In his Thoughts from the Frontline newsletter of December 2, John Mauldin wrote:
Given the deflationary pressures that are the natural result of a recession and deleveraging/default, they can print a lot of money without igniting too much inflation.
In this case, “they” refers to the European Central Bank, which under its new President Mario Draghi seems to have redefined its mission to include fighting deflation as well as inflation. But the interesting point here is a more general one: Is default deflationary?
Mauldin rightly points out that: “If the problem were one of liquidity, then this week's action would be enough. But the problem is solvency. The majority of European banks are insolvent. They own too much debt of sovereign countries that are going to have to reduce their debts.”
Every liquidity problem does not involve solvency, but every solvency problem does, at some point, involve liquidity. The coordinated central bank action of November 30 dealt effectively with an immediate liquidity problem. The only solution to the solvency problem is a large write-off of sovereign debt in the PIIGS countries that will, in turn, require the reorganization of most large European banks.
Although the trade organization for those who have written credit default swaps has said with a straight face that the Greek cram-down on their sovereign debt-holders is not a default requiring the members of their organization to make good on their contracts, this is unlikely to be more than a negotiating position in the inevitable lawsuits by those who bought the credit default swaps. The coming write-offs from the rest of PIIGS won't even have the patina of a “voluntary” write-down to avoid payment. Because the payments are so large relative to assets and equity of the banks in question, it looks like widespread defaults by both the now-unprotected purchasers and now-insolvent issuers of credit default swaps will be the order of the day.
Which brings us back to the original question: Is default deflationary? In Mauldin's Endgame: The End of the Debt Supercycle and How It Changes Everything he makes it clear that he expects deflation before inflation, a position shared by Gary Shilling in The Art of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation and Robert Prechter in Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression. To these authors, default is another form of deleveraging, and therefore deflationary – and deflation is not avoidable.
And on the superficial numbers, they seem right. The world has far too much debt. If it has to be repaid, the burden will slow economic growth for Shilling's decade or more. If.
I take a more behavioral approach in my book, Survive the Great Inflation: How to Protect You Family, Your Future and Your Fortune from the Worst Fed Regime Ever. I contend that Fed Chairman Ben Bernanke is an expert on deflation and an avowed enemy of deflation, and will do everything in his power to prevent it. His power includes an unlimited checkbook, right up to the day people and governments refuse to accept the U.S. dollar for goods and services. Those who say: “The Fed is out of bullets” take the chance of facing a central bank firing squad any day that, as we learned on November 30, has many bullets left, indeed.
Furthermore, I believe that one of the biggest of those bullets is sovereign defaults because a default extinguishes debt. Deflationary pressures come from debts, interest rate burdens and the austerity required to pay the interest and reduce the debt. As demonstrated repeatedly, most recently by Iceland, default relieves deflationary pressure faster than trying to repay the debt.
In the short term, default could be termed deflationary because it takes the coming decade of deflation and packs maybe three years of it into one. That deflationary pressure can be offset by printing money. But with the debt gone, the deflationary pressure dissipates relatively quickly, the money printing can slow down to a sustainable level, and the formerly insolvent country becomes solvent. Compared to the alternative of trying to pay off the debt or inflate it away, default is a faster, less inflationary solution to the solvency problem. I suspect default is a major arrow still in Bernanke and Draghi's quiver.
As for a bank that holds too much European sovereign debt, or one that sold credit default swaps to those who do, there is general agreement that the most efficient way to deal with them is the Norwegian or Scandinavian approach: Wipe out the shareholders and bondholders by nationalizing the bank, split the assets into a good and a bad bank, and take the good bank public as quickly as possible. The bad bank has no other function but to liquidate the assets at the best available prices and be done with it. The Norwegian taxpayers made money on the deal.
Following the quote that opened this article, Mauldin wrote: “I just don't see how they can do so without seeing the valuation of the euro fall rather smartly.”
If he were measuring the value of the euro against precious metals, commodities, real estate, stocks or other assets, he would be right. But the value of the euro in the basket of currencies need not decline at all, because the dollar and the yen may well be falling at the same rate.
Bernanke will be backstopping the European Central Bank through both announced and unannounced means, including U.S. participation in the International Monetary Fund, and at the same time printing enough money to cover the failure of the “Too Big To Manage” U.S. banks that wrote the credit default swaps.
The Japanese will continue to blatantly massage the value of the yen to protect their export industries, as they assess whether it is even possible to rebuild from the tsunami and its nuclear meltdown aftermath.
The euro need not fall relative to the dollar and yen at all, because they, plus the tied-to-the-euro Swiss franc, are the bulk of the currency basket.
Welcome to the topsy-turvy world of default economics, in which we are all likely to learn many interesting lessons directly ahead.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.