The Deflation-Inflation Two-Step

The Big Crash dance, with the CNBC orchestra led by Ben Bernanke...

"HAPPY FAMILIES are all alike," wrote Leo Tolstoy in Anna Karenina, but "every unhappy family is unhappy in its own way," says Dan Denning in his Australian Daily Reckoning.

Today, let's look at the unhappy family of nations in Europe, and their coming family feud. Each is definitely unhappy in its way, too. Yet there is a common thread to the current state of economic melancholy – money.

Most failed marriages, we've heard, end up breaking up over money. Why would Europe or America...or Australia...be any different?

Greece's on-again, off-again bailout flirtation with the European Union is driving the market nuts. It's reality sovereign debt TV at its most dramatic. But what, really, is at stake? The European monetary family is in crisis. It meets on March 25th and 26th to discuss whether to kick Greece off the island (Survivor-style) or to intervene and save the prodigal son.

And the problem, from a German perspective, is that Europe is full of prodigal children. To save Greece means saving the rest of those economies troubled by rising public debt-to-GDP ratios. Where will it stop? With the trashing of the Euro. But is doing nothing an option?

The Greeks have already said they will meet with the IMF on April 2nd if Europe resolves nothing by the end of March. And in the meantime, bond yields on Greek debt are left twisting in the wind. Rising bond yields wipe out the benefits of austerity measures and deficit reduction. According to Bloomberg:

"The yield on Greece's 10-year government bond rose 12 basis points to 6.21 percent. The euro fell for a second day against the dollar, slipping as much as 0.7 percent to $1.3648. Credit-default swaps on Greek sovereign debt rose 7 basis points to 295, the highest in a week, according to CMA DataVision prices."

It's hard to imagine the Northern European powers hanging Greece out to dry. Families are supposed to look out for each other. You do more for your family when the chips are down than you do for most people in the world. But maybe Greece will spare Germany the hand-wringing and default on its own...just throw up its hands and shrug.

A willing default on sovereign debt is what Societe Generale analyst Albert Edwards expects. In a note to clients earlier this week Edwards wrote:

"Ultimately, as my colleague Dylan Grice writes, I think we head back to double-digit inflation rates as governments opt to default. I certainly again expect to see CPI inflation above 25% in the UK and indeed in most developed nations in my lifetime."

This is the old "asset-deflation-first-then-hyperinflation-later" two-step. It's the Big Crash dance, with the CNBC orchestra, led by Ben Bernanke, providing mellow tunes as you promenade your way to the lifeboats.

Edwards writes that:

"In the near term, however, the deflationary quicksand will suck us ever lower until we suffocate. A key driver for underlying inflation remains unit labour costs. While unit labour costs decline at an unprecedented rate, they are sucking us inevitably into a Fisherian, debt-deflation spiral. Only then will we see how far policymakers are willing to go to debauch the currency. Last year saw them cross the Rubicon. Monetisation is now the policy lever of first resort."

Some Daily Reckoning readers think we're trying to have it both ways on the inflation/deflation debate. But it is one of the issues you have to be flexible about.

So prepare for falling asset prices and a sovereign debt crisis. Then watch out as central banks reach out and take us to strange new monetary places...boldly going where Weimar Germany and Argentina have gone before.

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