During the last few months, investors have been focusing on prospects for an economic recovery. Equity markets have rebounded strongly from the March lows, long-term bond yields have risen—together with inflation expectations—and commodity prices are well up since the beginning of the year.

But what if this is a false dawn? What if, despite government attempts to inject cash into the global economy, the downturn intensifies and prices continue to fall?

While a deflationary outcome for the major world economies likely will remain a minority view, it’s worth investigating in detail what signs might suggest that this is starting to be a concern, and how an exchange-traded funds investor should position his or her portfolio in such an environment.

Is Deflation Really Possible?

It’s difficult to believe that deflation can occur in a monetary system where central banks control the supply of currency. As U.S. Federal Reserve Chairman Ben Bernanke said in a famous 2002 speech, “the U.S. government has a technology, called a printing press, that allows it to produce as many U.S. dollars as it wishes at essentially no cost … we conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

Nevertheless, some economists assert that Bernanke’s understanding of the monetary system is faulty, and that falling prices are indeed possible, even likely. Followers of Irving Fisher (who wrote the “Debt Deflation Theory of Great Depressions”) and Hyman Minsky’s Financial Instability Hypothesis, they argue that the overall amount of private and public sector debt in the financial system has become fundamentally destabilising, and that we’ve passed the peak in the debt accumulation cycle. From here on, they point out, central banks’ attempts to reflate the bubble will be overwhelmed by the much larger forces of deleveraging—attempts by individuals, corporations and eventually also by governments, to reduce their levels of indebtedness.

In a recent interview with IndexUniverse.com’s sister publication, ETFR, Australian economist Steve Keen suggested that a warning sign that central banks’ reflationary attempts are failing would be given by a falling money multiplier—the ratio of broader measures of the money supply to base money (reserves held by banks with the central bank). Any such fall in the multiplier would tell us that banks are failing to use the cash pumped into the system by the government to expand their own lending.

What does the evidence show? In the US, the M1 money multiplier fell dramatically in the fourth quarter of last year and has remained at historically low levels.

Actual inflation statistics show that most G7 economies are already in deflation.

The latest year-over-year change in the consumer price index was -1.3% in the US, -0.1% in the Eurozone, -1.1% in Japan and -1.1% in the UK’s retail price index (though the consumer price index in Britain, which excludes the cost of mortgage payments, remains in slightly positive territory).

1 | 2 | 3 |