Australia to join 1920 global bust rerun

Now that Australia has printed its first decent inflation number in ten years, the hysteria for rate hikes has built to a crescendo.  I now hope that the RBA hikes in May just to finish off the appalling Morrison Government.

Alas, that may be the price we have to pay because in panicking about inflation and heading into a tightening cycle all the RBA is going to achieve is to push Australia into the post-Spanish Flu 192o crash rerun that is playing out globally.

The Depression of 1920–1921 was a sharp deflationary recession in the United States, United Kingdom and other countries, beginning 14 months after the end of World War I. It lasted from January 1920 to July 1921.[1] The extent of the deflation was not only large, but large relative to the accompanying decline in real product.[2]

There was a two-year post–World War I recession immediately following the end of the war, complicating the absorption of millions of veterans into the economy. The economy started to grow, but it had not yet completed all the adjustments in shifting from a wartime to a peacetime economy. Factors identified as contributing to the downturn include returning troops, which created a surge in the civilian labor force and problems in absorbing the veterans; a decline in labor union strife;[3] changes in fiscal and monetary policy; and changes in price expectations.

There were two main forces at work in this depression. There was a degloblisation shock from the war underway that had triggered a major inflation spike leading up to the pandemic. Then the pandemic itself exacerbated these trends with an even larger supply-side shock.

The US FOMC responded with rate hikes of 225bps over the six months from the end of 1920 and the rest is history. Growth collapsed just as enlisted men flooded back into the civilian labour force. The result was a depression and spectacular deflation:

The similarities with today are striking. We have the same deglobalisation and post-pandemic supply-side tensions, with a war to boot.

The absence of a demobilisation labour supply shock is meaningful in terms of the possible outcomes but not decisive. Today’s economies are far more leveraged than in the early twentieth century and growth much more responsive to yields. So, labour markets will loosen more today they did in the 1920s given the same amount of tightening.

The absence of the positive labour supply shock may mean the policy error leads to a recession rather than a depression.

Nonetheless, with the RBA set to join the inflation and interest rates panic, the base case is now that Aussie yields derail the Australian economy right along with the rest of the world over the next year. If so, there will be a major property and equities bust and a likely recession, even as commodity prices crash globally delivering terms of trade shock.

Is this just the pain we have to take after overdoing stimulus in the pandemic? No, it is not. Any monetary economist will tell you that addressing supply-side inflation with a demand management tool is stupid.

Supply-side deflation will arrive in due course anyway and the RBA hiking into it is literally pushing the Australian economy off a cliff when it could be on cruise control through the global retrenchment.

Anyways, policy errors throw up great opportunities and the Australian version is now long-duration bonds as the curve first flattens then inverts while the RBA directs the economy into the bust.

Houses and Holes

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