Roubini - The Deadly Dirty D-Words - Roubini: Výtečník Buffett podlehl přeludu, trhy se zřítí

I have been warning since January 2008 that the biggest risk ahead for the US and the global economy is one of a stag-deflation, the deadly combination of an economic stagnation/recession and deflation.

Let me discuss the details of this toxic mixture of deflation, liquidity trap, debt deflation and rising household and corporate defaults:

We Are Close to Deflation and Stag-Deflation

First of all, signs of stag-deflation now are clear: we are in a severe recession and now the recent readings of both the PPI and the CPI are showing the beginning of deflation. Slack in goods markets with demand falling and supply being excessive (because of years of excessive overinvestment in new capacity in China, Asia and emerging market economies) means lower pricing power of firms and need to cut prices to sell the burgeoning inventory of unsold goods; slack in labor markets with sharp fall in employment and sharp rise in the unemployment rate means lower wage pressures and lower labor cost pressures; and slack in commodity markets – that have already fallen by 30% from their summer peaks and will fall another 20-30% in a global recession – means lower inflation and actual deflationary forces. Given a severe US and global recession deflation will soon be a reality in the US, Japan, Switzerland, UK and, down the line, even in the Eurozone and other economies.

The Risk of a Liquidity Trap

When deflation sets in central banks need to worry about it and worry about a liquidity trap. Take the example of the 2001 recession: that was a mild 8 months recession in the US and over by end of 2001. But by 2002 the US inflation rate had fallen towards 1% (effectively 0% or negative given imperfect measurement of hedonic prices) that the Fed was forced to cut the Fed Funds rate to 1% and Ben Bernanke - then a Fed Governor – was writing speeches titled “Deflation: Making Sure “It” Does Not Happen Here” meaning it would not happen in the US as Japan was already in a deflation at that time. So if a mild recession – that was not even global – led to deflation worries how severe deflation could be in a recession that even the IMF is now forecasting to be global in 2009?

When economies get close to deflation central banks aggressively cut policy rate but they are threatened by the liquidity trap that the zero bound on nominal policy rates implies. The Fed is now effectively already in a liquidity trap: the target Fed Funds rate is still 1% but expected to be cut to 0.5% in December and down to 0% by early 2009. Also, while the target rate is still 1% the effective Fed Funds rate has been trading close to 0.3% for several weeks now as the Fed has flooded money markets with massive liquidity injections; so we are effectively already close to the 0% constraint for the nominal policy rate.

Why should we worry about a liquidity trap? When policy rates are close to zero money and interest bearing short term government bonds become effectively perfectly substitutable (what is a zero interest rate bond? It is effectively like cash). Then further open market operations to increase the monetary base cannot reduce further the nominal interest rate and therefore monetary policy becomes ineffective in stimulating consumption, housing investment and capex spending by the corporate sector: you get stuck into a liquidity trap and more unorthodox monetary policy actions (to be discussed below) need to be undertaken.

The Costs and Dangers of Price Deflation

Before we discuss the monetary policy options in a deflation and liquidity trap let us consider the costs and dangers of deflation.

First, if aggregate demand falls sharply below aggregate supply then price deflation sets in (and indeed there is already massive price deflation in the US in the sectors – housing, autos/motor vehicles and consumer durables – where the excess inventory of unsold goods is huge). The fall in prices and the excess inventory of unsold goods forces firms to cu ...