Deflation and Liquidity

"The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand - a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending - namely, recession, rising unemployment, and financial stress." – Ben Bernake, November 2002

As aggregate demand collapsed post the 2008 financial crises, the most significant response of the policy makers was to expand liquidity at an unprecedented pace. This addressed the immediate cliff the multiple markets and participants faced. But the expansion of liquidity never addressed the underlying issues that caused the crises. The underlying cause was that the world had just one principal consumer, the US, and rest of the countries (China, Japan, EU or the South-East Asian nations) were just net exporters into this vast market. Bernake knew that aggregate demand was the root cause but he sought to address this through asset inflation (higher asset prices expanding demand). But he did what he could; rest is in the realm of government policy action rather than with central banks.

This lack of demand has manifested in different ways:

• China has >250% debt to GDP and slowing domestic demand especially for materials is manifesting itself from Australia to Brazil and coal, iron-ore and oil have all faced significant declines;
• Europe is staring at down-right recession with massive youth unemployment in Southern European countries;
• Japan has struggled to grow despite a ~25% currency depreciation;
• US Fed has added international growth worries to its list of reasons why they might postpone increase in interest rates despite the earlier principal marker being domestic employment.

The incremental worry that the central bankers face with a declining commodity prices, especially energy, is it fuels the deflation scare. This leads to talk in the media and political circles to have more of the same medicine - further central bank action, the latest being the ECB - rather than improving productivity regulations (i.e. labour laws).

The other side of this coin of global slowdown and imbalances as I have pointed earlier is the Saving-Investment (S-I) mismatch. Globally, Savings has to be equal to Investments. But as country, if Savings is greater than Investments it manifests itself in the country having a current account surplus (exporting capital) and vice versa.

Country	Global Investment Share 1990	Global Investment Share 2013	Global Savings Share 1990	Global Savings Share 2013
US	24.1%	17.8%	22.6%	15.4%
Japan	19.0%	5.7%	21.1%	5.8%
China	2.6%	24.8%	3.1%	25.5%
Germany	7.5%	3.4%	7.9%	4.7%
India	1.6%	3.2%	1.5%	3.0%

US has consistently carried a current account deficit (demand surplus) while China, Japan and Germany a current account surplus (demand deficit). As Chinese investment demand declines on the back of credit issues, export slowdown and population decline, it will result in its current account surpluses expanding even further. While this expanded liquidity directed globally will keep cost of capital low, it will create issues of Chinese influence and ownership of assets, principally in the US as that is the economy with the potential to absorb this scale of savings. This potentially also explains the new trade deals the US is pursuing like TPP (with Pacific countries excluding China) and TTIP (with European Union) to correct this imbalance one way or another.

Consequently, the critical questions that will need to be answered for the global economy in the next few years - Will the US turn insular to retain more of its internal demand or will it force rest of the world multilaterally to address the massive imbalances which exist and, therefore, force them to create their own demand?

Global Disorder

At the core of the balance of power theory is the idea that national security is enhanced when military capabilities are distributed so that no one state is strong enough to dominate all others - Kegley & Wittkopf 2005

Global system witnessed a ‘balance of power’ between the World War II to the break-up of USSR in 1991. In essence USA and Russia restrained themselves and their alliance partners in substantially a geopolitical status quo system during the period. With the break-up of USSR and the Japanese economy going into a tailspin, the American’s emerged as the sole super power globally. What followed was an era of increasing number of countries being pulled into the capitalist system (Eastern Europe, South East Asia, even India initiated liberalization in 1991). US became the sole global policeman managing multiple theatres (Bosnia, Iraq) and ensuring sea lanes of communication with its blue water navy. With its economy powering ahead, it also became the central pole of the global economic system allowing it to outspend the next 10 countries on defence.

Following 9/11, it intervened in Afghanistan and more importantly Iraq, breaking the ‘distributed power’ that existed in the region. As Iraq disintegrated, Iran became free to exercise influence in Iraq and the Levant. While Russian defence spending collapsed post the disintegration of USSR it recovered and has been sustained between 4-5% GDP for the last 15 years (3^rd largest budget globally). In the same period, the Chinese economy powered ahead and its defence spending accelerated to ~US$150bn (11% of global spend as against 37% by US).

The Americans are able to address grand strategy of nations (e.g. USSR), empower nations given time geographically proximate to the relevant theatres to maintain stability (as long as they have basic institutions unlike Afghanistan) and exercise significant leverage through international institutional structures but the ability to address near term situations in distant areas like Ukraine or seek to address long-term changes in area-denial (South China Sea) capability of the Chinese are limited.

Let’s take each of the situations one at a time:

• Russia / Ukraine – When the USSR disintegrated, Ukraine, US, UK and Russia entered into a treaty in 1994 whereby Ukraine would give up the nuclear weapons in exchange for ‘independence and sovereignty of the borders’. But when the Crimean crises and its aftermath came there were no guarantors for the borders. Given Ukrainian importance to the Russians (Odessa is the largest warm water port, gas pipeline infrastructure, food security and geopolitical space) this situation were to come the moment West tried to wean Ukraine away from Russia. Russia would exert its full might to ensure Ukraine stayed. US and UK understand not only the importance of Ukraine but also their inability to exert meaningful pressure on the Russians, despite the economic sanctions. Therefore, the situation continues. It will take a while to resolve till Russian core interest are agreed to be protected. Not to say the current impact doesn’t impact the Russians, it does run against the clock they set for economic modernization before the adverse demographics takes over;
• Syria / Iraq – As Iraq disintegrated the Americans looked to stabilize it but they had destroyed whatever governance structure including the Army. This meant some regional influence had to move in (Old maxim ‘Power abhors a vacuum’). As Iranians moved in old rivalries, principally Sunni Saudi Arabia, came to fore. The Americans allowed the same to exit Iraq and that drew a blowback from the Sunnis. Syria anyway a multi-ethnic state (Kurds, Sunnis, Shias, Allawites and Christians) became a stage for the Iranians and Saudis primarily and then the rest including Russians and Americans joined the party. The blow-back of break-down of power structures is the ISIS which now the new ‘coalition of the willing’ resists;
• China and the South China Sea – China is a more long-range issue unless it faces a significant economic decline. Like the Mediterranean became central to Europe and Caribbean is the ‘American Mediterranean’ which American’s rule completely allowing it ability to throw spare power across the globe, the Chinese seek to rule the South China Sea. South China Sea not only is the heart of today’s global maritime economy where more than a third of global shipping transits, it has potentially large oil & gas reserves. This is the path way to China, South Korea and Japan in the North and surrounded by Malaysia, Vietnam Philippines and Cambodia and Indonesia. By 2050, East Africa through to Japan (via Indian Ocean and the South China Sea) will have more than 2/3^rd of humanity and all their commerce and defence will be played out in these crowded waters. As China ups the fight for these waters by improving defence capabilities and denying space to US Navy and other regional players, we will see significant pressures play out at the global stage.
• In addition to geopolitics, a universal issue of global climate change will create more pressure on under-developed and developing countries in terms of food, water and health issues resulting in greater social and consequently political issues.

These political pressures have emerged as economic issues brought out by the 2008 crises have refused to dissipate. Central question raised by the economic crises is the future of Europe as a union, which I have discussed in my previous articles, that still remains unanswered. This disorder is exaggerated by the massive pace of innovation especially in information technology. After two decades of relative calm, the change in power distribution has created disequilibrium. All this comes at a time mankind enjoys remarkable progress in health, technology, education…but so did Europe as against any time in history before the World Wars.  

It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way - in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only. – Tale of Two Cities