Inflation or deflation - which is the biggest threat?

Do we face inflation or deflation, and what can you do either way? Merryn Somerset Webb chairs our panel of experts and asks where they stand in the debate, and why.

Our Roundtable panel this week: James Ferguson, head of strategy, Arbuthnot Securities; Liam Halligan, chief economist, Prosperity Capital Management; Peter Warburton, director, Economic Perspectives Ltd; and Thomas Wittenborg, partner, Wittenborg Capital Management.

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The idea that we should be frightened of deflation has served a lot of banks and their chief economists very well; this myth has driven the expansion of our money supply tripling it in a year, something which would obviously be massively inflationary. Sterling has also depreciated 30% in the last few years that is massively inflationary. We have had expansionary fiscal and monetary policy and that's usually inflationary; government debt is rocketing which is hugely inflationary.

And then on top of all that, contrary to the expectations of all the deflationists, oil prices are very firm and looking firmer all the time, even as the Western world teeters on the brink of a double dip. We face an inflation tsunami, yet we are kidding ourselves it doesn't exist. The rest of the world knows that the West faces big inflation because big inflation is what Western governments tacitly want, to undermine the weight of their huge historic liabilities.

What I don't buy into is the double-dip scenario, at least not yet. The medicine has been so strong, I think it would be remarkable if we didn't have 6-8% nominal growth in the global economy this year. I don't think we do have an output gap. But even if we did, it would be closing far more quickly than people imagine. This tightness doesn't express itself in an even way across everything. It is accentuated in the context of food, drinking water, minerals, energy; all the things that the poorest countries in the world spend more on.

James Ferguson: Well, I'll have a stab. The first thing I would like to say is that this is a much more complicated story than most people make out. I totally understand the inflationary case. We've got massive money printing and negative real [adjusted for inflation] interest rates and the authorities really need inflation to get them out of the debt hole. There is also, of course, a risk that if all this plays out really badly, and the guys who are running the printing presses get out of control, we could see a total loss of confidence in fiat currencies. But all that is just too obvious. You need to look for the dog that didn't bark in the night to see what's really happening. And that is the fact that despite the massive currency devaluation we have already seen in the UK- 28% - we have very little inflation.

Liam: We have above consensus inflation. At the height of the deflationary mania [Bank of England governor] Mervyn King was writing letters as to why inflation was so high. That's been the case, even when- as every economist, if they are being really honest, would admit - almost every published measure of inflation that we have, certainly headline measures of inflation, are underestimates. So actual inflation- at a time when we keep being told we are to be engulfed by a deflationary tsunami- has probably been 4-5%.

Outsiders thought that interest rates were super low; they thought that credit was available but no one wanted to borrow. It was preposterous nonsense. After a banking crisis, the resolution of the banking crisis is what really matters. The banks rebuild their balance sheets and the normal monetary policy transmission mechanism breaks down [see: The G20's plans for banks would be a disaster for the real economy]. So the base rate is no longer a shortcut for cost of credit in the economy. In normal times you take the base rate and add 2% to give you the mortgage rate. But right now the banks don't want to lend, so they add 4%. And they won't lend at all to anyone wanting more than 75% loan-to-value. That's why net new mortgage lending is at record lows now. And if you think interest rates are 0.5%, check out overdraft rates now on average nearly 19%.

James: Super high with record high spreads. That means that we have effectively had no real monetary stimulation despite the very deep recession. Not even from quantitative easing. QE was designed to offset the fact that you usually grow money supply via bank lending and that's not happening. But even with QE, properly measured M4 is currently growing at only around about 1% in nominal terms. It's shrinking in real terms - which is an absolute disaster.

Thomas Wittenborg: I am. Look at a chart not of M4 but of M3 on a seasonally adjusted basis in 2007 and you see it's been collapsing ever since. But looking beyond the UK and ignoring the monetary arguments for a bit, and the deflationary forces are clear. In the US, foreclosures are up by a record amount. 13% of all households are now basically either delinquent or in foreclosure. Before we fix that and the job market, there isn't going to be any demand pressure, there isn't going to be any inflation. There is no pricing power of anything. I recently saw an estimate of the number of factories that have closed in China 70,000. There are 350,000 factories in the US. It all suggests the output gap is just enormous and it is going to continue to be enormous for quite a while.

