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  • Dec 24, 2014
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PUBLISHED : Wednesday, 19 September, 2012, 12:00am
UPDATED : Wednesday, 19 September, 2012, 3:07am

Warning: quantitative easing could end up causing deflation

Printing money doesn't necessarily fuel inflation, especially when people are paying down debt and banks are reluctant to create new credit

On Monday Monitor looked at the argument that holds that the real purpose of the Federal Reserve's latest exercise in printing money is to pump some inflation into the US economy.

The idea is that rapidly rising prices would shrink debt levels relative to nominal output and encourage consumers to go out and spend before things get more expensive.

It sounds like a high risk strategy. Any talk of printing money inevitably conjures up images of 1923, when price rises got so out of control that the good burghers of Weimar Germany had to wheel barrows loaded with bundles of million-mark notes to the local baker's just to buy a loaf of bread.

That's the most infamous incidence of hyperinflation, but there have been plenty more. In 1949, runaway price rises forced China to print a six-billion-yuan note, while in 2006 Zimbabwe issued a 100-trillion-dollar note.

But as the Fed has discovered, printing money doesn't necessarily fuel inflation, especially in an environment in which consumers are paying down debt and banks are reluctant to create new credit.

Hence the belief of hedge fund manager James Rickards that the true objective of the Fed's latest round of quantitative easing is to force a real appreciation of the yuan.

Rickards argues that either Beijing will have to print such vast quantities of money to maintain the yuan's exchange rate that it will stoke domestic inflation, or the authorities will be forced to revalue the currency upwards against the US dollar.

Either way, the price of Chinese-made goods would rise, allowing the US to import the inflation it can't generate at home.

Even that strategy may not work, however.

Financial historian Russell Napier points out that China has already created enormous quantities of money in its efforts to keep the yuan's exchange rate stable against the US dollar. He estimates that since 2007, China has created almost four times as much money as the Fed has with its successive rounds of quantitative easing.

Initially that liquidity did generate some inflation, notably in workers' wages and the property market. But now, warns Napier, the big danger is that it will tip China over into deflation.

There are two factors at work here. First, the money created by China's financial system has largely been channelled into fixed investments, which merely add to the economy's overcapacity, weighing on prices.

Second, the increases in wages, commodity prices and property costs resulting from Beijing's orgy of credit creation have all helped to erode returns on capital.

According to Napier, the return on capital among China's listed companies has slumped from 15.6 per cent in 2007 to just 10.5 per cent today, considerably lower than in either the US or Europe.

As a result, investors are evading China's capital controls and pulling their money out of the country to seek higher returns elsewhere.

Napier notes that although China is running a sizeable trade surplus, capital outflows of US$65 billion meant that it recorded an overall balance of payments deficit of US$11.8 billion in the second quarter of the year, the first quarterly deficit since 1998.

As a result, its foreign reserves are now falling.

"This is the most important piece of data for 20 years," he says.

With capital flowing out of the country, Napier explains that Beijing has a choice. It can either allow the yuan to fall in line with market forces or it can support the currency's exchange rate against the US dollar by buying yuan from the market.

The first course would exacerbate trade tensions with the US, while the second would suck yuan out of circulation, leading to a contraction in the money supply that would only add to domestic deflationary pressures.

Either way, from the perspective of US consumers, Chinese goods would end up getting cheaper.

In other words, Napier argues that the end result of quantitative easing will not be the inflation the Fed desires, but the opposite: falling prices.

"Deflation is coming," he warns.



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The basic dilemma still remains, can you cure the illness that was caused due to excess money (created by careless lending during the pre-Lehmann era) chasing assets (most notably U.S. housing properties and stocks in developing markets) by providing more money (this time by continuous quantitative easing by the Federal Reserve)? Seems like completely bad idea to me.
1.) Inflation in some countries while delfation in others.
2.) Inflation in some sectors while delfation in other overcapacity sectors.
3.) Deflation in period of months while inflation in period of years.
4.) A mix of the above three and overall inflations are coming ?
Oh all this mess just to beat up bad bad China thanks to good good US
Who cares? Value-added in China is a microscopically tiny proportion of the U.S. CPI basket...
There's nothing to fear from a spot of corrective deflation after a community is drugged up and over-dosed after a wild party of massive asset price inflation. Only unbridled speculators have anything serious to lose.
Inflation is a giant Ponzi scheme created by over-geared investors and the new breed of bankers (professional gamblers) trying to wriggle out of their debts when party-time ends.
From 1800 to the 1930's , when 'money' was really money ( and linked to the price of gold) the cost of living remained generally quite stable. Only when the gold standard was abandoned did inflation become deemed as acceptable and in today's world almost fashionable.
Bring back the gold standard.


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