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.

What to Watch For in Early 2011

There are four situations in the financial area that require special attention in, at least, the early part of 2011. These situations pertain to the European debt problem, both sovereign and corporate, the problems being experienced by state and municipal governments in the United States, the problems connected with the rolling over of commercial real estate loans, and the consolidation that is taking place in the United States banking system.

The European situation seems to be the first out-of-the-box for the new year. Although most of the attention on Europe has been focused on the sovereign debt problem, the potential for problems to arise in the corporate sector should not be overlooked.

Europe cannot put its debt problems behind it because its leaders are not really facing up to the real problem. The real problem relates to the fiscal integration of the countries within the European Union.

As I have stated many times over the past year, a region cannot have just one currency if capital flows within the region are not restricted and if the political entities within the union continue to conduct their fiscal policies independently of one another. The European Union cannot be successful over time if it tries to maintain all three of these objectives.

Simon Johnson in “The Baseline Scenario” states that “Most experienced watchers of the eurozone are expecting another serious crisis to break out in early 2011. This projected crisis is tied to the rollover funding needs of weaker eurozone governments…” A solution will not be reached until the leaders of the European Union really face the fundamental facts of their crisis.

But, the sovereign debt of Europe is not the only concern. Although the corporate sector has been relatively successful in staying out of the limelight, concern is rising over what might happen here in 2011 if there are spillover effects coming from the “sovereign” sector. Especially worrisome is the amount of speculative-grade bonds maturing in the future and the potential number of defaults connected with the roll-overs. (See “Gearing up for 2011,” http://www.ft.com/cms/s/3/4b13a710-1363-11e0-a367-00144feabdc0.html#axzz19ypGKK7a.)

The second uncomfortable situation that is looming over 2011 is the fiscal soundness of many states and municipalities in the United States. Almost daily, new information comes out about the condition of our state and municipal governments, the cutbacks in police, firemen, educators, and social workers, the un-funded pension funds, and the labor unrest that is stirring because of the changes being proposed.

Bankruptcy is an issue. In some states, the bankruptcy of a municipality is unrecognized. For example, the situation in Hamtramck, Michigan is extremely bad, yet, the state of Michigan will not let the city declare bankruptcy. (See http://www.freep.com/article/20101205/NEWS02/12050500/Hamtramck-can-t-declare-bankruptcy-state-says.) Harrisburg, Pennsylvania and a host of other municipalities are just plugging holes attempting to avoid the worst.

But, many states are not doing much better.

And, the unrest in these areas continues to grow. However, this unrest is not just associated with the citizens losing services, the unrest is connected with the workers and the unions that are losing jobs and benefits. More than 50% of the union workers in the United States are in state and local governments so the potential conflicts with budget needs can be substantial. But, the times may be changing: “In California, New York, Michigan, and New Jersey, states where public unions wield much power and the culture historically tends to be pro-labor, even longtime liberal political leaders have demanded concessions—wage freezes, benefit cuts and tougher work rules.” (See http://www.nytimes.com/2011/01/02/business/02showdown.html?_r=1&scp=1&sq=public%20workers%20facing%20outrate%20in%20budget%20crisis&st=cse.)

Commercial real estate is another potential disaster area. For twelve months or more, commercial real estate loans have been on the list of major looming problems, in Europe as well as the United States. Yet, a crisis never seems to occur. One reason is that “banks on both sides of the Atlantic have been ‘ever-greening’ loans—or essentially extending the maturities, and practicing forbearance to avoid recognizing losses.” (See Gillian Tett, “Commercial Property Loans Pose New Threat”, http://www.ft.com/cms/s/0/c23e885e-1422-11e0-a21b-00144feabdc0.html#axzz19yRTp3ed.)

“Banks and borrowers have been able to conduct such ever-greening because interest rates have been rock-bottom low. But if rates rise, this ever-greening will be harder to maintain.”

Tett concludes with something we all need to keep in mind: “while a sense of peace might have returned to parts of the financial system in the past two years, this has only been achieved by virtue of government aid—and rock-bottom interest rates.”

As I have said over and over again, Federal Reserve policy has been aimed at achieving “a sense of peace” so that banks and others could work out of their debt problems: so that the FDIC could close banks in as quiet an environment as possible. And, some participants believe that the reduction in the size of the banking system will still be in the 1,000s over the next four or five years.

The question remains: has deleveraging taken place by a significant enough amount so that we can declare the bank crisis over?

The first three situations described above indicate that the deleveraging still has a ways to go and that as this deleveraging takes place the banks, in both the United States and Europe, could face further stress. There is certainly concern “out there” that the problems in the banking sector are not over. See, for example “Banks Pushed Together in a Wave of Deals,” http://professional.wsj.com/article/SB10001424052748704774604576035732836200772.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj, and “Bailed-Out Banks Slip Toward Failure,” http://professional.wsj.com/article/SB10001424052970203568004576044014219791114.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.

In terms of closing banks in an orderly fashion, another problem has existed: the FDIC has just not had the resources to act as quickly as needed to fully deal with those banks that are seriously facing financial difficulties. Thus, even in troubled banks, “ever-greening” is a methodology for keeping the doors open because this buys time and “who knows what might happen” if a bank can keep open. “There’s just not enough manpower and coordination to catch all these failing institutions at once.” For more on this see “Hard Call for FDIC: When to Shut Bank,” http://professional.wsj.com/article/SB10001424052970204685004576045912789516274.html.


I am not saying that it is a sure thing that we will face eruptions in these four areas in 2011. And, I am not saying that these four situations are the only ones to be looking at during the year. It is just that the problems that exist in these four areas have not been resolved and will have to be resolved at some time in the future for the economic recovery to really pick up steam. The interesting times are not over.