Why Central Banks Want to Unleash More Inflation

Having read through US Federal Reserve chairman Ben Bernanke’s speech at Jackson Hole, Wyoming over the weekend we can only come to two conclusions.

Either Mr. Bernanke is stark raving mad and should be sent to a nut farm immediately. Or, he should be carted off to The Hague to face charges of crimes against humanity.

You can read Bernanke’s speech here, but in a nutshell the content can be summed up in the following phrase, “Governments and central banks must do more.”

Unfortunately, the doing more involves pushing the US economy further down the drain and leading to the impoverishment of even more people.

But the really frightening thing is the admission that the Fed has no real idea what impact their policies will have on the economy. As Bernanke points out:

“One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions.”

Bernanke is referring to the Fed’s decision to reinvest proceeds from maturing mortgage backed securities into longer dated Treasury securities.

However, not knowing what the consequences will be doesn’t mean the Fed is about to stop what it’s doing.

That’s because even though the Fed doesn’t know the consequences to the wider economy it does know the consequences to the banking sector should it pull the pin on its zero interest rate monetary policy.

Bernanke, perhaps unintentionally, gives the game away when he said:

“Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.”

Yes, that’s right, deflation isn’t so crash hot for bankers because it makes servicing loans that much more difficult. If prices fall – a good thing – then it could lead to a fall in wages – not necessarily a bad thing if prices have fallen – which would naturally make it harder to repay a loan where the repayments are now higher in real terms.

In other words, your debt repayments are the same, but your wages are lower. Hence Bernanke using the example of “debt contracts” to highlight the supposed perils of deflation.

It’s funny how the only example Bernanke could come up with to fear deflation is the impact on debt contracts. But that’s probably because it is the only negative of deflation – negative for the banks that is.

And if Bernanke and his posse at the Fed are worried about deflation and the impact on their chums in the banking sector we can guarantee that Glenn Stevens and his “peeps” at the Reserve Bank of Australia are even more worried about deflation and banking – as I’ll illustrate shortly.

But as we’ve pointed out before, deflation isn’t the bad guy. It’s the good guy. Inflation is the bad guy. Monetary and price inflation is what makes you poorer. It’s what makes you have to work harder.

Inflation discourages savings and encourages spending and borrowing. Inflation means you have to work harder and longer. Whereas deflation should mean you can afford to retire early as the savings you’ve built up in your younger years increase in value as your cost of living decreases as you get older.

Furthermore, because your savings are increasing there’s no need for you to take excessive risks by investing in the stock market or in property. You can just keep the money in the bank… or even under the mattress and it won’t lose purchasing power. In fact it will gain purchasing power.

That’s how it should work anyway. Of course you can be sure that even in countries with deflation, the crackpot government will still try it’s hardest to find some way of even stuffing that idea up.

Anyway, you see, not only does deflation mean bad news for the banks in terms of existing loan contracts, but also, deflation means bad news for the banks in terms of potential loan contracts.

Put it this way, imagine that you’ve saved up a bunch of cash in the bank. It doesn’t matter how much, but there’s something you really want to buy – a house, a car, a new television…

In an inflationary environment there’s the pressure to buy now before prices go up – you’ve heard that one before! You’re worried that if you hold out any longer the thing you’re after will be more expensive. So, what do you do? You take out a mortgage, a car loan or a personal loan to buy it now.

That means, over the lifetime of the loan you end up paying a lot more than if you’d paid in cash for it at the time, or most likely if you’d just waited until you had the cash.

But in a deflationary environment where prices are gradually falling towards the equilibrium price then the savings in your bank account (or under your mattress) are appreciating in real terms – even if you don’t earn any interest.

Therefore, you’d be more inclined to wait before you made the purchase. Or if you’re really lucky, prices could be falling so quickly that you don’t have to wait.

Let’s just look at a couple of examples of price inflation in action. Take a look at the numbers and consider which you think makes you better off.

First up, below is a table from a paper prepared by the Bank of International Settlements (BIS):

It shows the relative household balance sheets for Japan, United States, France and Germany combined, and the United Kingdom.

As you can see, not surprisingly, banking deposits account for 51% of all Japanese household savings, but only 16% of US household savings.

