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?