Avoiding a Deflationary Spiral

Member Group : Lincoln Institute

Since the onslaught of the panic of 2020, the Federal Reserve has been moving to preserve liquidity in the financial markets. The central bank has reduced interest rates to near zero.  Thirty year TIP (inflation protected securities) are trading at negative interest rates in the United States.

Denmark, Germany, Switzerland and Finland have been issuing short term government notes at negative interest rates since mid year 2012!

Total worldwide negative interest rate debt from government now exceeds $16 Trillion and the U. S. may soon follow suit.

The Federal Reserve has promised to infuse as much is $4 trillion into the United States economy in order to preserve liquidity and prevent the economy from seizing up.  The balance sheet of the Federal Reserve will grow from $6 trillion to over $10 trillion with only $39 billion of capital.

All these steps are taken by all the central banks, including the Federal Reserve, to preserve liquidity in the market and to prevent a deflationary spiral.

This dangerous precedent has happened before.  In the United States we moved into the world of quantitative easing of over $4 trillion with almost zero interest rates to battle the housing market fiasco in 2008.  Prior to that, Japan experienced negative interest rates in the 1990’s and the European Union has languished in negative territory for almost 10 years.

Alan Greenspan clearly understood the growing dangers in the economic world in his book, “The Age of Turbulence” in which he explains the continuing saga of an increasingly turbulent world economy.

Deflation is characterized by falling prices, falling incomes, declining value of real estate and an inability to fund government debt and unfunded obligations.

Deflation has begun and governments continue to push the “cliff” date as far into the future as possible to battle the economic effects of  COVID-19.

The $2.2 trillion CARES Act is absolutely the right thing to do at the right time. The act preserves liquidity and cash flow to reboot the economy after the pandemic. It is a stroke of genius in the way it is structured for the most part. At the same time, the post pandemic economy must deal with the federal reserve stimulus, negative interest rates, and an out-of-control fiscal and monetary policy or the crisis that follows will make all of the economic dislocations of the past 20 years look like child’s play.

The CARES Act and the Federal Reserve stimulus must be looked at as a temporary measure to move us out of the economic shutdown caused by a pandemic.  The underlying economy is strong and, as such, our post pandemic government and Federal Reserve must operate with fiscal austerity to restore our financial arsenal for the future.

Unfortunately, current fiscal and monetary policies of most western nations are merely moving us farther up the fiscal cliff rather than away from it.  It is easier to spend more rather than be disciplined in managing nations’ financial affairs.

The first economic victim of the pandemic will not be the consumer.  It will be the host of municipalities already operating on the brink of financial disaster from the housing bubble bursting.  States like Illinois, Massachusetts, New Jersey, and California will feel the crisis first.  Other states will follow.

Should federal government fiscal and monetary policies become ineffective in bailing out the states (which is of dubious constitutionality), the death spiral of deflation begins. Economic recovery will be difficult at best because deflation’s spiral is so difficult to reverse.   Buyers are rewarded with even lower prices by waiting to purchase goods and services.

Deflation has devastating effects in every aspect of life.

First, anyone with debt will find it more difficult to repay the debt in a deflationary cycle. Incomes and prices will fall making debt repayment difficult or impossible.

Second, organizations with high fixed cost such as airlines, hospitals, automobile manufacturers, drug and pharmaceutical companies, governments, and sports teams to name just a few will find that they must reduce prices in order to cover their fixed costs or lose customers. While this strategy works in the short run the economic consequences of the lower prices will ultimately translate into lower pay.

Third, once the deflation cycle starts, the ability of a society to pay for things such as Social Security, retirement benefits, unfunded obligations, and any type of retiree healthcare cost will be impaired. The deflationary spiral will prevent any of these organizations from increasing prices.

To avoid all of the negative issues of deflation it is essential that our elected leaders and the Federal Reserve work immediately to eliminate uncertainty and reduce wasteful spending within our government. Failure to do so will lead to substantial deflation.

The deflationary spiral may occur unless plans to restore solvency post crisis are well known to give the lenders to government the confidence to know that the financial custodians of the debt have the financial will to restore solvency to government itself.

The time to act is now.  The Age of Turbulence will look calm in retrospect should government not act now to prepare for austerity on government spending once the pandemic is conquered!

Col. Frank Ryan, CPA, USMCR (Ret) and served in Iraq and briefly in Afghanistan and specializes in corporate restructuring and lectures on ethics for the state CPA societies.  He has served on numerous boards of publicly traded and non-profit organizations.  He can be reached at [email protected] and twitter at @fryan1951.