Everything seems topsy-turvy! It would be, would it not, if central banks burn the midnight oil printing money but the world is gripped by deflation? Billionaire businessman Warren Buffet, the Oracle of Omaha, warned long ago that the derivatives market was heading for financial catastrophe; now he has done it again. On March 9th he told CNN that the "US economy has fallen off a cliff"; it must be all upside-down as it plunges to nowhere. And Bloomberg TV’s gorgeous female announcers chant that we ‘Can’t see the bottom’, making my forlorn soul cry out: ‘When, oh when can we see it!’ Yes, the global economy is in uncharted waters, none has a compass, no bottom is in view. Wall Street, as we have known it for decades is gone, the investment banking system as we knew it is gone, there is a new ball game in town and the rulebook is still being written.

According to the text books, if you print loads of money and allow interest rates to plummet, then you are courting disastrous inflation. The US Troubled Assets Rescue Programme threw $700 billion into the melee in September 2008. Weeks ago Obama obtained Congressional approval for a $787 billion stimulus package and on March 23rd Treasury Secretary Geithner laid out his $500 billion public-private partnership plan to use a part to neutralise toxic assets. The Chinese are injecting $585 billion into stimulus and the Bank of England will inject £75 billion ($105 billion) over a 15-week period. All over Europe the name of the game is the same though the scale differs. Then, on March 19 the Fed announced that it was pouring an incredible $1.2 trillion into US Treasuries ($300 billion), mortgage backed securities ($750 billion) and bonds of government owned companies ($100 billion). In laymen’s language this means printing money like there is no tomorrow (new cock-and-bull jargon, ‘Quantitative Easing’). This should be carnival time for the demons resident on Mount Inflation. And look at interest rates - US 0.25%, UK 0.5% (the lowest since the Bank of England was founded in 1694), Japan 0.1% (negative real interest rates has been the BoJ Governor’s job description for decades), and low or historic low rates across Western Europe. Now in theory this should have the inflation demons dancing wildly atop Mount Improbable.

No! What do we see? A trend towards deflation in America (a 2 to 3% deflation rate forecast for second half of 2009), and also in Germany, France, Italy. In the Eurozone dis-inflation, that is inflation slashed down to 1.1%, is forecast. Indeed all across Western Europe, except the UK where they are still importing inflation, the expectation is near deflation. And now real deflation in China - the February 2009, year-on-year Chinese inflation figure, has just been released; it is -1.6%. In Japan deflation has been as common as chopsticks since 1990. Firstly, all this does not make sense and secondly, what does deflation do to an economy?

The second question first. Deflation is bad for debtors and good for creditors. Debtors on fixed interest rate loans have to continue servicing debts but the value of the underlying assets (houses, businesses, stocks) are declining. In the worst case it leads to what is incongruously called ‘debt deflation’. It should in fact be called debt escalation because what is meant is that the loan remains unaltered in money terms and ability to service it becomes onerous as economic conditions worsen, but the market value of the underlying assets (houses, businesses, stocks) decline; hence net worth turns negative.

Deflation also signals an unwillingness of consumers to spend, and of entrepreneurs to invest in new businesses; it is the sure sign of an economic downturn. Despite low interest rates people hoard cash, they save for fear of the morrow, they don’t trust the government and they have no confidence in the economy.

Why deflation and not inflation?

A key to understanding the prevailing financial climate is to unravel why despite these huge cash injections the threat of deflation, not inflation, clouds the landscape. There are huge debts out there (toxics, as they are called these days), and there are huge leveraged commitments out there. People are desperately disposing of assets to pay off debts and cover leveraged positions and this is driving down asset values relentlessly. This will go on until a large part of this rot is wiped out.

A simple example of what leverage means may help lay readers. If I have a million and borrow nine million from the bank (leveraging) to buy stock, and then the value of the stock plummets to five million, where do I stand? Not only have I lost my million but am also four million in debt to the bank even after disposing of my stock. I then have to dump all sorts of other assets to try to cover my positions; otherwise bankruptcy looms. Banks become similarly desperate if many customers and businesses can’t pay up. How is the bank to face those it borrowed from, whether investors or other banks? It is a spiral; as asset values fall, people need to dump, which makes asset values fall further. Snowballing bankruptcies drive the financial system into free fall, credit is refused, terrified consumers and investors back off, demand declines and deflation hits with cruel force. It can end only when bad debt is wiped out by default, bankruptcy, government guarantees for toxics, nationalisations, and pouring out newly minted money. When the scale of the problem is as monumental as it is today - maybe there is $100 trillion in problem debts out there - it takes years to clean out.

