The next recession will push the Western economic system over the edge into deflation

An exchange store staff shows a Chinese RMB$100 banknote) and a US$100 banknote in Hong Kong
Photo: Reuters

Half the world economy is one accident away from a deflation trap.

The International Monetary Fund says the probability may now be as high as 20pc.

It is a remarkable state of affairs that the G2 monetary superpowers - the US and China - should both be tightening into such a 20pc risk, though no doubt they have concluded that asset bubbles are becoming an even bigger danger.

"We need to be extremely vigilant," said the IMF's Christine Lagarde in Davos. "The deflation risk is what would occur if there was a shock to those economies now at low inflation rates, way below target. I don't think anyone can dispute that in the eurozone, inflation is way below target."

It is not hard to imagine what that shock might be. It is already before us as Turkey, India and South Africa all slam on the brakes, forced to defend their currencies as global liquidity drains away.

The World Bank warns in its latest report - Capital Flows and Risks in Developing Countries - that the withdrawal of stimulus by the US Federal Reserve could throw a "curve ball" at the international system.

"If market reactions to tapering are precipitous, developing countries could see flows decline by as much as 80pc for several months," it said. A quarter of these economies risk a sudden stop. "While this adjustment might be short-lived, it is likely to inflict serious stresses, potentially heightening crisis risks."

The report said they may need capital controls to navigate the storm - or technically to overcome the "Impossible Trinity" of monetary autonomy, a stable exchange rate and free flows of funds. William Browder from Hermitage says that is exactly where the crisis is leading, and it will be sobering for investors to learn that their money is locked up - already the case in Cyprus, and starting in Egypt. The chain-reaction becomes self-fulfilling. "People will start asking themselves which country is next," he said.

Emerging markets are now half the global economy, so we are in uncharted waters. Roughly $4 trillion of foreign funds swept into emerging markets after the Lehman crisis, much of it by then "momentum money" late to the party. The IMF says $470bn is directly linked to money printing by the Fed . "We don't know how much of this is going to come out again, or how quickly," said an official from the Fund.

One country after another is now having to tighten into weakness. The longer this goes on, and the wider it spreads, the greater the risk that it will metamorphose into a global deflationary shock.

Turkey's central bank took drastic steps on Tuesday night to halt capital flight, doubling its repurchase rate from 4.5pc to 10pc. This will bring the economy to a standstill in short order, and may ultimately prove as futile as Britain's ideological defence of the ERM in September 1992.

South Africa raised rates on Wednesday by half a point to 5.5pc to defend the rand, and India raised a quarter-point to 8pc on Tuesday, all forced to grit their teeth as growth fizzles. Brazil and Indonesia have already been through this for months to stem a currency slide that risks turning malign at any moment.

Others are in better shape - mostly because their current accounts are in surplus - but even they are losing room for manoeuvre. Chile and Peru need to cut rates to counter the metals slump, but dare not risk it in this unforgiving climate.

Russia has a foot in recession but cannot take action to kickstart growth as the ruble falls to a record low against the euro. The central bank is burning reserves at a rate of $400m a day to defend the currency, de facto tightening. As for Ukraine, Argentina and Thailand, they are already spinning out of control.  


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commented 2014-02-01 01:47:17 -0500 · Flag
Stanilic writes:

Since Gordon Brown `saved the world’ capitalism has been in denial. Since 2008 the capitalists have had all the profits and none of the risk which was taken up by the taxpayer so that we now have this corporate soup called an economy run to benefit a bloated state and bankrupt banks.
In order to work capitalism requires that its destructive phase is given full voice. This was smothered by the people who saved the world with their money printing. Yet, the destruction will still come as it needs to; only if you shut the front door it will come in via the windows or up a drain-pipe in due time.
The idea of the social-democrats that the government can somehow cancel the destructive side of capitalism by state fiat is an idiocy. For capitalism to function in its positive and constructive way which benefits us all, then the destructive phases must be allowed to work through. You can’t have the one without the other.
If in the autumn of 2008 there had been the full bust, which was likely after the insane exaggerations of the period, we would now be in the fifth year of recovery, working hard but getting paid in cash. As it is now it is all expressed in debt.
Let the forces rip!
commented 2014-02-01 01:31:09 -0500 · Flag
T.N. writes:

Bring it, I am so tired of this False Cunard about Deflation, it is shallow, sub-standard, ahistorical, it is like denying there is a cycle to life, Birth, Life, Death. We are where we are because the officially sanctioned Central Planners, have Failed Miserably at there jobs, So what else is New ?

and because they continue to Refuse to allow the System to Cleanse itself of the massive
Leverage which they in part championed and have Refused to be liquidated,
i.e. PRICE DISCOVERY will NOT BE TOLERATED ! Declining prices Bad, Inflation Good, spare me the Idiot speak !

gotta go change my Adult, (depends) Diapers now so I can return to Peter Rabbits hole
with a clean bottom !!