Debt Deflation: Is It a Possibility?

There is still too much debt around.  The fact that there is too much debt around is a result of fifty years of credit inflation and financial innovation that resulted from it. 

The concern now as financial deleveraging takes place is whether or not we will go into a spiral of debt deflation.

The headlines currently are coming out of Europe.  Austerity plans are forthcoming everywhere.  Sovereign debt is the crowning issue…but there is growing concerns over corporate debt. 

And, with the cutback in government spending, the cutback in business spending, and the cutback in personal spending people are getting gloomier and gloomier about a new, European recession.  The clouds seem to be on the horizon.

But, a spillover of a European recession would be another American recession.  The United States depends upon the exports that it sells to Europe.  If Europe goes into a recession then the probability of the United States going into another recession increases. 

The problem is that America still has lots of problems on its own.  Just note some of the issues that have recently been floating around.

For one, corporate bankruptcies still are taking place on a regular basis.  Just recently we have Solyndra going bankrupt which brought attention to the solar industry area as a source of more financial difficulties.  Then we had Syms and its Filene’s Basement go into bankruptcy.  And, then who could forget MF Global.  And, there are many more still on the edge of considering such action…one of them possibly being Kodak.

And, what about the financially tenuous position of state and local governments?  Just Wednesday, Jefferson County, Alabama filed for the largest municipal bankruptcy in United States history.  And, Harrisburg, Pennsylvania was just taken over by the state of Pennsylvania because of its financial problems.  Now we learn that Flint, Michigan is on the verge of insolvency where the state government will takeover there.  And, what about Detroit, Michigan?  Again, the state is about to take over this financially distressed city.  And, there are many more still cities and states still on the edge of financial ruin with underfunded pension funds and so on.

Then we hear that mortgage problem is still not over and that banks are facing further write-downs of the mortgages on their books.   The latest case is that of HSBC which has garnered all sorts of attention over the past few days.   HSBC is still paying for its move into subprime loans earlier.  But, it is also facing a relatively new thing…a customer taking a mortgage payment “holiday.”  Given the political climate financial institutions are finding that people feel that they have very little to lose if they just stop payments on their mortgages.  Banks are finding it very difficult to foreclose on delinquent properties these days and that people fear little retribution if they just quit on any kind of payment to the bank. 

“Customers realized that if they stop paying, there’s very little we (HSBC) oar other banks can do.  This is an emerging trend.” (http://dealbook.nytimes.com/2011/11/09/hsbc-warns-of-economic-challanges-even-as-profit-rises-66/?scp=3&sq=julia%20werdigier&st=Search)

The commercial real estate market is not in very good shape either.  Although commercial real estate is picking up in some areas of the country, a look at the commercial banking data indicates that loans on commercial real estate is the item that is declining the fastest on the balance sheets of commercial banks…especially those that are smaller than the largest 25 in the country. 

Of course, these problems come through when we consider the condition of the banking system.  The commercial banking industry is still not very healthy yet and the prospect of it getting much better through 2012 is not that great.  Many small- and medium-sized banks are still really suffering. (http://seekingalpha.com/article/303929-business-lending-is-increasing-especially-at-the-largest-u-s-banks)

The Federal Reserve can’t really afford to tighten up at all because of the weakness that still exists within much of the banking system.  (See my post, “Post QE2 Federal Reserve Watch: Part 3” of November 7: http://maseportfolio.blogspot.com/. ) And, the FDIC still continues to close two banks per week and this does not include any banks that have been acquired and absorbed into other banks within the system.

The general desire within the economies of both Europe and the United States is to continue to shed debt…to de-leverage.  But, if this de-leveraging takes place at the same time that the economies of Europe and the United States go into another recession, the situation can become a cumulative one.  That is, de-leveraging can contribute to slower economic growth or even declining growth, which leads to more de-leveraging, which leads to even slower economic growth and so on.

This is a debt deflation.

We are not there yet, but, it seems as if we are edging closer to the precipice. 

The problem seems to be that this situation cannot be undone by fiscal stimulus.  If people want to de-leverage they will de-leverage.  Adding more debt to the situation, even government debt created through more government spending, does not help the situation as the “fundamentalist” Keynesian would like to think.  More debt implies more taxes in the future, which just adds that much more of a burden to the person trying to de-leverage.  And, maybe, this just adds incentives to the equation leading the individual to take a debt payment “holiday”.

But, more debt write-downs can cause more debt write-downs.  And, this is the problem of a debt deflation.  It can become cumulative.  And, this is something the Keynesian models cannot pick up.

And, writing down debt for some people just means that someone else has to “eat” the loss elsewhere…and then someone else has to take a loss…and so on and so forth.  The consequences of debt do not just go away. 

The dilemma: if fiscal spending is not an option and monetary policy is basically “spent”, what is there left to do?  Not much?  Is the problem of creating a situation where there is too much debt outstanding that you just have to wait until people work off the excess debt?

