Here’s what Nouriel Rubini says about deflation:

Deflation is dangerous as it leads to a liquidity trap: nominal policy rates cannot fall below zero, so monetary policy becomes ineffective. Falling prices mean that the real cost of capital is high and the real value of nominal debts rise, leading to further declines in consumption and investment - and thus setting in motion a vicious circle in which incomes and jobs are squeezed further, aggravating the fall in demand and prices. 

The simple way I like to think of deflation is that falling prices keep people from spending money unless absolutely necessary because they become confident that they can get more for their money later.  This leads to the perfectly rational notion that holding cash is good. The perception of the high value of cash leads to a vicious circle of lower revenues and lower prices. The same principle holds for investments; cash becomes a rational alternative to stocks and to any bonds that are perceived to entail risks. 

Rubini was the most negative economist going into the current downturn, which makes him the most correct.  A full commentary on his expectations going forward is below.    In sum, he expects a horrible economy in 2009 with a risk of deflation but with the possibility that aggressive government actions taken around the world could save us from that.

I suppose the best indication of whether the world will fall into deflation or not will be the action of the stock market.  If it tanks below its November 20th lows and keeps heading south then it probably is signaling a multi-year period of deflation during which one does want to be in cash.  

If it can stay above those lows (which are about 15% below the current market levels) and perhaps work higher, and the longer it does that, then it is signaling that the worst has been seen.  If that is the case then in general one would want to go back into the water.   I suppose the best stocks to own will be those good companies that have been hurt the most.  An example, and one that I own, is TBSI, a shipping company with a unique high-service-component profile that is less impacted by the Baltic Dry Index than are bulk carriers. 

Obviously there are many other beaten down stocks, not least Citibank and other banks.  I expect that reforms to the regulatory system and simple market damage will vastly erode the “shadow banking” alternatives to real, government- regulated and deposit-guaranteed banks.   So the banking business should be pretty good in the next upturn. 

Will oil stocks be among those that react best on the upside if the economy has bottomed?  Perhaps so.  But a substantial glut in spare oil capacity is building, particularly with the more optimistic outlook for Iraq. So I suspect the price of oil itself will not obtain $100 plus levels for some years after the economy bottoms.  Thus oil stocks will begin to discount somewhat higher oil prices quickly.   But I doubt the bounce in oil stocks will be quite as robust as the bounce in stocks of companies that are more sensitive to an economic recovery. 

The question is whether the next upturn will come before a fall into deflation occurs.  In addition to watching stock prices to get an early reading on that question, I will continue to scan the data environment in the hope of finding some signals that might be useful.   Feel free to contribute your own observations on the deflation outlook, dear readers.  And Happy New Year.

Rubini’s full comments are below:

NEW YORK - Global financial markets in 2008 experienced their worst crisis since the Great Depression of the 1930’s. Major financial institutions went bust; others were bought up on the cheap or survived only after major bailouts. Global stock markets fell by more than 50%; interest-rate spreads skyrocketed; a severe liquidity and credit crunch appeared; and many emerging-market economies staggered to the International Monetary Fund for help.

So what lies ahead in 2009? Is the worst behind us or ahead of us? To answer these questions, we must understand that a vicious circle of economic contraction and worsening financial conditions is underway.

The United States will certainly experience its worst recession in decades, a deep and protracted contraction lasting about 24 months through the end of 2009. Moreover, the entire global economy will contract. There will be recession in the euro zone, the United Kingdom, Continental Europe, Canada, Japan, and the other advanced economies. There is also a risk of a hard landing for emerging-market economies, as trade, financial, and currency links transmit real and financial shocks to them.

In the advanced economies, recession had brought back earlier in 2008 fears of 1970’s-style stagflation (a combination of economic stagnation and inflation). But, with aggregate demand falling below growing aggregate supply, slack goods markets will lead to lower inflation as firms’ pricing power is restrained. Likewise, rising unemployment will control labor costs and wage growth. These factors, combined with sharply falling commodity prices, will cause inflation in advanced economies to ease toward the 1% level, raising concerns about deflation, not stagflation.

Deflation is dangerous as it leads to a liquidity trap: nominal policy rates cannot fall below zero, so monetary policy becomes ineffective. Falling prices mean that the real cost of capital is high and the real value of nominal debts rise, leading to further declines in consumption and investment - and thus setting in motion a vicious circle in which incomes and jobs are squeezed further, aggravating the fall in demand and prices.

As traditional monetary policy becomes ineffective, other unorthodox policies will continue to be used: policies to bail out investors, financial institutions, and borrowers; massive provision of liquidity to banks in order to ease the credit crunch; and even more radical actions to reduce long-term interest rates on government bonds and narrow the spread between market rates and government bonds.

Today’s global crisis was triggered by the collapse of the US housing bubble, but it was not caused by it. America’s credit excesses were in residential mortgages, commercial mortgages, credit cards, auto loans, and student loans. There was also excess in the securitized products that converted these debts into toxic financial derivatives; in borrowing by local governments; in financing for leveraged buyouts that should never have occurred; in corporate bonds that will now suffer massive losses in a surge of defaults; in the dangerous and unregulated credit default swap market.

Moreover, these pathologies were not confined to the US. There were housing bubbles in many other countries, fueled by excessive cheap lending that did not reflect underlying risks. There was also a commodity bubble and a private equity and hedge funds bubble. Indeed, we now see the demise of the shadow banking system, the complex of non-bank financial institutions that looked like banks as they borrowed short term and in liquid ways, leveraged a lot, and invested in longer term and illiquid ways.

As a result, the biggest asset and credit bubble in human history is now going bust, with overall credit losses likely to be close to a staggering $2 trillion. Thus, unless governments rapidly recapitalize financial institutions, the credit crunch will become even more severe as losses mount faster than recapitalization and banks are forced to contract credit and lending.

Equity prices and other risky assets have fallen sharply from their peaks of late 2007, but there are still significant downside risks. An emerging consensus suggests that the prices of many risky assets - including equities - have fallen so much that we are at the bottom and a rapid recovery will occur.

But the worst is still ahead of us. In the next few months, the macroeconomic news and earnings/profits reports from around the world will be much worse than expected, putting further downward pressure on prices of risky assets, because equity analysts are still deluding themselves that the economic contraction will be mild and short.

While the risk of a total systemic financial meltdown has been reduced by the actions of the G-7 and other economies to backstop their financial systems, severe vulnerabilities remain. The credit crunch will get worse; deleveraging will continue, as hedge funds and other leveraged players are forced to sell assets into illiquid and distressed markets, thus causing more price falls and driving more insolvent financial institutions out of business. A few emerging-market economies will certainly enter a full-blown financial crisis.

So 2009 will be a painful year of global recession and further financial stresses, losses, and bankruptcies. Only aggressive, coordinated, and effective policy actions by advanced and emerging-market countries can ensure that the global economy recovers in 2010, rather than entering a more protracted period of economic stagnation.

Nouriel Roubini is Professor of Economics at the Stern School of Business, New York University and Chairman of RGE Monitor (www.rgemonitor.com), an economic and financial consultancy.

This entry was posted on Wednesday, December 31st, 2008 at 11:08 am and is filed under The Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.