Conventional economic wisdom is that eventually the chickens will come home to roost; that is, massive inflation will arrive because of the excess liquidity being created. But my gut feeling is that this will not be the case; the severity of the collapse in the financial and real economies is so extensive, and the recovery will be so slow, that older recession-recovery pathways and theories are no longer relevant. What is needed now is more, not less stimulus (Long live Keynes!) to shore up falling demand. Eventually, inflation will pick up, but slowly, and can be managed by rising production and monetary and fiscal controls. My Marxist caveat, of course, is that all this is conditional upon capitalism, with a sumptuous dose of state-capitalism, recovers its global status. Exploration of other options must await another piece which I will undertake later this year.

The turn of events in China is likely to be a different because of the huge size of its undeveloped domestic market, China’s intrinsic industrial strength and the astronomically large foreign reserves the People’s Bank is sitting on. Chinese financial banks are intrinsically strong and not exposed to the toxic, leveraged, derivatives and other decoctions that are now the staple poison of the Western financial sector. Nevertheless, it is true that the sudden drying up of American and European markets has sent shockwaves through the Chinese economy. Foreign trade, both exports and imports, have plunged in the last two quarters. Nearly 20 million migrant workers have been thrown out of work, thousands of factories have closed in the south and the east and house prices have declined sharply as buyers back off.

However, because of the basic strengths of the economy it will be possible to rev up the domestic market and turn production inwards to compensate for a contracting external sector. This will also have the benefit of improving living standards of ordinary citizens, a matter long neglected by Chinese Stalinism for reasons too complicated to explain here. Premier Wen Jiabo insisted at National People’s Congress on March 5 that an 8% growth rate will be achieved in 2009 (down from 13% in 2007 and 9% in 2008) and government will boost spending on healthcare and other social programs and take steps to offset rising unemployment. China has the ability to stimulate powerful growth in the domestic economy and meet these objectives; the challenges though should not be underestimated. Chinese consumers will not relax their penchant for saving, nor begin spending freely, until they see this social security net firmly in place. So the ball is still in the government’s court.

We do not hear much about the ex-Soviet countries so a few comments may interest readers in Lanka; more interested readers please visit Eastern European Economy Watch at:

http://easterneuropeeconomy.blogspot.com/.

The recession is hurting Eastern Europe and hurting bad. Many economies are shrinking and expectations are that in 2009 Latvian GDP will fall 12%, Ukrainian by 10 to 20%, Hungarian by 6%, and so on; overall GDP in this bloc will shrink by over 3% this year. The problem is not just falling output but deep trouble in the banking sector and collapsing currencies. In the halcyon days of post-communism Eastern Europe borrowed, and the West lent with gay abandon. Now many banks and governments in the region are hoist with their own petard; they can’t pay. Many West and Central European banks, especially Austrian banks, are in deep shit. This is a part of the world to watch with anxiety in the coming years.

I am afraid the prognosis for developing countries - including Lanka - is not good. Foreign Direct Investment in all ‘emerging economies’ worldwide was $900 billion in 2007 and fell to $400 billion in 2008; Bloomberg estimates that in 2009 this will further decline to $160 billion. The financial crisis is estimated to have wiped out about $50 trillion in global asset values, a disproportionately large $10 trillion in Asia. Foreign capital flows and remittances held up Lanka’s external economy for years, but the former in likely to decline significantly this year.

Prices of copper, aluminium and minerals in general have fallen by two-thirds of their value; so it is not going to be good times for mineral sands, rubber and tea either. In the Philippines export earnings have declined 41%. De Beers says diamond prices are down 30% - what fate awaits our collapsing gem industry? Our export markets including garments are going to be battered, but unlike giants like China we have no foreign reserves (our external assets are zilch) and the government has neither ability nor policy to create a thriving domestic economy.

The fall in oil prices will help bridge the trade deficit. Therefore, overall, the estimated $4.4bn trade deficit in 2008 will decline to about $3.5bn in 2009. But this is still massive. Our precarious foreign reserves will continue to evaporate; only the rate of decline may be a little mitigated. Lanka’s short term debt foreign debt to foreign exchange reserves ratio, has risen to about 500 to 600% (up to date data is impossible to come by); this is absolutely horrendous. That’s why they sent Cabraal, cap in hand, to the IMF, two weeks ago.