In memory of Dr. Andreas Höfert

Beware of corner solutions

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Falling commodity prices, 1Q 2013 growth rates slightly worse than average and retreating inflation rates: all have coincided to awaken the deflationist camp. According to these people, recession could be just around the corner. And where there is a recession, a depression and market crashes are often not far away.

A strategist colleague from a competitor expressed this in a recent note to clients, “The unfolding recession accompanied by full-blown deflation will result in a loss of investor confidence that central banks are able to prevent a Japanese-style deflationary event.”

In the same vein, Nouriel Roubini, also known as “Dr. Doom” and “one of the rare economists who saw the financial crisis coming,” told CNBC a couple of weeks ago, “Stocks aren’t in bubble territory as yet, but a huge rally in risk assets over the next two years puts markets in danger of a big crash. […] When gravity sets in, there will not be a recession but a depression.”

Despite all this sobering deflationist noise, the hyper-inflationist camp has not been quiet, either. A little more than a month ago, David Stockman, former director of the Office of Management and Budget in the Reagan administration, concluded an open editorial in The New York Times with, “The United States is broke — fiscally, morally, intellectually — and the Fed has incited a global currency war […] that will soon overwhelm it.”

Investors could still buy either a ranch in Montana or a former missile silo in Kansas, each equipped with running water, some cattle, an assault rifle, a Bible and a pair of pit bulls. But before considering such extreme actions we could also take a step back and think.

The 2007–08 financial crisis can be seen as the most important since the 1930s. It is well known that after a financial crisis of this magnitude, the return to normality is protracted. It is characterized by very low growth, due to the deleveraging of the private sector, so a succession of recessions is a high risk. Also occurring is a massive increase of public debt, which at some stage later will have to be addressed, probably also through higher than-normal inflation.

Don’t get me wrong. I am not at all an optimist. The world is still in bad shape, especially in the peripheral countries of Europe. That said, expected lower growth and higher inflation over the next decade don’t need to be embedded in end-of-the-world scenarios that range from the Armageddon of depression to the hell of hyperinflation. A painful healing process is likely a better description.