Does Recession Invite Inflation or Deflation?

Depends on measures taken to combat recession......

A common misconception related to inflation and deflation is that one is a result of an increase in price level while the other one is a result of a decrease in price level, respectively. These are however the symptoms of inflation and deflation, and not the underlying reasons.

The real reason why inflation occurs is because of increase of money supply in the economy; i.e, government prints more money, banks lend to the public at a greater propensity, credit cards and debit cards proliferate in the economy and so forth. As the amount of money circulating in the economy increases, prices of commodities across all sectors go up to match up with the increasing affordability. Similarly, deflation is a result of contraction of money supply in the economy; i.e, government stops printing money, banks lend at smaller scales (credit freeze), and consumers stop relying on credit cards as a mode of purchase, and start spending much less, exactly what is happening today in the recession affected countries.

Therefore, some amount of deflation is inevitable in countries affected the most by the current financial crisis.

Let us take US as an example.The recently published data indicates that the number of people unemployed will reach 10 percent of the working population. That is about 15 million more unemployed people compared to when the economy was doing well (unemployment rate was around 5 percent then). The purchasing power of these additional 15 million unemployed would be drastically reduced, resulting in a drastic reduction of the amount of money circulating in the economy, thus reducing the demand for consumer goods, and thus providing a downward pressure on price levels. In a recent McKinsey & Company survey, 90 percent of US respondents said that their households had reduced spending as a result of the recession—one third of them “significantly.” More than half said they expect to keep their expenditures down after the recession. As consumers return to more traditional spending patterns, companies will have little choice but to reduce prices in order to maintain competitiveness and retain market share. This is more so true for products that have positive elasticity with the income level of consumers.

In the great depression of the 1930s, the money supply in the US fell 25 percent from 1929 to 1933, and co-incidentally, so did the price levels by the exact same amount. This fact places primary blame for the depression on the US federal reserve for allowing the money supply to fall by such a large amount. Economists such as Milton Friedman have argued that contractions in the money supply have caused most economic downturns and that the great depression is a particularly vivid example.

The US federal reserve has been careful not to repeat the same mistake again and has been busy expanding the monetary base by injecting huge amounts of capital in the economy. However, these relief efforts have not led to desired results: consumer confidence has not increased and banks are still keeping credit frozen. This has created a surplus of Bank Reserves to fight the financial crisis.Banks have plenty of cash on hand at an affordable lending rate (Today, the Federal Funds Rate is at 0% - virtually free capital) but they are not putting it into circulation. Strangely, having a large cash balance sheet is typically a negative factor for banks. For their stock to perform, they need to turn those reserves into interest bering loans that yield them profit - expanding the credit and money supply. This has not transpired. We are also seeing deflation in the Consumer Price Index. The value correction in the US housing market by up to 30 percent in some markets has also contributed to deflationary pressures. In parlance, the cost of living has gone down. If the measures to combat the recession continue to include huge amount of capital injection in the economy by the fed, deflation today, combined with a mounting Federal Deficit will invariably lead to inflation tomorrow.

This argument--that the financial crisis will eventually lead to inflation--is based on the view that governments will be tempted to monetize the fiscal costs of bailing out the financial system, and that this sharp growth in the monetary base will eventually cause high inflation. The massive injection of liquidity in the financial system will be inflationary, as it accommodates the demand for liquidity that the current financial crisis and investors' panic have triggered. Once this excess demand for liquidity shrinks, the supply will remain in excess and thus giving rise to inflationary pressures. In other words, the fiscal costs of bailing out financial institutions would eventually lead to inflation if the increased budget deficits associated with this bailout were to be monetized, as opposed to financed with a larger stock of public debt. However, as long as such deficits are financed with debt or higher taxes--rather than by the printing presses--such fiscal costs will not be inflationary, as taxes will have to be increased over the next few decades and/or government spending reduced to service this large increase in the stock of public debt.

It can be beleived that central banks will be tempted to monetize these fiscal costs--rather than allow a mushrooming of public debt--and thus wipe out with inflation these fiscal costs of bailing out lenders/investors and borrowers. What exactly happens remains to be seen.

SP

A Brief Reflection on Maoist Government's Eight-Month Rule in Nepal

Having left for the US in 1992, each trip to Nepal is anticipated with excitement. The gallis in which I ran, the chaurs on which I sweated cricket matches, the schools in which I studied, a longing desire to see these places once again somehow remedies the painfully long flight. As the saying goes, a land in which one is born is second to none, not even heaven. The touchdown point at Tribuvan international airport, then works at its best to dust off the excitement. The 'Je Pani Chalcha' modus operandi makes itself clearly evident right when I enter the immigration hall and carries throughout.

