Tags: economic | growth

Four Real Ways Things Can Still Go Very Wrong

By Hans Parisis
Thursday, 09 Apr 2009 01:50 PM More Posts by Hans Parisis

The just-released Fed minutes inform us the members saw further broad-based downside risk, even as Bernanke saw “green shoots” in the economy.

Let’s pray he isn’t wrong again.

The staff's projections for real GDP in the second half of 2009 and in 2010 were revised down, with real GDP expected to flatten out gradually over the second half of this year and then to expand slowly next year.

The Fed’s projected path of the unemployment rate is expected to rise more steeply into early next year before flattening out at a high level over the rest of the year.

OK, this is not headline news but nevertheless very important. Several staff members have expressed concern that inflation is likely to persist below desired levels (2 percent) with even a few pointing to the risk of deflation. As an investor I wouldn’t disregard this deflation warning. Even without a continuation of outright price declines, falling inflation expectations should raise the real rate of interest and thus increase the burden of debt and further restrain the economy.

Also, investors should not overlook that we now have to face four deflationary spirals, all well under way:

  • The Keynesian savings paradox, whereby, due to a collective lack of confidence, individuals trying to build up savings when everyone else does the same. As a result, output and income decline and all individuals fail in their attempt to increase savings. This negative interaction will continue until there is efficient external intervention by the government.

  • Fisher’s debt deflation, whereby due to a collective movement of distrust we see individuals simultaneously trying to reduce their debt. We know from experience that such an action is self-defeating until they can be convinced not to deleverage at the same time. Of course, this is also easier said than done.

  • Cost-cutting deflation that is inspired by collective fear about future profitability and causes simultaneous cost cutting. Again, we know from experience that such a simultaneous cost-cutting action cannot restore profitability, but as individual firms have no incentives to do this we’ll probably have to wait until there is serious fiscal or other stimulus.

  • Bank credit deflation, which occurs when banks are gripped by extreme risk aversion. Authorities are now in the process of trying, with all they have at their disposal, to convince banks that the simultaneous loan cutbacks is self-destructive. Question is, when will banks rediscover their own confidence.

    The common characteristic of these four deflationary spirals is a coordination of failure. This market failure, which is an enormous obstacle that has to be overcome, can in principle only be solved by collective action organized by the government.

    Until now, we cannot know or be sure if all the actions undertaken by the U.S. government will succeed. We can only hope they do but have to admit that hope is an insecure foundation for investing.

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    The just-released Fed minutes inform us the members saw further broad-based downside risk, even as Bernanke saw “green shoots” in the economy.Let’s pray he isn’t wrong again.The staff's projections for real GDP in the second half of 2009 and in 2010 were revised down, with...
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