1. Innovation and competition within the private sector are natural sources of deflation

A free market system supported by modern science and efficient capital markets leads to innovation and increased production across most sectors. In agriculture, for example, production per hectare of many crops increased by a factor of four in the 50 years after the war (in the UK farms were producing two tonnes of wheat per hectare and this rose to eight – by the way now stable at that level for the past 15 years).

More recently, globalisation and the internet have transformed the traded goods and media industries with lower costs. And these powerful sources of efficiency now threaten lower costs in the service industries. Other things being equal, such rapid increases in efficiency naturally create deflationary pressures.

2. Government actions – an increasingly important off-setting inflator

Of course in many periods of history “other things have not been equal” and new supply has been met with equally vigorous new demand so that prices have risen rather than fallen. Population growth after World War II in America and in Europe and overall real economic growth created significant demand growth for many goods and services. Growth of credit markets, which had shrunk during the Great Depression, also helped expand demand and keep prices moving up in the post war period.

Further to these private sector sources of increased demand, government policy has also been important. Indeed as demographic growth has slowed, and as credit market expansion reached a ceiling with the “revolt of the private sector credit markets” in 2008, government policy became increasingly important in off-setting deflation.

Early post-war stimulus efforts by governments revolved around deficit spending. Governments seeking growth spent in excess of their receipts from taxation and financed the difference with debt (and/or with printed money – an exercise we will discuss again below).

However debt financed fiscal stimulus, like credit market expansion, has now largely reached a limit in the west. Government debts become unsupportable when they approach 100% of GDP – a level they have reached or exceeded in many developed countries.

Government debt to GDP (%)


Sources: World Bank, Trading Economics

This “debt cap” on fiscal stimulus has proved less of a constraint in emerging markets – where real and nominal GDP growth has normally been fast enough to keep up with the growth in debt.

Government debt to GDP (%)


Source: World Bank, Banco Central do Brasil, Trading Economics

As a result of their “debt cap”, developed country governments have increasingly turned to accommodative monetary policies to stimulate economies and off-set deflation. In periods like the early 1990’s and the early 2000’s (during all of which period inflation rates were declining – next graph) this monetary accommodation took the form of lower interest rates.

Inflation (Consumer Prices)

Source: OECD

Accommodative monetary policy has been important in many emerging markets also, with e.g. India managing interest rates to levels below the rate of inflation. In China, also, interest rates have been managed down to low levels (through financial repressions not dissimilar from the QE in the West). Real economic growth and inflation have both tended to run at higher levels in emerging markets. But these countries (especially China) have also increasingly resorted to fiscal and monetary stimulus (and exchange rate intervention) in order to support growth.

Emerging Markets Inflation (Consumer Prices)

Source: OECD

3. Summary so far

In the West and increasingly also in the East, the story of the past 20 or 30 years of macroeconomics has been on the one hand high levels of production growth driving natural deflation, but this has been by and large successfully offset via government intervention, especially via (increasingly) credit fuelled demand for goods and services.

4. Monetary and credit driven expansion of demand is unsustainable

Of course the above pattern is unsustainable. Annual GDP is a flow. Credit (unless invested) is a stock. If you borrow money to build a house or buy a car then that boosts GDP in the year of the borrowing, but it does nothing for GDP the next year.

Economic policies which “win” the battle against deflation via monetary stimulus and credit expansion have to invest increasing amounts of additional credit each year, for each new unit of GDP.

Credit Intensity of U.S. Growth

Sources: Bloomberg, U.S. Federal Reserve

China’s credit intensity of GDP

Sources: People’s Bank of China, China National Bureau of Statistics, Haver Analytics, Fidelity Investments (AART)

This disequilibrium will eventually collapse (as it attempted to do in 2008-2009). But how will that collapse express itself?

5. Which of deflation or inflation is going to predominate?

In many major economies (the US, Japan, the Eurozone) monetary stimulus delivered via lowering of interest rates has also now reached its limit as interest rates are now approaching zero and cannot feasibly be lowered much further (bond investors can be forced to pay interest in order to hold bonds but the wider population, with bank deposits, have the right to withdraw the deposit and hold their savings in cash i.e. will not be persuaded to endure negative interest rates on bank deposits).

The zero interest bound makes traditional monetary policy driven stimulus impossible. Therefore the US, UK, Japanese and, imminently, European central banks have all begun active programmes of injecting what is effectively printed money into their economies, by buying government and private sector securities (and currencies of foreign nations – in order to defend exchange rate pegs) onto their balance sheets in return for non-sterilised money creation.