Peter: The idea of the output gap can be a useful tool in a normal, kind of cyclical, deviation around a continuous trend of growth. But this is not what we have now. This has been a generational destruction of capacity - the destruction of the viability of activities that were based on mispriced credit and obviously hugely exaggerated leverage of the banking system. So we have to say goodbye to huge swathes of economic capacity.

The consumer has been relatively protected in all of this. The epicentre of the crisis has been in the global trading economy in businesses. We are now putting the global supply chain back together again, but absent massive numbers of companies and businesses. Restaurant closures, pub closures, petrol station closures, leisure club closures. They won't be opening again because the finance isn't there.

Liam: Selling their factories wholesale. That is a very stark illustration of the point that Peter is making. The deflation myth isn't credible but the output gap idea is being used an intellectual conceit; a way of saying, "don't worry that we've tripled the money supply, even though it took us 55 years and two World Wars to triple it last time, the output gap means it's not inflationary, it's fine". Well, the rest of the world is laughing at that position.

Peter: Governments are making sequential decisions to monetise past credit creation because that's the politically easy path to take. They think they have a free pass on inflation it cannot possibly appear because of the output gap so they can monetise anything. Any group of people who are disadvantaged by anything, OK let's monetise it. So one step at a time we are just going down the monetary road. We gave up on macro-monetary discipline in the mid-1990s and we are only just now exploring the consequences of the mismatch between the inflation target and the fact that it is no longer connected to an underlying monetary discipline. Look at China. Inflation there could easily go to 10%. And we want the Chinese to revalue their currency so we can import more of their inflation.

Peter: But if you look at corporate free cash flow ratios to GDP, they are at 40-year highs. Corporate profit margins were briefly under great pressure they are now rebounding. If you look, the corporate share of income has risen in the past year because the economic risk has been transferred from the corporate sector to the government and the government doesn't really have a clue how to transfer it back.

Peter: What we have is a global corporate sector that is reinstating capital expenditure; we are on the verge of a global IT boom because the return on capital of the quick payback of global IT expenditure is extremely attractive. The global corporate sector is going to get us out of this mess for the next six months, taking on a lot more labour as they do. As the global corporate surplus pays down then it allows budget deficits to fall in the household sector.

James: It seems to me that the corporates have no real reason to spend money on the likes of IT at the moment. They may have wide spreads now but that's down to the huge drop in global trade and industrial production the biggest we've seen since the 1930s. Things dropped so fast there was suddenly no point in competing on price, so production just got shut down. In the US, car production literally halved for six months, because GM and Chrysler went into Chapter 11.

Honda closed down its Swindon plant for five months. So now, as demand comes back a little, we are seeing better margins. But, as Thomas says, at the expense of the labour market. So where is consumption demand going to come from now? Sure you usually have a round of corporate capex when demand picks up after an ordinary recession. But this is different a classic post-bank crisis position where there is nothing to feed sustainable recovery.

Peter: But I'm saying this is not like your typical downturn. The spasm in the global traded goods economy meant that global industrial production fell about twice as far as it would have needed to do, to match the fall in final demand. So at the moment we are trying to recalibrate global industrial production to global final sales. OK, at a lower level than they were. However, as we are trying to do that we are finding that demand is picking up a little bit too, despite everything. So there is a long way to go now to get inventory to meet final demand. There is a V-shaped recovery in terms of the growth rate in the traded goods economy.

And on capex, the point is that businesses didn't stop believing in the capex that they were planning to do in September 2008. What they did was, they acted in an emergency way to conserve cash. They no longer need to do that. Now the crisis has stripped out a lot of the smaller/medium sized businesses that were the active competitive force in the market. So we have stronger global oligopolies able to exploit their position. The other point is that these companies don't need to operate at full capacity (hence producing deflation in times of low demand). They can make a profit at 75% capacity utilisation.

Liam: Ordinary people know we are. Look at the way middle England is desperately working to pay down mortgages before rates rise which they will. The hoi polloi see through the nonsense most City economists are spouting about low inflation. It's almost undeniable now, to anyone who is willing to look at this objectively, that with the money supply increase and with the massive expansion in government debt, we are facing inflation. I think the great British public is canny enough to know that that rings true. History is littered with examples of people waking up to reality a long time before the ruling elite does. And now the markets are starting to wake up to the enormity of the situation. Despite all the vested interests, they are beginning to price it in.

