Credit Inflation or Debt Deflation?

The world never stands still.  It is either moving one way…or moving in another way. 

In terms of the macro-economy, the world is either experiencing a credit inflation…or a debt deflation. 

For the past fifty years or so the United States (and Europe) has experienced a period of credit inflation.  Now, with debt levels so high, there is a real possibility that the United States (and Europe) will experience a period of debt deflation.

The fundamental response of many is that the United States government must continue to “jack-up” economic stimulus and create even more dramatic extensions of the credit inflation that has put the United States in the position it now finds itself in. 

The still unanswered question in the current situation is whether or not credit inflation can continue to be extended or will it ultimately reach a position in which the economy is so saturated with debt that further credit inflation is unsustainable.

The further question that accompanies this question is whether or not we have currently reached the tipping point in which further credit inflation is unsustainable. 

If credit inflation cannot continue then debt deflation must take over…it is either one or the other.

The reason for this conclusion is that credit inflation…and debt deflation…are cumulative movements.  That is, credit inflation builds on itself…just as debt deflation builds on itself. 

The basis for credit inflation is that the creation of more and more debt in the economy exceeds the possible growth of the whole economy, in the aggregate sense, or exceeds the possible growth within a sector, in the case of bubbles like the housing bubble in the decade of the 2000s.

For the economy as a whole, the gross public debt of the United States government rose at a compound rate of growth of more than 8 percent over the past fifty years.  The real economy was able to grow at a rate slightly in excess of 3 percent.  This is the foundation for the credit inflation that took place over this time period.

The cumulative effect of the credit inflation can be seen in the increased risk-taking that occurred over this time period as actual inflation “buys out” dumb decision making through price increases.  Financial engineering prospers during such a time as financial institutions and business firms benefit from more and more financial leverage and the assumption of interest rate risk.  Furthermore, one finds financial innovation thriving during such times as more and more opportunities present themselves for the “slicing and dicing” of cash flows.  Finally, finance triumphs over manufacturing as companies devote more and more resources to financial transactions.  In the 1960s, who would have thought that General Motors and General Electric might, at some time in the future, earn more than two-thirds of their profits from their financial wings?

Private sector debt, depending upon the series used, grew at a compound rate of 10 to 12 percent over the past fifty years.

The cumulative build up of debt on balance sheets results in two things.  First, economic recoveries become weaker and weaker over time as more and more people fight to overcome their debt burdens in order to “get spending again.”  Second, the economy bifurcates into two groups, one that is over-burdened with debt, and, one that is in control of its finances.  As the cumulative effects of credit inflation pervade the economy, the proportion of people in the first group grows relative to the proportion of the people in the second group.  This change makes it harder and harder for the economy to recover over time. 

A recent article by Amir Sufi, Professor of Finance at the University of Chicago, titled “Household Debt Is at Heart of Weak Economy” (http://www.bloomberg.com/news/2011-07-08/household-debt-is-at-heart-of-weak-u-s-economy-business-class.html) makes this very point.  “From 2001 to 2007, debt for U. S. households increased to $14 trillion from $7 trillion, and the ratio of household debt to gross domestic product was higher in 2007 than at any time since 1929.”

William Galston writes on this dilemma in The New Republic (http://www.tnr.com/article/the-vital-center/91856/economy-recovery-foreclosure-housing-prices): “To understand the burden this imposes on households, let’s took at a key measure: the ratio of household debt to disposable income.  Between 1965 and 1984, the ratio remained steady at 64 percent.  Between 1985 and 2000, it rose virtually without interruption to 97 percent.  And then, it shot into the stratosphere, peaking at 133 percent in 2007.  Four years later it has come down only modestly…118 percent of disposable income.”

But, many businesses, especially small- and medium-sized ones, at in similar straights. 

How many commercial banks in the United States are going to fail or be merged out of business?

And, what about many state and local governments?

And, what about the federal government?

The start of this period of credit inflation began in the early 1960s.  The philosophy behind this period of credit inflation is Keynesian, although a corrupted Keynesianism because Keynes argued that the government should balance its budget over the credit cycle, creating budget surpluses during the “good times” to balance out the budget deficits that were needed during the “bad times.”  The “bastardized” Keynesian approach argued for continuous budget deficits to create higher and higher rates of economic growth. 

Robust economic recovery becomes harder and harder to achieve as the cumulative credit inflation continued.  The burden of the financial leverage built up in the past becomes heavier and heavier.  At some point, this burden becomes too great and the continued efforts of the government to inflate credit become unsustainable. 

Evidence that we have reached this point or are getting closer and closer to the point is abundant.  First, we see that the fiscal stimulus programs of the United States government have achieved very little over the past four years or so.  Second, the massive failure of the Federal Reserve to “jump start” the economy through QE1 and QE2 is also an indication that credit inflation may not be working at this time. 

If we are going to enter a period of financial de-leveraging in spite of the efforts of the government, what does this mean for the stability of the economy and financial markets? 

It means that there will be a fundamental restructuring of the economy.  Those people and businesses that have been financially prudent up to this point will prosper.  Those that have not still have a bunch of pain to go through.  There will be a substantial restructuring of industry as those that have will take advantage of those that don’t have.  Also, there is still a major restructuring to come of the banking industry. 

A period of restructuring means opportunities.  I see a substantially different America in the next five-to-ten years.  The goal is to identify where the opportunities are.