Will these “Quantitative Easing” measures be successful in creating inflation, or at least off-setting deflation? Or is there a chance deflation will either creep around the world, as seems to be happening in second half of 2014, or even burst out dramatically as it did in 2008?

Before trying to answer this crucial question we need to first investigate the “wealth effects” of falling interest rates, then quickly review Soros’s theory of reflexivity.

6. Asset price inflation at times of falling inflation

When an economy has high interest rates (especially high real interest rates), asset prices as a % of GDP tend to be lower. Conversely, as interest rates fall then asset prices rise.

This is ironic as the rise in asset prices may well be occurring at a time of falling inflation in the prices of goods and services.

In fact this very pattern, of rising asset prices yet falling inflation, has been one of the major economic characteristics of the 30 years since 1985.

During this period, typical asset prices (e.g. of urban housing or farmland) increased by a factor four times while general pricing levels in the economy increased by only two times.

U.S. Farmland Value vs CPI (base 100 in 1985)


Sources: USBLS, USDA, Craigmore analysis

This asset price surge is explained by yield rate compression (next graph):

U.S. Farmland: Return on assets vs Interest Rates


Sources: USDA ERS, A. Damodaran, Craigmore analysis

A generation of financial managers who managed portfolios during the past 30 years became complacent about this phenomenon. It was an amazingly lucrative period for financial types – a “Goldilocks” financial economy of low (or even falling) prices of goods and services yet at the same time rising asset prices.

Of course this trend did go sharply into reverse in the 2008-09 financial market de-leveraging. Since 2010, however, the post-1985 pattern has resumed. But this time with the role of “inflator” falling more and more onto monetary policy. Weak demand in most areas of the world economy have meant more of the “inflator” has been needed to come from the ramping up of asset prices resulting from quantitative easing. Central banks apparently hoped and intended that QE would find its way into goods and service markets, and into ordinary folk’s incomes. However it has not really happened – it has flowed almost entirely into asset prices.

Thus, whether it was intentional or not, the macroeconomic policies of the major countries have been reduced to combatting global deflation by gingering up a “wealth effect” where owners of financial and investment assets are made to feel wealthier by lifting asset prices – and therefore spread their wealth around (via consumption or via investment).

Not only is this economic policy unsustainable it is grossly unfair, and risks social unrest. It directs government support to the already wealthy in the economy, especially the financial sector but also the property owning classes. This includes farmers in those countries which are practising QE. Which does not, I am proud to say, include New Zealand where we are still honestly paying 5.5% interest on our mortgages i.e. where real interest rates have not been fiddled by government.

I am confident the QE policy will eventually fail, with the crisis of its failure triggered either by a populist revolt, or by its financial inconsistencies, or a mixture of the two. At that point the wealth effect may begin to selectively unwind. Some classes of assets (I am thinking of nominal assets like bonds) may fall in real terms (relative to goods and services) as selective monetary support of asset prices is withdrawn.

To develop a theory of how the collapse of these policies might play out, we next turn to Soros’s theory of reflexivity.

7. Soros’s theory of reflexivity revisited

Soros developed a theory of reflexivity to enable economic agents (investors and governments):

  1. to identify unsustainable trends or dis-equilibria that are likely to be resolved by market and/or government actions
  2. to analyse and estimate the next one or two actions and counter-reactions (“reverberations” if you like) that are likely to occur
  3. to then position oneself or one’s policies accordingly

The recent Swiss withdrawal of its exchange rate cap with the Euro is a good example. The Swiss, caught in an alliance with a currency that is about to be debased, acted reflexively in anticipation of future negative consequences (of being forced to exchange good Swiss Francs for enormous quantities of a currency that is being debased).

8. So what are the likely first round of actions and reactions in the global arena?

At some point in the future a major crack will occur in the macro-economic edifice. Candidate crises are:

  • Russia may threaten to default (for the second time in 20 years) on its debts
  • The citizens of a European Union peripheral country may elect to leave the Euro
  • US inflation may begin to increase necessitating the lifting of US interest rates, dramatically lifting the USD, and causing a wave of defaults in the “carry trade” (including emerging market countries and companies with declining currencies but dollar denominated debt).
  • Economic growth in another region (Europe and Japan are obvious examples) may be so low that desperate money printing measures are brought into play (a debasement already largely underway in Japan) undermining confidence in their currencies.

How will the key actors, especially the US Federal Reserve, the Chinese and Japanese Governments and the European community react to that next crisis?

I think the answer is fairly clear. The authorities will act (in concert if necessary) using printed money both to support the markets, purchasing debt and even equity securities directly if necessary, to rescue the sector that is in crisis e.g. if Russia is threatening to default China might purchase Russian bonds and companies.

