By John Richardson
THERE has been a great deal of discussion lately about the differences between “good” and “bad deflation”.
Good deflation, we are told, includes the fall in oil prices that has put more money in the pockets of consumers and has enabled the Indonesian and other governments to roll-back wasteful fuel subsidies.
You can also define bad deflation as when falling prices encourage less spending, This is when people hold on to their money in anticipation of goods and services being cheaper tomorrow than they are today.
A further negative consequence of bad deflation is that as the value of money falls, the real cost of debt increases as it has been incurred at yesterday’s higher value of money. So you end up with consumers and companies less willing to borrow, and again spend, as they are too busy paying-down borrowings before their real value increases any further.
Some people, including Mark Carney – the governor of the Bank of England – argue that good deflation exceeds bad deflation.
But the “good deflation” boosters are harmful and the quicker we accept that “bad deflation” will dominate, the sooner we can then start looking for the solutions.
The root of the problem is that Western central bankers and politicians thought they could print babies – i.e. they could create demand where it doesn’t exist. But populations are ageing and as people grow older, all the evidence shows that they spend less money.
And in China, it seems as if its politicians tried to make everyone middle class by Western standards virtually overnight. This was, in effect, what the 2008-2013 economic stimulus programme was all about.
It has clearly failed because China’s average per capita income in 2014 was still only $3,294, according to the latest data from the country’s National Bureau of Statistics. Anybody in the West earning this small amount of money would be below the poverty line.
This is how things started to go so badly wrong:
- Because of the Fed’s quantitative easing programme, investors in financial markets were facing a weak dollar and very low US interest rates. So they had to seek higher returns elsewhere.
- They did this partly by going into oil and other commodities. This explains why, for instance, the oil price went above $100 a barrel in 2011, even though the real supply and demand fundamentals have never supported this price.
- The investors needed a good story to spin to the media and to analysts etc. to justify $100 a barrel crude. So, in time-honoured tradition they turned to China.
- “Look it is becoming middle class now” they claimed during the height of the country’s 2008-2013 stimulus programme. This was used to back up their argument that there was not enough oil and other commodities to meet China’s demand during that period – and crucially, also, in the future.
The high price of oil and other commodities, along with the very low cost of borrowing money, sent the wrong signals to the rest of us.
US shale-oil companies loaded-up on debt – no less than $1.2 trillion since 2010 alone, which is bigger than the entire value of the Australian economy – as they expanded capacity.
So too did petrochemicals companies in the US and iron ore companies in Australia.
In China, too, everyone loaded-up on debt, from real estate developers to manufacturers because of the availability of easy lending at home.
Soaring real estate prices in China, on speculation again rather than fundamentals, led to more claims from Western investors that China was, indeed, becoming middle class as it also rapidly urbanised. This justified pushing oil and commodity prices even higher and so on and so on…..
All was fine until the middle of last year. The cracks were effectively papered over.
But after around June 2014 it became clear to everyone, far too late, that China was serious about its “New Normal”.
People at last realised that excessive stimulus had been brought to an end because of the damage it had done to China’s economy.
And they belatedly figured out that because China had relied on investment for more than 50% of its GDP growth, take a fair chunk of that investment growth away and you have a major problem.
Hence, the main reason for the collapse in crude, and, of course petrochemicals pricing – and also the pricing of other commodities.
So we have a huge amount of surplus capacity chasing too little demand. Some examples of this include:
- US oil inventories have reached yet another record high of 8.43 million barrels.
- There are enough empty apartments in China to house six years’ worth of urban migration.
- An additional 341 million tons of iron ore capacity will be added over the next five years by Rio, Vale, BHP, Fortescue and Hancock Prospecting Pty. This is despite the fact that China’s steep production is expected to peak at 870 million tonnes over the next few years, compared with early estimates of a peak at 1-1.2 billion tonnes
- China’s phenol capacity was only 870,000 tonne/year in 2010 against local consumption of 1.3 million tonnes, according to ICIS Consulting, But by 2014 capacity had risen to 2.4 million tonnes/year with demand at 1.8 million tonnes.
Some people will still be telling you that this will all quickly balance itself out as higher cost shale oil capacity and iron ore capacity etc. is shut down.
This is a wrong reading of how the world will work – especially in China – and so you will still end up with too much supply chasing too little demand.
But let’s, for arguments sake, assume I am wrong about capacity closures and that instead lots of oil, iron ore, petrochemicals and other companies will quickly wind-up their businesses so others can take market share. How generous.
We would still be left, thanks to central bankers, with global debt that has risen by $57 trillion to $199 trillion since 2007 – nearly three times global GDP, says McKinsey.
Surely this, by itself, will be hugely deflationary. When people are paying down and restructuring debt, which has to happen from now onwards, they are not spending more money – and people need to spend more money if inflation is to happen.