Peter: But the money multiplier isn't worth talking about any more. It belongs in a world where banks' only source of funding was deposits. It isn't any more. Now they can borrow in the markets and have done so hugely. They are no longer constrained by reserve ratios. So any ratios like this that we draw on over long periods of time just don't have the significance now that they might have had before.

But what if there really was inflation about and policy makers acted accordingly? Normally the base rate is 2% over inflation. So it should be 6% now (if we use RPIX [RPI excluding mortgage interest costs]). Then add a 4% margin for the banks to use to repair balance sheets, and we've got mortgage rates over 10%. But we don't have that because you aren't right and the central banks are still desperately working to bail us out. That is the real elephant in the room: there may be an inflationary overlay here, but it is on top of a deeply deflationary situation.

Liam: The inflationary implications of it are still there. Let's not forget that this time last year Mervyn King said we could expect inflation at 1%. And here we are with RPIX at 4.5%. The RPI might have been negative for a bit, but you can add up as well as me. We all know that's only down to low interest rates and low mortgage payments and the VAT cut. At no point did the CPI go even below target.

Peter: The real question we have to ask is what is the resolution of this? I don't think you can overlay the Japanese experience on the UK and say we have embarked on a seven-year boot camp of debt repayment and hence a deflationary world. Anglo-Saxons are already back out there borrowing and spending again if they can. The savings rate in America went up to 7%, yes. But it's gone back to 3%. Same in the UK. Up to 8% now back to 4% or 5%. We want to normalise. So what is going to finance these high budget deficits if not inflation? The only reason we haven't got higher nominal bond yields is down to lot of clever footwork by investment banks.

James: That's not true. The QE of £200bn was used by the Bank of England to buy outstanding gilts at the long end. They bought at the long end because there is already a massive new buyer of gilts at the short end the banks. The banks buy government bonds after every single banking crisis. It is a normal part of the process of de-risking their balance sheets. In the last five quarters, the banks have bought £280bn-worth of short-dated gilts. Much more than we have spent on QE. Long-term buyer of short-term gilts.

James: Yes, but short-term interest rates stayed below 2.5% for 25 years, even though we had the fiscal stimulation of the New Deal and the Second World War. In Japan we are now 20 years in, and we've still got interest rates well below the 2% mark. The evidence is that if you've got a big one, this stuff stays deflationary for quite some time. The game - if you are a central banker - is to try and make it inflationary. I do not disagree with you guys that they want to make it inflationary; they need to make it inflationary. I'm just debating whether they can.

Peter: I think there are two issues here. One is whether you think that the huge public sector intervention is being effective, and I think it is. And the second one is, do you think that private sector responses to this intervention are entrepreneurial? Now I can well see, in other times, that private sector response was not there. But I don't think you can impute that to the current situation. Basically, what I'm hearing about the way that global corporations are behaving, they are excited about the prospect. They can see huge potential gains from the investments they are about to make.

James: My concern with this is still the shortage of credit. Big listed companies can get finance. But they will find that their clients don't have that luxury. So we are back to the fact that there isn't any self-sustaining return to the aggregate recovery. You were saying, Peter, that the important thing is whether the economy can respond to the fiscal and monetary stimulation. The monetary stimulation, if you are not a corporate, is non-existent and the fiscal stimulation is unfortunately unsustainable. And this is our Catch-22. All we can do is to try and deliver monetary policy along fiscal channels i.e. have the state continue to lend very cheaply to the banks until the balance sheet repair process is complete.

Liam: Which is the crucial prerequisite for solving it. The only way to rebuild proper trust within the interbank market, is to lower fear of counterparty risk. When every bank knows that they are hiding junk on their off-balance sheet vehicles then of course they are going to be worried about lending to other banks. That gums up the wheels of finance and means that creditworthy firms and creditworthy households can't get access to finance. Yet we are failing to do this. Our politicians don't know enough and the banks have captured them. We need full disclosure of legal liabilities.

James: Anglo-Irish has so far admitted over €20bn of losses on a loan book that peaks out at €73bn. And Brian Lenihan says there is another €10bn of state support liable to be needed [see: Should Britain set up a 'bad bank'? ]. All the evidence says you are not finished with your banking crisis until the banks' balance sheets are fixed. And their balance sheets are not fixed until they have crystallised all the losses.