The authorities regard themselves as having made a mistake when Lehman (in my view correctly) was allowed to default in September, 2008. They are determined not to allow a further downward spiral of that type.

9. We cannot know what will break this impasse, but something will

The above disequilibria and likely policy responses leave us in a paradox. The natural forces of deflation are increasingly dominant in many spheres of the world economy, as evidenced by sharp falls in prices of many commodities:

Moves in the Components of the CRB Index

Sources: Bloomberg, ANZ Research

In response policy makers are countering this by using opportunistic and increasingly unconventional and untested interventions. We are seeing, and we will see, more and more wholesale financial market operations designed to support high asset prices and to keep financial markets liquid.

These first order responses may address the symptoms, but they will not address the cause. Which is, of course, a whole lot of GDP created in recent years by unsustainable policy measures and therefore itself likely to be unsustainable. The first order (continuing) disequilibrium is an accident waiting to happen.

10. What will be the second-order series of action and reaction?

When we do eventually get a crisis big enough to resolve the disequilibria, how will this crisis appear? I believe there are three candidate outcomes:

  1. Debt Deflation: One possibility is one of those accidents will be large enough that government responses are not able to sooth the markets and another panic like that of 2008-09 occurs, with widespread defaults on debts, and competitive devaluations and so forth. People will seek the safety of the USD and gold and, in an extreme case, breakdown in industrial flows and trade finance may quite rapidly lift the prices of (now) scarce goods and services. In a sense the world would go into the reverse of the low goods inflation (in many cases deflation) but high asset inflation of the past 30 years. Goods and service prices may start rising, but asset prices would deflate. In particular nominal asset prices would deflate, especially risky nominal assets. Corporate bonds and loan books would be hard to sell. Many bank and non-bank financial institutions would face problems.
  2. Outright inflation. A second possibility is that governments in the West, spurred on by populist political manoeuvrings (all populist movements dislike featherbedding of the financial sector and concentration of government support on the wealthy) in fact continue to print money and invest it in the economy, but that this largesse becomes directed at more 1970’s style government programmes e.g. education, infrastructure investment, green jobs. If this occurs then, far more rapidly than has been the case with quantitative easing (which was applied only in the asset markets), this injection of money into the real economy will translate into inflation. As with debt deflation this “inflationary” policy may also somewhat reverse the past 30 years of relative out-performance by asset market prices over goods prices. But it might not. A vigorous resumption of inflationary growth would eventually lift interest rates, causing carnage in the fixed income markets (again especially in risky credits), but it would likely dramatically lift real asset markets i.e. stock and property markets as capital owners flee inflation and attempt to secure claims on inflation protected assets.
  3. Tea Party Economic Policies. A third if remote possibility is that governments elect to “do it the hard way” as New Zealand and Sweden did in the 1980’s and 1990’s respectively, following economic policies to wean their economies off fiscal deficits and credit driven growth. Ignoring for the moment their zany views on Climate Change, these are the Tea Party’s economic prescriptions and I support them. The US, China, Japan, UK, Europe and others who are seeking growth driven by monetary expansion (and trade advantage via currency debasement) should instead allow credit markets to collapse, should tough out the waves of defaults, and should get themselves back onto equilibrium, with positive real interest rates (not subsidising credit creation), with low government deficits and with currencies floating freely rather than pegged to other countries.

I place a 20% probability on a debt deflation being allowed to occur (for any beyond a short crisis window), a 75% probability of government money printing being shifted away from  asset markets to more directly inflationary policies, and a 5% chance that sensible orthodox equilibria are created.

In other words, following the above reflexive analysis, I foresee some element of debt deflation returning to parts of the world economy in coming years. But, in the medium to long term, I believe the major economies (as the Japanese are now doing) will directly monetise problem areas of their economies; this will eventually undermine confidence in those currencies not just internationally but also domestically. This will lower the value of money relative to both goods/services and real assets. However the population never perceives inflation as a lowering in the value of money (because even in a deflation we and our accountants use money as the yardstick of value). As always the population will perceive the fall in the value of money as a rise in the prices of both goods/services and real assets.

The losers in the inflationary scenario will be owners of debt instruments (“neither a debtor nor a creditor be”, but for choice better to be a modest debtor in times of debasement) such as investors in conventional pension funds and insurance policies, and the financial sector more generally.

In the midst of all this farmland assets (and all asset markets) are likely to experience significant volatility. However, high quality real assets such as farmland (and defensive equities) will not be a bad place to be invested during the “reflexive” unwinding of current disequilibria that must, at some point, occur.


Forbes Elworthy.

Published: 2 March 2015