U.S. banks fail. Recovery from this too would have been rapid, but its political fall-out led to the election of leftists who retarded recovery until they were stymied by the Republican midterm election gains of 1938. Notably in Britain, which was politically luckier since the left were in power during the crisis and out thereafter, the 1930s were much more satisfactory; indeed 1932-37 saw the fastest sustained growth the British economy ever managed.

The above potted history suggests that even major deflation is not always to be feared. As for minor deflation, of 1% a year or so, it can be positively benign. At that level, the Fed is perfectly capable of adjusting real interest rates to stimulate the economy, if it should wish to do so, while beleaguered savers are rewarded with a modest increase in the value of their savings.

There are however considerable economic implications to a substantial deflation, say of 20% spread over four years. At that level, prices are declining by 5.4% per annum, given the effect of compounding, and if we assume a 4-year duration for the deflation it is not simply a blip that policymakers can ignore – it does for example cover an entire Presidential term.

Janet Yellen may believe she can counteract the effect of such a deflation through monetary policy, but this is rubbish. The practical limit for negative interest rates is about minus 1% per annum. Even if Yellen wanted to institute an interest rate of minus 6% per annum to pursue the Fed’s normal Bernankeist policy of negative real interest rates, she couldn’t. Well before rates got that low, the larger savers would simply withdraw their savings in $100 bills from the banking system and deposit them in strong boxes. The alternatives, of buying gold or moving money to a country such as Germany that had avoided the foolishly extreme monetary policies would also be available. Less solid alternatives, such as Bitcoin deposits and tech stocks, would doubtless also find favor.

The mass withdrawal of the nation’s savings would quickly destroy the U.S. banking system, which is operating on leverage and loan-to-deposit ratios that would have been thought hopelessly extreme 50 years ago. This would turn a period of fairly mild deflation into a Great Depression 2; it would replicate the destruction of banks, partly caused by a withdrawal of savings from them, that occurred in 1931-33.

It would thus be necessary in a major deflation for the Fed to keep interest rates only slightly negative, which would ensure that real interest rates in the economy were of the order of 4% or more. The government could attempt to issue Treasuries with negative interest rates, but it’s difficult to see how they could ensure that investors paid the negative coupons when they came due.

In the long run, real interest rates of 4% or more for a period of 4 years would be highly beneficial. They would restore the rights of savers paying them a substantial return for their money. This in turn would encourage more saving, de-leveraging the economy (which would in any case happen forcibly through mass defaults on consumer debts that had become unenforceable.) By the end of the deflationary period, the U.S. capital base would have been rejuvenated, and the U.S. capital availability advantage that had made the country rich for two centuries would have been restored.

Needless to say the interim period would be painful. There would be mass defaults on consumer debt and on the more adventurous home mortgages (though most home mortgages would be perfectly serviceable, albeit expensive, as the cash flow required to service a 4% 30-year mortgage is not onerous even in a period of deflation.) There would also be a massive crash in asset prices and the stock market, as 4% real interest rates wiped out the over-leveraged financial system. But again, the pain would be worth it; at the end of the four years the U.S. would be well capitalized, with plenty of savings to fund new investments and with the detritus of 20 years of funny money swept away.

It’s difficult to assess the probability of a prolonged period of substantial deflation. It’s probably not all that high. And yet the de-capitalization and overleveraging of the years since 2009 must end somehow, and the collapse in oil prices and decline in commodity prices may just be sufficient to set off a financial collapse that triggers such a major deflation. Two decades of over-stimulatory monetary policies, and a final seven years of policies that have gone far to destroying the U.S. savings base, may end in a deflationary financial crash, the very result against which the Fed has been struggling.

If so, it will be hard for us all, but we will at least be able to reflect on the sublime irony of Ben Bernanke’s misguided career.


(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)