Why? Look, I won’t claim to be an expert on Japan. There are plenty of people out there who lay claim to that. And we won’t make any sweeping generalisations about the Japanese culture either.

But according to the authors of the paper – Shinobu Nakagawa and Yosuke Yasui:

“Several reasons could apply, among them (1) a representative Japanese household needs a significant down payment to purchase a house and thus would like to avoid investing in risky financial assets such as stocks, (2) most elderly people, who hold a majority of retail deposits in Japan, were educated to believe – and still believe, to some extent – that saving (such as through bank deposits) is a virtue and that the indirect finance system works, and (3) there has been no rational reason to invest in risky assets in the deflationary or disinflationary environment that has enveloped the Japanese economy for many years.”

See? You don’t need to invest in risky assets like shares or housing when price inflation is non-existent.

Another reason of course is that there’s less need for households to go heavily into debt. Take a look at the Japanese Consumer Price Index (CPI) for the period 1994 to 2009.

I don’t have enough space to paste the whole table here, but here’s some of the highlights…

The general CPI in 1994 was 100.8, today it’s 100.3.

Food in 1994 was 102.3, in 2009 it was 103.6.

In 1994 housing was 94.9 and in 2009 it was 99.8.

How about fuel, light and water? In 1994 it was 97.2, and 106.1 in 2009.

Clothing was 102.9 in 1994 and just 101.0 in 2009.

And get this, Furniture and household utensils was 130.5 in 1994, but only 93.9 in 2009.

In other words, the cost of living across most categories is flat or down – what the mainstream economists would call deflation – over a fifteen year period. It means that Japanese households don’t need to go so heavily into debt in order to fund everyday purchases or even big ticket items.

Now, explain to me again how price deflation is bad for you? It needs some explaining, because to be honest we’re puzzled how falling prices of something like furniture and household utensils could be bad for any consumer.

I mean, who doesn’t want to pay a cheaper price for a spoon?

But how do we compare in Australia? A country that isn’t as “moribund” as Japan supposedly is. A country that’s supposedly much better off because we haven’t “suffered” the deflationary peril that Japan has.

In the March quarter of 1994 the Consumer Price Index (CPI) in Australia stood at 110.4. By the end of 2009 it was…

169.5.

Take a look at that number again… 169.5.

Once more… 169.5.

In other words, an approximate 50% increase in the price of goods when during the same period Japanese households suffered the ravages of deflation that caused a… [ahem] 0.4% drop in prices!

Does the massive increase in price inflation in Australia mean that Australians are vastly wealthier or better off than Japanese households? I don’t know. As I said, we aren’t about to make a sweeping statement about Japan considering our one and only visit there was a 14 hour stopover on a flight to the UK about thirteen years ago (Australia to the UK via Japan was the cheapest flight available at the time!)

But what we do know is that the Australian household is comparatively exposed to a much higher level of debt compared to the Japanese household. Take another look at the Japanese household balance sheet again. In Japan, deposits account for 51% of household finances, and mortgages only 12%.

Compare that to the Australian experience where just 23.9% of the household balance sheet is in deposits, and mortgages (owner occupier and investor) account for 38.7% of the household balance sheet (not including home value so we can compare with the BIS numbers).

And if we compare the financial surplus of assets versus liabilities then Japan has a healthy 75% surplus, whereas Australia has a much less healthy 58.7% financial surplus. Much worse than the US at 68%, France and Germany at 68%, and the UK at 62%.

That’s why our central banking boffins are keen to keep the inflation tap running. It’s got nothing to do with inflation helping to grow the economy or keeping the economy strong.

Inflation is nothing more than a devious attempt to keep the population under the influence of the banks. Because without inflation there’s less need for consumers to rely so heavily on loans from the banks.

And if the banks don’t lend as much then that means their profits suffer and asset prices tend not to rise. And again, who suffers most in that instance? That’s right, the banks.

We can only hope that the US Federal Reserve and the Reserve Bank of Australia are ultimately just as hopeless with their attempts at ramping up inflation as the boffins at the Bank of Japan have been.

But until that happens, Australians can be guaranteed to see their real wealth decrease as their debt liabilities and phoney asset prices increase.

Cheers.
Kris Sayce
For Money Morning Australia

Tagged as: asset, bank, debt, deflation, economy, financial, inflation, price, risk