Inflation, Deflation and Excess Capacity

There is a titanic debate percolating among policymakers throughout the world regarding the threat of inflation versus deflation and whether austerity versus continued government stimulus of the global economy is the appropriate policy response. I posit that the economy in the US in particular (although probably throughout the world) is burdened with massive excess capacity that is deeply rooted in the flawed legal structure of the massive bailouts of 2008-2009. The degree of excess capacity is shown in the chart above, which still shows the economy with more than 25% excess capacity, on par with the depths of the recession of 2001. Simply put, this excess capacity rules out any real inflationary threat and could well fuel a deflationary spiral given persistent high debt levels, which will operate to stifle consumption as well as investment. The bond market is sending precisely such a deflationary signal.

I have argued for sometime that the structure of the massive financial bailouts of 2008-2009 were upside down. I was against the bailouts from the beginning on the grounds that they did not bailout the right people and instead excessively favored financial elites. I argued that elites would hoard cash and strangle the economy, just as zombie banks did in Japan during the 1990s. Instead, financial elites should face harsh sanctions for crashing firms at the government's cost. This culminated in my most recent law review article Subprime Bailouts and the Predatory State, available for free download right here.

My central point has always been that the legal structure of the massive bailouts entrenched financial elites, allowed them to hide the weakness of their balance sheets, and encouraged them to hoard cash and rein in lending. This is exactly what has happened. For example, reserves held at the Federal Reserve by banks has surged to over one trillion dollars as shown at right. The fact that the Fed now pays above market interest on these reserves does not help. As I have argued previously this is highly contractionary because if banks do not lend their reserves the economy cannot grow. One trillion in bank reserves amounts to massive idle capital. Moreover, Federal Reserve Governor Elizabeth Duke states that it could be "years" before credit conditions return to normal, even though credit restoration is already lagging past business cycles.

Further, there is still massive unemployment within the economy, as shown by this broad measure of employment showing a historic dive that has not really moderated at all. Over 50% of all Americans have now suffered some employment related set back due to the recession. This has caused over 60% of consumers to trim spending. Thus, the underutilized human resources in our economy is a direct hit to consumption. Until employment markets recover, there is no likelihood of inflation. Wage growth is key to inflationary pressures on both the supply and demand side. Today's job report shows that even after nearly three years of recession conditions the economy continues to lose jobs.

All of this means massive idle capacity in terms of human and capital resources. Indeed, add in all the capital idly invested in the gold bubble and the Treasury market and one can only conclude that economy is burdened by historic levels of capital tied up in very liquid and low yielding assets consistent with massive risk aversion.

There is simply too much idle capacity plaguing the American economy right now.

Thus, to the extent there is any debate regarding inflation or deflation in the economy, Paul Krugman's position that we are headed for a depression seems fundamentally sound. The great threat facing the American economy is debt-deflation and zombie banks. In short, it is hard to discount the view of economists like Robert Schiller who suggest we are turning Japanese.

In my view, the upside structure of the bailouts (as well as the upside down stimulus package) will be tagged as the root of a historic down-turn in growth. This has been my fear for some time, and combined with Europe's mess could lead to highly contractionary conditions across the globe.

The bottom line is that we wasted massive resources bailing out the bankers and cutting taxes for the rich when we should have been massively investing to rebuild our economy, in accordance with this article which I wrote in 2002.