Interview with Paul Kasriel
There has been a raging debate on Silicon Investor, the Motley Fool, Minyanville, and nearly everywhere else too about whether or not it is possible for a Japanese style deflation to happen in the United States. Almost everyone denies the possibility outright.
Because most people writing about or discussing this issue do not have a background in economics (myself included), I asked Paul Kasriel Sr. V.P. and Director of Economic Research at The Northern Trust Company for his thoughts on deflation in Japan vs. deflation in the US. We also had a brief follow up phone conversation after I received his email response. What follows is an email from Kasriel as well as a synopsis of our phone interview. These conversations took place on December 7th and 8th 2006 with one followup question over the weekend.
No, this is NOT a spoof as was An
email from Bernanke.
This is the real deal.
Email from Paul Kasriel
Japan experienced a deflation in recent years because the bursting of its asset-price bubble in the early 1990s created huge losses in its banking system. The Japanese banks had financed the asset-price bubble. When it burst, the debtors could not keep current on their loans to the banks and therefore were forced to turn back the collateral to the banks. The market value of the collateral, of course, was less than the amount of the loans outstanding, thereby inflicting huge losses of capital to the Japanese banks. With the decline in bank capital, the Japanese banks could not extend new credit to the private sector even though the Bank of Japan was offering credit to the banks at very low nominal rates of interest.
Banks are an important transmission mechanism between the central bank and the private economy. If the banks are unable or unwilling to extend the cheap credit being offered to them by the central bank, then the economy grows very slowly, if at all. This happened in the U.S. during the early 1930s.
U.S. banks currently hold record amounts of mortgage-related assets on their books. If the housing market were to go into a deep recession resulting in massive mortgage defaults, the U.S. banking system could sustain huge losses similar to what the Japanese banks experienced in the 1990s. If this were to occur, the Fed could cut interest rates to zero but it would have little positive effect on economic activity or inflation.
Short of the Fed depositing newly-created money directly into private sector accounts, I suspect that a deflation would occur under these circumstances. Again, crippled banking systems tend to bring on deflations. And crippled banking systems seem to result from the bursting of asset bubbles because of the sharp decline in the value of the collateral backing bank loans.
Hope this helps,
Paul L. Kasriel
Sr. V.P. and Director of Economic Research
The Northern Trust Company
50 South LaSalle Street
Chicago, IL 60603
I was fortunate to catch Paul for a brief phone interview after I received that email. Here it is.
Mish: Would you say that consumer debt in the US as opposed to the lack of consumer debt in Japan increases the deflationary pressures on the US economy?
Kasriel: Yes, absolutely. The latest figures that I have show that banks' exposure to the mortgage market is at 62% of their total earnings assets, an all time high. If a prolonged housing bust ensues, banks could be in big trouble.
Mish: What if Bernanke cuts interest rates to 1 percent?
Kasriel: In a sustained housing bust that causes banks to take a big hit to their capital it simply will not matter. This is essentially what happened recently in Japan and also in the US during the great depression.
Mish: Can you elaborate?
Kasriel: Most people are not aware of actions the Fed took during the great depression. Bernanke claims that the Fed did not act strong enough during the great depression. This is simply not true. The Fed slashed interest rates and injected huge sums of base money but it did no good. More recently, Japan did the same thing. It also did no good. If default rates get high enough, banks will simply be unwilling to lend which will severely limit money and credit creation.
Mish: Do you have any comments regarding Greenspan?
Kasriel: Greenspan is a fascinating study. Some day I hope to write a book about him. Right now I willing to say he is the luckiest Fed chairman in history.
Mish: Greenspan is the luckiest Fed chair in history? How so?
Kasriel: He was fortunate in two very big ways. First off, he was fortunate to preside over the economy at a time when productivity was soaring and the global supply of goods was expanding rapidly because China had entered the world trading arena. In that environment the Fed could create large amounts of money and credit without causing inflation other than in asset prices.
Mish: Does that mean you believe that inflation is a monetary phenomenon related to increases in money supply and credit as opposed to rising prices?
Kasriel: Yes, and that is exactly why Greenspan was so lucky. Inflation was masked by the factors we just mentioned.
Mish: I am very glad you said the word "masked". I have used that word for quite some time but most just do not get it. What is the second way Greenspan was fortunate?
Kasriel: When the Fed slashed interest rates to 1%, the U.S. banking system was capitalized well enough to be willing and able to relend the cheap credit it was being offered by the Fed. This stimulated housing. Housing provided jobs. With jobs and with rising real estate prices people felt confident to borrow and banks felt comfortable to lend.
Mish: How does inflation start and end?
Kasriel: Inflation starts with expansion of money and credit. Inflation ends when the central bank is no longer able or willing to extend credit and/or when consumers and businesses are no longer willing to borrow because further expansion and /or speculation no longer makes any economic sense.
Mish: So when does it all end?
Kasriel: That is extremely difficult to project. If the current housing recession were to turn into a housing depression, leading to massive mortgage defaults, it could end. Alternatively, if there were a run on the dollar in the foreign exchange market, price inflation could spike up and the Fed would have no choice but to raise interest rates aggressively. Given the record leverage in the U.S. economy, the rise in interest rates would prompt large scale bankruptcies. These are the two "checkmate" scenarios that come to mind.
Mish: Thanks Paul. When you do your book on "The Luckiest Fed Chairman in History" please send me a copy. I am sure it will be a best seller.
Kasriel: Will do.
Well I hope that puts to bed two ideas
- That it is impossible or nearly impossible for the US to suffer Japanese style deflation
- That slashing interest rates to 1% will matter one iota if it happens.
It should also put to bed (but probably won't) the distinction between inflation (a monetary event) and prices.