This is a conclusion that most people don’t like.

The United States Economy Will Continue to Grow

I believe, as I have written before, that the United States economy is recovering and will continue to recover. 

However, I also believe that “financial crises are protracted affairs.” (Reinhart and Rogoff, “This Time is Different”, page 224.)

Why don’t I believe that there will be a “double dip” recession, a 1937-38 depression like the one following the 1929-33 Great Depression?

In the case of the 1930s, there were policy errors committed that resulted in the 1937-38 depression: the most prominent one being the effort of the Federal Reserve to eliminate all the excess reserves being held by the commercial banks at that time so that the Fed would have more “control” over the money markets.

Unfortunately, the banks wanted those excess reserves around even though they were not in the mood to expand their lending activities.  As a consequence, when the Fed attempted to remove those excess reserves by raising reserve requirements, the banks cut back even more on their lending activities in an effort to achieve the financial protection they believed those excess reserves brought them.    

This has not happened in the current situation because Fed Chairman Ben Bernanke (a student of the Great Depression era) and the Fed have done just about everything possible to make sure that the banking system is flooded with excess reserves so that a similar contraction of the banking system does not occur.  There are questions about what this means for the future, but we are not at that future yet.

So, I believe that the economic recovery will continue.

The economic recovery, however, will not be robust.  One reason for this is the debt overhang that exists in the private sector.  David Brooks speaks to this point in his Tuesday morning column in the New York Times. (http://www.nytimes.com/2011/10/18/opinion/the-great-restoration.html?_r=1&hp) 

“Quietly but decisively, Americans are trying to restore the moral norms that undergird our economic system.

The first norm is that you shouldn’t spend more than you take in. After an explosion of debt over the past few decades, Americans are now reacting strongly against the debt culture. According to the latest Allstate/National Journal Heartland Monitor poll, three-quarters of Americans said they’d be better off if they carried no debt whatsoever. Not long ago, most people saw debt as a useful tool for consumption and enjoyment. Now they see it as a seduction and an obstacle.
 
By choice or necessity, eight million Americans have stopped using bank-issued credit cards, according to The National Journal. The average credit card balance has fallen 10 percent this year from 2010. Banks, households and businesses are all reducing their debt levels.”

This same phenomenon is occurring in the world of state and local governments, and the non-profit world.

How is spending going to expand within the context of this kind of behavior?

The general fundamentalist Keynesian response to this is that the federal government needs to do more to stimulate the economy.  The argument is that government spending actually needs to be much greater than is being proposed at the present time.  The people that are making this argument also state that the economic recovery in the 1930s was as slow as it was because the government did not spend as much as it should have back then.  Government expenditures will never be large enough for these people. 

But, how is more government debt going to change the picture?  As Reinhart and Rogoff state in their book, “the value of government debt tends to explode” (page 224) in the aftermath of any severe financial crisis anyway.   

The reason is that as incomes drop, tax revenues decline and the government deficit increases. 
But, greater deficits mean greater interest and principal payments in the future, and someone like Robert Barro argues that this will mean more taxes for the private sector in the future so that current savings will increase even further to offset this future obligation.     

Even if the private sector does not fully discount future taxes into their current spending plans, people may just accelerate their efforts to save to provide themselves with more flexibility to manage their financial affairs in an uncertain future world dominated by huge government debts. 

The problem that results from this scenario, in my mind, is that given the behavior of the Federal Reserve System there is lots and lots of cash floating around in the economy, but this cash is not in the hands of those people and businesses that are trying to restructure their balance sheets.  Because, this cash is not in the hands of those people and those businesses that are trying to restructure their balance sheets, the fundamental economic recovery will continue to be modest. 

Thus, you have lots and lost of cash looking for places to invest where there are very few “productive” places for the money to go.  So, money seems to be chasing assets.  However, the uncertainty seems to be causing other problems and this is resulting in increased market volatility. (http://professional.wsj.com/article/SB10001424052970203658804576637544100530196.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj)

“The problem is a lack of liquidity—a term that refers to the ease of getting a trade done at an acceptable price.

Markets depend on there being many offers to buy and sell a particular stock, across a range of prices. But as investors have gotten nervous, many of those offers have dried up. That is causing wider-than-normal gaps between prices showing where stocks can be bought and where they can be sold—the difference between the "bid" price and the "ask" price.

Many big investors, such as hedge funds and mutual funds, which at times can act as shock absorbers for trading because they tend to trade large chunks of stocks, have been on the sidelines. Some hedge funds, for example, say they're not trading as much until they know how much money their clients will withdraw at the end of October, a deadline some clients have to inform funds of intentions to redeem money at year-end. “

In my mind, the economic recovery is going to continue on its slow path.  But, given all the money around and given the general impatience that is attached to this money, wide swings in asset prices are going to continue well into the future, especially if the Federal Reserve really keeps interest rates as low as they are into the middle of 2013.

