Steve Bain

What is Reflation in Economics?

The term reflation is used to refer to a process of boosting the rate of economic output after a recession (or slow growth period) that has caused the inflation rate to fall below its target level.

This may be achieved either by an expansion of the money-supply combined with lower interest rates, or by a fiscal expansion of increased government spending (or lower taxes), or by both monetary and fiscal measures together.

During reflation periods, there is often extra activity on the stock market as investors pile into those stocks which are expected to perform relatively well as a result of the stimulus packages. These sorts of trades are called reflation trades.

In this article I will explain how the Federal Reserve Bank's reflation policies since the 2008 financial crisis have affected the economy, and what dangers lie ahead. 

The Great Reflation

In the aftermath of the 2008 financial crisis, the major financial institutions of the western world were in danger of collapsing due to insolvency. In the years prior to the crisis the banks had extended vast amounts of credit to consumers, primarily in the form of mortgage lending. The result of this was that prices in the housing and real estate sectors ballooned, as consumers piled into the market.

Many home-buyers had been desperate to get on the property ladder due to fear of being priced out of the market altogether if they were to wait. In other cases, the persistent rising prices in the market (up to the crash) had encouraged some people to fund lavish lifestyles by simply remortgaging their homes to release the equity that they had built up.

However, by 2007 it was clear that a very large bubble market had inflated and was about to pop. That created a huge problem for the banks, because the mortgage loans that they had extended were in many cases bad debts i.e., lots of borrowers were simply defaulting on their repayments.

The defaults happened either because people had lost their jobs and couldn't afford their mortgage repayments, or because the value of their homes was plummeting below the price that they had paid for them and, rather than accept the negative equity, they decided to allow the banks to foreclose.

Whatever the reason, the mortgage-backed-securities that the banks held were collapsing in value, and that created a solvency problem for the entire banking system.

Rather than allow untold numbers of the banks to collapse, and thereby destroy a large part of the money-supply (which would likely lead to a new Great Depression), the politicians and central bankers decided to pump vast amounts of money into the banking system.

They did this by paying top dollar to buy all the worthless mortgage-backed-securities from the banks - effectively giving them free money to cover the losses from their reckless lending that led to the booming real estate market in the first place (the commercial banks are not wholly culpable though - the Fed should have increased interest rates way before 2008 in order to slow things down).

The free money handouts, which were termed Quantitative Easing (QE), started the reflation of the economy after the recession that followed the 2008 crisis. It came to be known as 'The Great Reflation'.

Reflation Trades

Along with all the free money that was given to the banks, the Federal Reserve and other monetary authorities of the world, wanted new regulations to prevent inflation from taking hold. Printing money is known to cause inflation if it gets into the wider economy, and QE had entailed massive amounts of money-printing.

To prevent this from creating inflation, the new regulations agreed at the Basel 3 accord included a provision to pay interest on reserves held at the central bank. This had the effect of deterring lending to the risky private sector, because the banks could instead earn interest on all the free money that they had been given, simply by keeping it in their accounts at the Federal Reserve. This is sometimes referred to as a reverse-repo.

While much high-street lending had been deterred, mortgage lending once again took off since it was once again considered to be low risk 'secured' lending. At the same time, the financial asset market started to explode higher as financial intermediaries borrowed from the banks and poured money into speculative stocks and shares.

These stock market trades were a form of reflation trades. They were heavily weighted towards 'growth stocks' i.e., stocks that were considered to have a lot of growth potential even if their current earnings were low. By 2020 a veritable frenzy of buying had led price-to-earnings ratios to explode higher as investors sought to profit from the new 'everything bubble' that had developed in the equities market.

However, all these reflation trades were exposed by a new crisis that hit the economy after the Covid-19 global pandemic. The government response to the pandemic had been to enforce lockdowns, thereby destroying the supply-side of their economies. At the same time, massive stimulus checks were sent out to people in order to fund ongoing demand. The inevitable result was rapidly rising inflation.

At the same time that the lockdown stimulus policy was driving inflation to historical highs, confidence in the financial assets markets collapsed. Major investors in the reflation trades after 2008 were caught cold, the most notable being Cathie Wood's Ark Invest asset management company, whose ARK Innovation ETF collapsed by more than 60% over the course of 2022.

Reflation vs Deflation Ahead?

At the start of 2023 the economies of the western world appear to be riding the crest of a wave that is about to come crashing down with devastating effect. The only question relates to the nature of the coming crash.

On the one hand, if our governments and monetary authorities stick to their plan of beating inflation, a deep recession and a rise in unemployment looks likely. The problem then is that tax receipts will fall, making the already enormous government budget deficit even larger.

Plugging the gap in the public finances will either require more borrowing, or drastic cuts to government spending.

Extra borrowing would mean even higher debt levels, which will require much higher interest rates to entice lenders to buy government bonds. Higher interest rates will then require increasingly larger debt repayments, and the debt repayments are already unaffordable.

Demand destruction would have to become so severe that deflation and a new Great Depression would be the inevitable end result; making the value of the national debt even higher in real terms. A liquidity crisis would also emerge, as banks find that the loans they have made are being defaulted on, meaning that the money-supply would contract sharply. Eventually this leads to a 'debt death spiral' where no interest rate, no matter how high, will be acceptable to lenders because a default by the government would become inevitable.

The other option, of drastically cutting government spending, would similarly lead to a collapse of aggregate demand that would then mean even lower tax receipts in future. That would then require even less government spending and so on as a downward spiral takes hold. Essentially, this is just another way of ending up in a new Great Depression.

On the other hand, if our governments and monetary authorities abandon their fight against inflation, and pivot too soon by lowering interest rates and printing more money, reflation will quickly bring a return to rapidly rising inflation (and ultimately hyperinflation if this option is pursued long enough).

If the fight against inflation is abandoned too soon, which I believe is the more likely option, the collapse of the global monetary system would likely ensue. That's because it leads to a different type of spiral whereby the only way to fund the government and service the ever-expanding national debt is to keep printing ever larger amounts of money.

Fiat currencies would lose value faster and faster, and a sound money alternative would have to be found. It is unclear at this point what that sound money system would look like, but time will tell!

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