Worldwide Supply-Demand Imbalances, Inflation/Deflation Risks, and Feedback Loops

There's been many calls for hyperinflation or high inflation, particularly from libertarians and others who don't like the Fed (but not everyone who doesn't like the Fed, including me). These statements are usually highly politically motivated comments by people who have no idea of basic balance sheets--as I've addressed before. I'm just writing this initial part to point out that not only are such calls complete nonsense, but worldwide inflationary risks are effectively at all time lows--with a few countries like commodity exporters/LDCs and Japan being exceptions.

As I've pointed out in my economic and geopolitical posts about China, it's China that's driving the demand for the world's commodities. We're seeing Chinese growth rates come down sharply and they're not going up any time soon. In other words, we're likely to see commodity prices plummet. What does this mean? It means that countries who use commodity prices as inputs are likely to get a benefit by seeing deflation on the supply side.

We're also likely to see falling energy prices as we see capacity and production levels collapse across the world. Natural resources used for energy are economic inputs in production, so falling production levels and expectations of falling production levels will place downward pressures on energy prices. Energy importers will see a boost while countries with excess capacity or those heavily reliant on exports (particularly commodity or energy exports) will get hit very hard. Although we live in a world with excess capacity and little demand, the falling production levels will only end up pushing worldwide demand even lower.

This brings up the next question: why would falling production levels cause falling demand?
As I stated, increases in supply create increases in demand, but not necessarily increases in net demand. If the supply corrects very sharply towards the downside, all of the demand that was created by the excess supply will correct. However, it is very important to notice that even though supply and demand could (and probably will) fall sharply together, net demand will go up because of how sharp the correction would be. Simply put, production and consumption will fall, but production will fall faster than consumption.

It's also important to note that, in many countries, the kind of demand increases that we've seen are exactly the kind of demand increases that we don't need. The kind of demand increases we've seen (particularly in countries like China) have come because of sharp, unsustainable increases in capacity. As you increase capacity and supply, it's natural for demand to increase as well since the increase in production (productive or not) results in more workers to produce whatever is being produced. In other words, you do get an increase in demand, but it's net demand that the world needs--not demand stemming from unsustainably rising capacity.

Example(s):
If we take the United States as an example in the Great Depression, we see how sharp this correction can be. In 1920's, the US had the highest trade surplus in history at around .6% of GDP and accounted for around 36% of the world's GDP. From 1929-1933, US NGDP fell by almost 50%. That's how these kind of corrections can occur--although the US case is an extraordinary example.

To put this in perspective, China accounted for around .5% of the world's trade surplus in the 2000's while China currently accounts for <12% of the world's production. The current investment boom in China is unprecedented in both scope and scale. China no longer runs as large trade surpluses as it used to, but it effectively replaced the export model by sticking shovels in the ground to put up high rise condos. The sharp increase in investment fueled much of the commodity price boom over the past decade or two, which has caused a massive increase in private sector debt. China has effectively turbocharged investment by massively increasing bank lending to finance this ridiculous investment boom (see my economic post on China for more details).

Note that it's very possible China won't correct the same way the US did in the 30's (sharply and quickly). I think there's a good chance China corrects in a slow and orderly manner with very low growth rates over the course of 15-25 years--like we saw Japan correct after the 90's.

Inflation Risk:
Basically, we're in a situation where falling production levels put downward pressure on input costs. In most of the world, we're likely to see falling input costs combined with stalling (or falling) demand. How are we likely to see higher inflation? The reality is that we're not. If anything, we live in an extremely deflationary world.

There could be particular countries that may experience cost push inflation (like Japan or commodity exporters), but the world as a whole is in the midst of a deflationary scenario that we haven't seen anything like since The Great Depression.

Feedback Loops:
The world is littered with excess capacity and very little demand. Every country in the world has been trying to simultaneously boost production at the exact same time while there's no demand that can sustain the current production levels. In other words, most of the countries in the world are effectively stuck in situations whereby they've been locked into certain policies that have created feedback loops. In order to sustain the rising worldwide gap between production and consumption, we've seen massive increases in the real debt burden that has created a worldwide boom. We've seen a positive feedback loop, but debt cannot rise faster than debt servicing capacity forever. In other words, what we're seeing will correct.

Not only did we see a feedback loop on the way up, but we're also likely to see a feedback loop on the way down. Falling production levels will lead to falling real demand and the massive debt burden will no longer be able to keep growing. We will see massive bankruptcies (both private and public) that will put downward pressure on demand and capacity. Falling capacity will place further pressure on worldwide aggregate demand. Just like we had a feedback loop on the way up, we'll have a positive feedback loop on the way down.

All of the countries that "rose" together (these are primarily, but not necessarily, countries that have tied themselves to China) will fall together. A slowdown in one country will cause a slowdown in the other, which will again create another feedback loop. These feedback loops will, in all likelihood, continue until some event causes a shift. That event could range from a sovereign restructuring to revolutions to a war to a whole bunch of other possibilities.

Note: None of what I'm saying applies to commodity exporters. As I've previously written, these countries could actually see inflation because collapsing worldwide aggregate supply and falling demand (stemming from the falling supply) will reduce the demand for commodity prices as commodity prices will (and have been) falling. The capital inflows that came from the explosion in commodity prices in these countries has been reversing and I suspect that trend will continue. The capital outflows from these countries will put the currencies of these countries under pressure. On top of this, these countries will (and have been) experience falling production while consumption costs could very well increase from the depreciating currency causing rising input costs.

Note #2: Up until around 2007-08, much of the world's capacity was sustained by large increases in debt in order to finance consumption. In particular, this applies to the US. Due to the nature of the boom (a relatively decentralized consumption boom), debt capacity constraints are reached relatively quickly to prevent the boom from getting too out of hand. The year 2008 marked the moment that the US consumer could no longer borrow in order to consume much of the world's excess capacity (primarily coming from China).