By Hui Zhong
The current U.S. economy has no doubt on the edge of cliff of deflation rather than inflation. That is determined by the demand and supply balance. When there is more money (liquidity) than the products and services available in the economy, we see inflation. On the contrary, when people muddle in the debts (credit bubble) and do not have enough money to buy the products and services available on the supply side, it is deflation. The deflation usually is accompanied by price deflation that digests the excess of the production ability by lowering price. The consumer incomes deflate accordingly as employers cut cost by layoffs and wage reductions to address the shrinking revenues. When consumers see their incomes decrease they in turn cut their budget to buy fewer products and services. That will result in further cost cutting from the supply side. This vicious cycle is really difficult to handle unless intervened by government with unconventional policies. The key word here is creativity.
The outstanding debts are just like black holes which suck in all the money they can see when consumers are struggling in paying their interests and principles. When money dries up we see recessions. The Federal Reserve chairman Bernanke of course understands the seriousness of the deflation as he has been famous for his study on the Great Depression of 1929 and widely regarded as the expert on depression. Under this circumstance the Federal Reserve decides to airborne money to the U.S. economy. The intention of the Quantitative Easing (QE) by Federal Reserve is to create inflation or stop a deflation to dilute the existing debts the U.S. has accumulated for the past 20 years. In QE 1, the Federal Reserve dropped the money to the banks hoping they would in turn lend the money out to the economy. But banks refuse to lend because fewer borrowers are qualified for more debts and the borrowers also have little interests to pile more debts in their balance sheets. The QE1 is not working.
The side effect of QE could be phenomenal however. It trashes the dollar, making the imports more expensive, especially the oil. Higher prices of oil and other commodities increase the production and transportation costs. Business owners have to lift the price and cut costs to uphold their profits. The increased product and service prices result in the price inflation. Cutting production costs make more people lost their jobs and see their income shank. This obviously is consumer deflation. The consumers, facing higher price and lower incomes, have to buy fewer with their already decreased incomes. That will in turn feeds back to the supply side with lower sale number, resulting in more cost cutting and more demand shrink. This is still a vicious cycle but is unintentional consequence of the QE and is more destructive than the traditional deflation. I noted the current economists basically are divided into two camps, the inflation camp at one side and deflation camp at the other side. They never see the scenario of price inflation and consumer income deflation. Price inflation is never good while consumer income inflation is.
In short, under the conditions of current U.S. economy, demand side needs money and supply side needs buying power. QE1 failed hard by pumping the base money to the supply side that they don’t need and neglected the demand for money in the main street. Further QE should be careful to maintain the strong dollar. The trash of dollars by QE would doom the unintentional consequence that generates price inflation and consumer deflation which is more destructive and irreversible. The right way to quantitative easing should be focus on providing the money liquidity for the much needed demand side while keeping the U.S. dollar stable. Even with the right QE, I am not optimism for its success, considering the huge amount of the credit bubble collapsed compared to the limited scale of QE.