Nouriel Roubini: How to avoid the horrors of ‘stag-deflation’

[RedEarth]

How to avoid the horrors of ‘stag-deflation’
By Nouriel Roubini

Published: December 2 2008 19:53 | Last updated: December 2 2008 19:53

The US and the global economy are at risk of a severe stag-deflation, a deadly combination of economic stagnation/recession and deflation.

A severe global recession will lead to deflationary pressures. Falling demand will lead to lower inflation as companies cut prices to reduce excess inventory. Slack in labour markets from rising unemployment will control labour costs and wage growth. Further slack in commodity markets as prices fall will lead to sharply lower inflation. Thus inflation in advanced economies will fall towards the 1 per cent level that leads to concerns about deflation.

Deflation is dangerous as it leads to a liquidity trap, a deflation trap and a debt deflation trap: nominal policy rates cannot fall below zero and thus monetary policy becomes ineffective. We are already in this liquidity trap since the Fed funds target rate is still 1 per cent but the effective one is close to zero as the Federal Reserve has flooded the financial system with liquidity; and by early 2009 the target Fed funds rate will formally hit 0 per cent. Also, in deflation the fall in prices means the real cost of capital is high – despite policy rates close to zero – leading to further falls in consumption and investment. This fall in demand and prices leads to a vicious circle: incomes and jobs are cut, leading to further falls in demand and prices (a deflation trap); and the real value of nominal debts rises (a debt deflation trap) making debtors’ problems more severe and leading to a rising risk of corporate and household defaults that will exacerbate credit losses of financial institutions.

......
In the next few months, the flow of macroeconomic and earnings news will be much worse than expected. The credit crunch will get worse, with de­leveraging continuing as hedge funds and other leveraged players are forced to sell assets into illiquid and distressed markets, leading to further cascading falls in prices, other insolvent financial institutions going bust and a few emerging market economies entering a full-blown financial crisis.

The worst is not behind us: 2009 will be a painful year of a global recession, deflation and bankruptcies. Only very aggressive and co-ordinated policy actions will ensure the global economy recovers in 2010 rather than facing protracted stagnation and deflation.

http://www.ft.com/cms/s/0/0fe65a48-c0a9-11dd-b0a8-000077b07658.html?nclick_check=1

[Hawkowl]

1. Nail on the head

This guy gets it exactly right. His interpretation of events is classically textbook. I would say that 90% of economists would agree with his above article about the situation we are in.

If Obama can't get the government can't get their shit together in his first 30-60 days, we are probably looking at a three year recession minimum. In fact Obama needs to stop Paulson and Bush now. It is beginning to look like they are deliberately looting the treasury and purposefully destroying the economy.

Obama need to focus on preventing wages cuts (concessions)--a raise in the minimum wage is counterintuitive but probably necessary. Unemployment needs to stop increasing and foreclosures need to stop flooding the market. It would also help to force credit card companies to charge a reasonable rate and to stop them from cutting further lines of credit. When car sales drop 30% and foreclosures increase 100%+ year over year, and unemployment is climbing at the fastest rate since the great depression--radical with a capital R actions must be taken. If the US can't jump start demand and consumer spending the recession will be a depression. In fact, I think at this point depression is almost a certainty. Obama would have to move at light speed with radical reforms to prevent it--or reverse it. I just don't see it in him.

[natrat]

2. i don't see it either- they are not even pushing for oversight of the bailout

it's a scam by the predator class with all the politicians bought off

[chimpymustgo]

3. Sad, but true.