Pondering Debt Deflation

Amid my recent difficulties (sickness, loss of my main computer, difficulties updating my blog software), I have been musing about the health of our economy going forward. Before I give my opinion, I want to share a range of views that I think are worth reading:

• China Institute Proposes Weaker Yuan to Boost Growth
• The Great Depression – Just the Facts, Ma’am
• Recession? No, It’s a D-process, and It Will Be Long
• The Chart That Changed the World — Wrong?
• More Than Two Aspirin
• Steve Keen’s Debtwatch
• No alternative to inflation
• How Government Created the Financial Crisis
• Hire Irving Fisher!

I admire the efforts that many are making in moving back to first principles. We see analyses from Classical, Austrian, Post-Keynesian, Minsky (nonlinear dynamics), and other perspectives.

My view remains that depressions result from a buildup of too much debt, including debt complexity. The recent analysis from Credit Suisse dissed adding together financial and nonfinancial debts, as there would be double counting. Let me first say that there is no good measure here, but the double counting in a complex debt economy is useful to see. When there is a chain of parties relying on debt repayment, like a set of dominoes, the system is fragile; one little jolt could change things for many.

Aside from that, our economy behaves like an economy in a depression. The banks lend considerably less. Corporations as a whole cut back as aggregate demand drops. People save more. Prices of asset ratchet down to reflect current buying power, which seems to be shrinking every day. The government replaces markets in the process of trying to save them. Protectionist pressures are global, as is the economic weakness.

I don’t find the actions of the Fed or the current stimulus bill to be very relevant to our crisis, because they do little to reduce our indebtedness as a percentage of GDP. In a credit-based economy, once the banks and consumers are stuffed full of badly underwritten debt, it is difficult for the system to clear until those debts are reduced / liquidated.

Comments

[patio:]

The country has a bad hangover, from decades of binging. It's time to stop drinking, go into rehab, and pay the piper. Companies and individuals are willing to do so, for the most part.
The government, being political, wants to "cure" the hangover by hair of the dog, which will only give us an eventual bigger hangover.
We haven't had a strong leader in so many years, that will stand in front of the American people and tell it like it is.

Feb 12 12:00 PM

[Jubilee Year:]

Nice analysis. Writing off debt is inevitable, either slowly or quickly. I believe nationalizing and writing them off quickly is the way to go.

Feb 12 12:02 PM

[levin70:]

David

I can't say that I have completely agreed with everything you have written in the past, but this article today is short, sweet and in my opinion totally on point. I also think that patio's hangover analogy is spot on.

The best government can and should do is be ready to roll out the safety net and do everything to not encourage protectionism. As i have noted elsewhere in 1939 the WMD count was zero. Today, its so large as to be able to destroy the world many, many times over. Take that off the table, but let the market work out the rest

Kind Regards

Feb 12 12:15 PM

[Dirk McCoy:]

Debt deflation has a few problems:

1. Cramming down banks requires breaking contracts- what does that say about rule of law?

2. Debt renegotiation requires all parties to negotiate, a time-consuming endeavor;

3. Bankruptcy "rewards" the worst offenders, while those who put 30% are punished;

4. Uneveness in this process creates future doubt about the ability for debt to be deflated.

The easier solution is to create inflation (reinflate) by monetizing the debt. This would slow price deflation, and quickly create price appreciation. As opposed to the above solution:

1. Contracts and rule of law can be maintained, albeit with some forebearance during the reflationary period, which is good business;

2. Instead of negotiations, debtors can just put their property for sale, with a reasonable chance to sell at a level to clear the debt;

3. Instead of rewarding jingle mail and bankruptcy, reflation would reward those who stick it out;

4. Inflation is a proven concept that applies across the market. If the solution to this problem really is less US consumption, more repayment of US debt, and more innovation to solve energy and health care challenges- people who aren't working and living on "fixed incomes" should be incentivized to spend less and get to work.