Once in Kathmandu, the excitement further erodes when I turn on the water faucet to see it supplying vacuum more than water. The erosion continues when I turn on the light switch only to be reminded of the power cuts at the expense of the resilient residents. The stench on the streets of decaying garbage, the abundance of dirt and debris – the list goes on. The so-called restoration of 'multi-party democracy' that was achieved in 1990 seems to have done no good. In the last eighteen years since the restoration, the country appears to have taken eighteen large steps backwards. For instance, throughout my childhood in Nepal, I do not recall experiencing load shedding similar in length to the one that is seen now. I do not recall lines in front of petrol stations, long enough to cause massive traffic gridlock for miles.

A corporation that epitomizes Nepal's downfall very well is the Nepal Airlines (Previously known as the Royal Nepal Airlines). The gross mismanagement of the corporation, which once had its network expanded to various cities in as far as Europe, has brought it to the brink of extinction. We might recall that when the airline sacrificed goats in hopes of survival, the news became a laughing stock material in the global arena. Nepal as a country has gone through similar downward spiral of sorts. The previous leaders of the country have done an excellent job in leading the backward march, making Nepal a laughing stock in the global arena. Travel anywhere in the world with a Nepali passport, and the point becomes clear.

Those of us that are aware of the new found middle-class prosperity in India and China must have heard of the term 'emerging economies'. Rather than put each of Nepal's feet on the back of China and India towards the race of prosperity, we seem to have completely missed the signal that the race in fact had even started. Our senior citizen politicians appeared oblivious to the leveled playing field that globalization bestowed upon us.

Although the present not so legitimate (rejected by janta) government claims that the Maoist government did not fulfill any of the promises that were made when in opposition, one must remember that revolution does not happen overnight. Blaming all the deficiencies on the Maoist government would be misdirected contention. One must remember that it takes years to accumulate the magnitude of deficiencies that Nepal is currently faced with, and the Maoist government was at the helm for hardly a year. Yes it is true that promises did outweigh the results during the Maoists' short stint in power, however, the efforts that they undertook suggested at least some level of business and commercial acumen in possession of those running the government, unlike in the past, and unfortunately the present.

In coming up with a plan to generate 10,000 MW of power in the next ten years, the Maoist government recognized uninterrupted GDP growth of the country as its top priority. It understood that the tremendous hydro power potential in Nepal can help boost the country’s GDP, but that the hydro power can only be extracted if the necessary capital from international investors can be entertained. The hydropower potential in Nepal makes entering the country a valuable proposition for foreign investors either in the form of FDI (foreign direct investment) or FII (foreign institutional investment), given the export potential of hydropower to neighboring countries such as India and China. Hydropower resources in the country are estimated to have a theoretical potential of 83,000 MW[1] out of which 43,000 MW is expected to be technically and economically feasible.[2] The required capital to extract this potential is beyond the nation’s capacity and therefore requires foreign investment. For instance, to generate each additional 1000 MW of electricity through hydropower requires approximately USD 1 billion worth of investment at a minimum. For Nepal, this level of investment is difficult to envision[3] without the help of foreign capital investment. The Maoist leadership recognized this and as a result aligned the objective of its foreign visits to encourage hydro power development in Nepal.

The Maoist government’s recent efforts and the subsequent success in collecting tax revenues have to be commended. In spite of the fact that additional revenues were not invested adequately, credit needs to given where it is due. What needs to be understood is that, because of inadequate tax revenue realization in the past, the government has been running on a budget deficit, and in order to meet the deficit, it either has been borrowing or printing more money.[4] The classical economic theory suggests that continuous printing of more money increases money supply in the economy and therefore increases inflationary pressures on prices. One of the reasons why inflation is out of control in Nepal therefore is precisely because of low tax revenue realization. As citizens, we want the government to build the country, but at the same time, also don’t want to pay taxes to help them build it. People in Nepal need to get over this wish and realize that payment of taxes are an integral part of the economy and cannot be avoided.

It was encouraging to hear the Maoist leader express concern over the increasing trend of brain drain in the country[5]. In doing so, the Maoist leadership recognized that no economic development is possible without the necessary intellectual capital, regardless of how much one accumulates the financial capital.

I do not recall the governments in the past speaking about economic development, much less doing something about it. At least the Maoist government spoke about it, and the points they have raised are validated by various economic theories. Transitions take time, and as such, it would be best that miracles are not expected overnight. Unfortunately, while Nepal's citizens have shown their uncanny ability to be patient while suffering hardship, the ones hungry for power have none of it, and jump at an iota of chance to grab it whenever possible, resulting in as frequent a change in government as some people change their underwear.

-SP

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[1] The total hydropower capacity need of Nepal for 100 percent electrification is currently about 1200 MW

[2] If the price of fossil fuels continue to rise, the economically feasible hydro power in Nepal will increase further

[3] Nepal’s GDP in year 2007 was approximately USD 10.2 billion

[4] The revenue raised by the printing of money is called seigniorage. The term comes from seigneur, the French word for “feudal lord”. In the middle ages, the lord had the exclusive right on his manor to coin money. Today this right belongs to the central government, and it is one source of revenue.

[5] Kantipur February 20, 2009