Patience is not an attribute of traders…and of politicians…but that is another story.

Struggling With A Great Contraction

Martin Wolf of the Financial Times recently returned from vacation.   It is interesting to see where this “top” economic commentator stands after taking off from his weekly writing for a full month. 

His view on his return: The major economies of the world are “Struggling with a great contraction.” (http://www.ft.com/intl/cms/s/0/079ff1c6-d2f0-11e0-9aae-00144feab49a.html#axzz1Wbu6HxQ0) His concern is not with the possibility of a “double dip” recession, but with something more sustained.  He asks, “How much deeper and longer this recession or ‘contraction’ might become.  The point is that, by the second quarter of 2011, none of the six largest high-income economies had surpassed output levels reached before the crisis hit, in 2008.”  Hence, the great contraction.

The turmoil in financial markets that was seen in August, he contends, tells us, first, that “the debt-encumbered economies of the high income-countries remain extremely fragile”; second, “investors have next to no confidence in the ability of policymakers to resolve the difficulties”; and third, “in a time of high anxiety, investors prefer what are seen as the least risky assets, namely, the bonds of the most highly-rated governments, regardless of their defects, together with gold.”

A pretty succinct summary…what?

There is too much debt around which means that all the efforts that governments are making to get the economy moving again face the up-hill battle of over-coming the efforts people, businesses, and local and regional governments are making to reduce their debts. (http://seekingalpha.com/article/285172-when-debt-loads-become-too-large)

While national governments deal with their own excessive debt loads and deficits, their central banks have responded with undifferentiated policies to flood banks and financial markets with sufficient liquidity in order to provide time for banks, consumers, businesses, and local and regional governments to “work out” their positions as smoothly as possible. (http://seekingalpha.com/article/290416-quantitative-easing-theory-need-not-apply)

The hope seems to be that “time will heal all things.”

Whereas there is too much deb around, there is too little leadership.  I will quote Wolf on this: “In neither the US nor the eurozone, does the politician supposedly in charge—Barack Obama, the US president, and Angela Merkel, Germany’s chancellor—appear to be much more than a bystander of unfolding events.” (http://seekingalpha.com/article/285658-if-the-economy-is-a-football-game-we-need-new-strategies)

If there are no leaders, then policy decisions tend to be postponed as long possible, and then, when a result is finally forthcoming, the outcome is more like a camel, something that appears to be an inconsistent piecing together of incompatible parts.

And, this is supposed to produce confidence?  To quote Mr. Wolf again: “Those who fear deflation buy bonds; those that fear inflation buy gold; those who cannot decide buy both.” 

The point being that it is not a time to commit to the future, to invest in real assets or investments.  Hence, the economies of the “high-income” nations stagnate, unemployment remains excessive, and public confidence continues to be depressed.   

Such a general condition argues for a continuance of the economic malaise and not a more robust recovery any time soon.  Hence, the great contraction.

Mr. Wolf still has hope: “Yet all is not lost.  In particular the US and German governments retain substantial fiscal room for manoeuvre…the central banks have not used up their ammunition.”  

But, this hope is based on the existence that leadership in these governments will arise.  Policy makers will come to their senses: “The key, surely, is not to approach a situation as dangerous as this one within the boundaries of conventional thinking.”  

Therein lies the problem.  Mr. Wolf is looking for the hero to ride in on her/his white stallion and provide the leadership necessary to clean up the mess and get things going forward on the right path. 

He has just argued, however, that that leadership does not seem to exist.  So, where is the leadership going to come from?

With all the debt loads outstanding, just how much can be done to overcome the drag on the spending and the economy coming from the efforts of many to de-leverage. 

The Federal Reserve and the European Central Bank have flooded the world with liquidity.  Their effort here is to give banks, consumers, businesses, and governments time to work out their bad debts.  This also provides time for banks and others to fail, consolidate, and/or raise capital without causing major disruptions to the whole financial system. Banks in the United States continue to fail, banks in the US and Europe continue to consolidate, and banks in the US and Europe continue to raise capital. 

Since debt seems to be the major problem here, the only other major suggestion that has been made that could relieve the credit crisis is to relieve debtors of some of their debt burden.  This would mean that some parts of the debt would need to be written off.  Whereas many have suggested such a program, the difficulty of creating such a problem is in the details and no one seems to have come up with any acceptable details of such a program.  Some have suggested that inventing such a workable and just program of debt reduction is nearly impossible.

So, we are back to square one…there are no “good” options.  And, when there are no “good” options, potential leaders tend to disappear into the woodwork.  It is easy to “lead” when you can create credit without end and encourage everyone to own a house and attempt to guarantee people jobs for their lifetime.  But, real leaders are the ones that can stand up and lead when there are no good options.

It is just that few want to be “out front” when none of the options are nice and comfortable.