Feb 12 12:24 PM

[Speedspirit:]

I agee the system as a whole is broken. Those who think that we can mend it or rewrite the rules are only postponing the inevitable. Debts cant be paid and the domino effect has begun. The economy is behaving like we are in a depression because this is the start of the depression. The recession has been going on since 2005. The Federal Reserve is a instument of the power elite to contol the world economy and the people. If we look at history and who was it that benefitted from the first great depression, OH it was JP Morgan and friends. And right now who is screaming act fast and save us or else. The big banks owned by the British. And who will benefit the most. Not the American people, not any nations people but the POWER ELITE themselves. Conspiricy or phophesy call it what you want there are coincidences happening here.

Feb 12 01:07 PM

[Chris V:]

I'm not an economist, so if my ideas have some massive downside which I haven't considered, or a practical reason why they can't be implemented, it wouldn't surprise me. My ideas are driven largely by how I, as a consumer with a bit more debt that I'm really comfortable with, would respond to these ideas. These ideas necessarily involve, much like the ability to declare bankruptcy, a bit of moral hazard. But ultimately, I think our need collectively to get out of this mess is greater than the need to meet out punishment which is commensurate with guilt. So, on to the ideas (some of which are incompatible with one another):

1) Government-mandated wage increases (essentially, forced inflation). Simply put, the government mandates that all employers, public and private, increase salaries by, for example 1% per month for 18 months. This gradually increases income relative to (fixed rate) debt load. Cost of goods can be increased as necessary to cover the increased labor costs. We'd have to figure out a way to help retirees and others on fixed incomes so they don't fall further in the hole, though.

2) Cap interest rates on all debt at the rate of inflation plus 5% or so. This makes it possible to make some headway on debt rather than paying so much money to interest that people continually get further behind.

3) The government makes an offer to mortgage lenders: all usurious loans get converted into "reasonable", fixed rate loans, and all loans get a 20% haircut. In return, the government guarantees all loans. Mortgage lenders are free to take the deal, or to sit on assets of unknown value.

4) Print money, and give it to people. If it's good enough for "Helicopter" Ben, it's good enough for me.

Feb 12 02:47 PM

[phaf:]

Nice article-
One really interesting point- "When there is a chain of parties relying on debt repayment, like a set of dominoes, the system is fragile; one little jolt could change things for many."
Analagous to the entangling alliances that led to WWI and it's years of wholesale slaughter??

Feb 12 02:49 PM

[Dave Wrixon:]

Inflation is not a good idea, but it is a given.

How anyone can be bullish on the dollar just defies imagination!

Feb 12 03:01 PM

[Dirk McCoy:]

Dave, I have a couple questions, with my guesses (I can't claim to actually know, but who does):

1. How much excess supply capacity do you think we have in the US? That is, at 100% capacity, what could US GDP be? $16 Trillion? $18 Trillion?

How about $25 Trillion? Because I know alot of factories and service companies (check your local sports bar) that are operating well below 80%- and that's before any investment in expansion;

2. How many extra trillions would we have to "print" and send into foreigner's hands before they ran out of ideas on how to spend it? $2 trillion? $5 trillion?

How about $25 Trillion? Because if we can increase GDP by only $5 trillion per year, we could redeem that within 5 years, so to speak. Sure, we would consume much of it here, but foreigners wouldn't want to consume that much, and could spend much of it elsewhere- $100/barrel oil would soak up alot before being spent on, US steel, Florida real estate, and shares in US solar power companies.

Given the numbers currently being discussed are much lower- and, according to Mr. Bernanke, mostly sterilized- I'm not as surprised as you that the dollar has remained stable.

I believe the vast majority of the carry trade has already unwound- you'd think a forward looking market would have discounted its demise into the exchange rates by now.

Feb 12 04:44 PM

[Tony Daltorio:]

Another day-dreaming deflationist who says that the actions of the Fed are irrelevant. In an economy with with fiat money, deflation can NEVER last for any long amount of time. What do you think the Fed will do when all else fails? They will print scads of phony money and pay off the debt. Debt will be 0% of GDP. Of course, the US dollar will be worth next to nothing.

Feb 13 03:02 PM

[Mr. Cynical:]

Wow. Thanks for Steve Keen's debtwatch. I just lost all the sleep I was planning on getting this weekend.

Feb 13 06:38 PM