Liam: Or creative destruction. Here we are not using the state to cleanse, we are using the state to cover up. That's the difference. NAMA [Ireland's 'bad' bank - see Should Britain set up a 'bad bank'? ] allows at least a 'fessing up of the losses. That will begin the long process of cleansing the interbank market, so allowing credit markets to work to get their economy going again. The Irish have grasped the nettle, I'm afraid the British have not.

Peter: There is going to be a diversity of experience with some countries currently in deflation and remaining in it for some time. But the key argument I want to make is that we went from having sovereign primary debt issue of about $1 trillion a year on net, to somewhere between $4 and 6 trillion a year, and we have no credible resolution of how that's going to be absorbed. There's not a rise in the private savings rate large enough to do this. The banks can do maybe a quarter of it but they can't do it all.

James: Peter, almost by definition they can do all of it. The reason you need it is because of the damage done to the economy by the contraction of credit into the private sector by the banks. In other words, it is entirely to negate a balance sheet move by the banks. If they can shrink risk assets and do nothing to risk-free assets, or they can shrink risk assets and expand risk free assets at the same time, for the banks it has marginal difference. But for the rest of us it is a huge difference. They can take it all as long as you make it short dated they don't want long dated.

James: The banks will not return to positive lending next year because they've not repaired their balance sheets. We know how long it takes to repair their balance sheets and we know what they have to do to repair the balance sheets. First of all they have to shrink the wholesale funding gap back to zero. Look at the size of the wholesale funding gap in Ireland or the UK. It's still a massive proportion of GDP it's still about 40 or 45% of GDP in the UK and bigger in Ireland [see: Should Britain set up a 'bad bank'?]. So there is no way they have repaired their balance sheets, that is the liquidity constraint of the banks. They haven't repaired or dealt with their capital constraints either, because they haven't actually crystallised the losses. When they do try to crystallise the losses like Ireland, you discover that the losses are truly, epically horrific.

James: You are right. So we are all going for the slow, 'let's pretend it's not happening', 'let the banks trade their way out of it', soft solution. The only way we can tolerate banks recapitalising themselves is doing it through higher profitability. And they are doing that, thanks to trading benefits, particularly through underwriting fees into the capital markets. Their net interest margins are no higher than they were at any stage pre-crisis, so they are not making more money than normal. On top of that, the banks' profitability on the income statement is completely and utterly negated by their losses on the balance sheet, which they are hiding.

Liam: In my view the fact that global growth is still very low and yet oil prices are extremely firm is a broader expression of the phenomenon that has driven gold above $1,000 an ounce. Do not underestimate the determination of the emerging giants of the East and their sovereigns to diversify out of Western government debt, given the debasement of the currencies in which it is denominated, and diversify into commodities. That will be an inflationary episode on the Western commodity importers of historic proportions.

Peter: My final point would be that inflation targets were a great psychological trick while they lasted. But their credibility is blown. Basically this is the third successive episode of blowing through and just assuming that people will acquiesce to lower wages and all the rest just because the inflation target is 2%. I don't really think that's going to happen anymore. Retail investors basically need to be in the income-paying equities of global oligopolists.

Thomas: The price of oil can be driven by markets. But when you run out of super tankers to store it in, the price will come down again. In 2008, it went to $147 a barrel and then collapsed. Nothing to do with final demand. The other point about sovereign wealthy funds funding the deficits of large nations like this one or the US, it's not that important compared to the banking system. China owns $850bn roughly of US treasuries. That's a fraction of what the US banking system holds. Sure, if they dumped it in one day it wouldn't be good. But what would they buy instead? You can't buy $850bn worth of anything apart from treasuries.

The money supply is the amount of money in an economy. In Britain, narrow money consists of notes and coins in circulation, plus commercial banks' deposits (reserves) at the Bank of England (BoE). The overall sum of money in the UK (broad money) is known as M4 (M3 in the US). This is narrow money plus the cur-rent and savings accounts of individuals and firms. So it reflects how much the banks are lending.

Cue Quantitative Easing (QE), in effect, printing money. The BoE buys assets, such as gilts, from investors. This increases those investors' bank balances, which pushes up commercial banks' reserves at the BoE, and so boosts narrow money. The aim is for banks to lend this extra cash into the real economy, lifting spending. But if the banks instead hoard the funds, the money multiplier falls. So broad money won't rise as the BoE hopes.

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