Deflation and debt

Finanza Operativa di Finanza Operativa 17 Novembre 2015 | 12:30

di Walter Snyder, Swiss Financial Consulting

There seems to be an agreement that central banks should aim to have an annual inflation rate of 2%. In the USA and Europe as well as Japan the inflation rate has stubbornly remained under this level. With the fall in commodity prices, especially that of oil, there is even a risk of deflation, that is, prices falling rather than rising. The lack of inflation in consumer prices is all the more surprising in view of the huge amounts of liquidity pumped into the global economy by QE.

The prices of equities have risen as have those of real estate in most places. It therefore seems that while consumer prices remain stable, the liquidity does not flow into the real economy. At the same time, interest rates are at all time lows, which is good for governments that are deep in debt. Servicing the national debt is cheaper when interest rates are near zero.

On the other hand, companies have made lots of debt because doing so is not expensive. In order to attract investors, who have difficulty in finding a way to increase the ROI of their capital, companies offer higher interest rates than government paper. Of course, some commercial investments are rather risky, but that has apparently not deterred investors determined to take risks.

Given this unprecedented situation, the intention of the Fed to raise interest rates, perhaps in December 2015, even if a rise of 25 basis points has already been priced into the stock markets, will mark a return to “normal” interest rates though the time span is probably going to be long. The rise in rates may end the recovery.

One of the most serious problems is that debt becomes heavier when there is deflation. If prices do not rise with a consequent stagnation of wages, then governments are going to have great difficulty in servicing sovereign debt. Local governments will also experience hardship while shaky companies may end up defaulting on their bonds. It is alarming to know that some banks have started charging negative interest on deposits in an attempt to drive money into investment in the real economy.

The lack of equilibrium can be exemplified by the gold market, where leverage has reached huge proportions. The physical gold is going to China and India while the futures market has seen ever lower prices for the yellow metal due to  manipulation by the BIS. Paper gold may now be trading with only one ounce of gold for three hundred ounces on paper. The market no longer seems to be connected with reality. Central bankers also seem to be far removed from reality after having experimented with the global economy. Who will pay for their errors?

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