Avoiding Global Deflation: Don't Rely on Keynesianism

Whichever way one tries to solve the global deflation problem, it is going to be very painful, but I think it is a high risk strategy to believe that a born-again Keynesian approach with massive fiscal stimulus measures can provide the solutions required for what are several deep seated structural and cultural problems.

The real problem is that too many households/companies are buried under a pile of debt. Getting people to spend money when they are fearful and are facing a debt hangover is not just a matter of firing up the “animal spirits”. What needs to happen, especially from a long term structural point of view, but also importantly from a short term psychological perspective, is that the massive debt overhang has to be worked off.

This can either take a long time (i.e. the lost decade in Japan) or it can happen more quickly if there are some innovative moves towards debt forgiveness.

A mechanism needs to be established which would allow mortgage holders and others mired in too much personal debt to consolidate and write down a portion of that debt without having to go through formal bankruptcy. Just like the auto companies, ordinary citizens and small entrepreneurs are reluctant to take on the stigma of a Chapter 11.

Banks and other large companies are allowed to re-structure and swap debt for equity; why not some similar and simple mechanism that allows individuals and small businesses to do the same? Essentially a framework needs to be devised that would enable one to wipe a part of the slate clean and in return grant some kind of future claim against one’s return to future prosperity.

This measure would also have the effect of mitigating a lot of flak from the prudent folks that have played by the rules and are getting angry about the constant parade of bail-outs, since those not suffering from too much debt and not seeking any forgiveness would not have to supply any piece of their future action and not be faced with an ever-mounting future tax burden.

Ultimately, global deflation, and especially that hovering over the US, will only be abated when the American economy has re-established affordability in the housing market. This will only happen when new buyers will be able to afford and qualify for new mortgages without having to factor substantial capital gains into their expectations of the cost/returns of purchasing real estate.

Comments

[Roger Knights:]

"a framework needs to be devised that would enable one to wipe a part of the slate clean and in return grant some kind of future claim against one’s return to future prosperity."

An excellent idea. How come no one in the mainstream -- or damned few, anyway -- is thinking along these lines?

2008 Dec 12 06:26 AM

[Danny Newton:]

"a framework needs to be devised that would enable one to wipe a part of the slate clean and in return grant some kind of future claim against one’s return to future prosperity."

Isn't that what bankrupcy is? I think they are looking for a mechanism that disconnects cause from effect and disaster from responsibility.

2008 Dec 12 09:46 AM

[Smarty_Pants:]

"a framework needs to be devised that would enable one to wipe a part of the slate clean and in return grant some kind of future claim against one’s return to future prosperity."

Sounds an awful lot like you are advocating a return to indentured servitude. Slavery-lite.

Only one problem is how do you enforce the terms on people who don't manage to make it back to future prosperity? Or those who don't even bother to try?

Where is the security for those who agree to write off (or 'invest' in) past debt in return for a part of future earnings when there is no collateral to fall back on in the case of unexpected injury, death, or outright fraud?

2008 Dec 12 09:54 AM

[Chris B:]

A high inflation rate for the next few years would reduce the burden of individual, business, and government debt, mostly at the expense of foreign creditors. In that way, Keynesean pumping of aggregate demand with the tradeoff of inflation may be the future. It has already begun. Note the 1% discount rate, open market sales, and $1T (and counting) in bailouts.

Key downsides include:

-reduced economic growth due to very high future interest rates.
-risk of capital flight, currency collapse, etc.
-wages are not likely to keep pace with prices.

In summary, look forward to a very austere future as a best-case scenario.

2008 Dec 12 02:46 PM

[morph366:]

Re comments from Smarty Pants

Where is the security for those who agree to write off (or 'invest' in) past debt in return for a part of future earnings when there is no collateral to fall back on in the case of unexpected injury, death, or outright fraud?

As suggested in the article the framework - admittedly it is no more than an idea in gestation at this point - would have to resemble a debt for equity swap. The point is not for the seriously indebted to swap one form of debt with collateral backing for another kind of debt. That's also why it is not as Smarty Pants suggests a form of servitude or slavery lite.
The replacement claim is a pure risk capital play as indeed all equity investments are.
The point that was being made can also be described as follows - Why should Joe the Plumber bear all of the risk for his own, and for that matter, the entire economy/banking system's, miscalculations about the soundness of the global economy?
Sure there will be a risk in taking a chance on some form of equity instrument that allows for participation in the possible future prosperity of lots of currently distressed individuals and small businesses, but how much worse would that be than seeing governments continuing to pile up mountains of inter-generational debt?

2008 Dec 13 05:16 AM

[{5U}:]

Well said.

Unfortunately due to the political climate we will be in a long period slowly letting the air out of the bubble instead of taking the necessary medicine.

This week's Barron's had an excellent article on the state of things:

online.barrons.com/art...

2008 Dec 13 03:47 PM