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Tom Armistead
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I am a retired accountant, having spent the early years of my career in the insurance industry and the later part in the field of accounting. My insurance experience has given me the willingness to accept investment risk if I feel the return justifies it; also, an interest in applying risk... More
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  • Looking at Debt-Deflation Theory  8 comments
    Sep 29, 2011 10:07 AM

    Economist Irving Fisher won lasting fame by his assertion that markets had reached a permanent plateau on the eve of the Crash in 1929. Personally he was all in, on margin, and was ruined.  After thinking about it for three years, he produced an explanation, "The Debt-Deflation Theory of Great Depressions." 

    The basic premise is that excessive debt destabilizes the system, which reaches its tipping point when everybody attempts (or is forced) to deleverage at once.
    This results in a death spiral where real debt increases faster than it can be paid, due to unleashing deflation.


    My mother was a college student in Chicago at the onset of the Depression, and prevailed on her parents to stay there, rather than retreating to the lower cost rural area they had come from.  Afterwards, it developed that the money spent surviving for a while in Chicago would have seen them comfortably through the Depression.  Mom explained it to me pretty carefully, how deflation wiped out debtors, and made creditors rich. There was something in the tone of her voice, it sticks with me, and I dislike borrowing money, and dread deflation. 

    Greece has been given a strong dose of austerity by its Eurozone creditors, producing a debt-deflation of sufficient severity that the country will not be able to repay its debts. Fiscal and monetary policy in the US should be run along lines that will preclude a debt-deflation spiral here. 

    Fisher discusses instability at some length, likening the economy's balance to a ship, that is normally stable and rights itself when tipped.  However, when it hits the tipping point, it becomes unstable, and capsizes. He does not mention it, but the passengers rushing from one side of the boat to the other exacerbates the problem.

    Much of modern economics rests on a theory of equilibrium, with supply and demand in balance. The system is self-correcting, so the theory goes, and its workings should not be tampered with.  A completely free market is the ideal.

    The Invisible Hand and The Gospel of Greed 
    This is driven by Adam Smith's invisible hand. Smith came from a time and a background where a certain degree of morality and behaving in the common interest was assumed to be normative behavior. In no way did he espouse the gospel, that greed is good, and that greedy men, each striving for their own gain, regardless of the consequences for others, will naturally produce prosperity for all.

    Buying Into the Theory

    In the wake of the GFC, much of Fisher's theory has made its way into common knowledge, or common assumptions, for the fact that it intuitively makes a lot of sense, particularly in the light of recent experience.  Hyman Minksy developed similar concepts, and the "Minsky moment" is used to describe the point where the ship capsizes.
    Where do we go from here?

    The situation in the US doesn't seem to be at a tipping point, in that DSR and FOR are back at levels last seen in the early 90's, and declining rapidly.  US government debt is still easily serviced, given the flight to safety interest rates.  However, the actual level of household debt, as compared to the cost to service it, is still very high.
    As far as the Greek debt crisis, the EU members are starting to talk in ways that make sense, the German assertion that a 50% haircut may be necessary implies an understanding of the toxic debt-deflation caused by excessive austerity in that country. To make it go away, the debt has to be cut to a level that can be repaid. It is entirely possible that after thinking about the results in Greece they will work towards a muddle through scenario of Italy and Spain.  Also, there is a growing acceptance that the banks will have to be recapitalized, the debate is now about how much. So that situation is now developing along lines that may prevent debt-deflation from cutting in throughout the zone.

    As an investor, I feel that the most likely outcome is an eventual dose of inflation, given the Fed's considerable efforts to flood the system with liquidity. I've done some work that suggests that as interest rates rise, to about the point where the 10 year treasury yields 5% or even 6%, equity prices will also rise. 

    Thinking along those lines, I plan to hold my long positions unhedged, on the grounds that a recovery is more likely than a death spiral. I do plan to keep following macro events, and if the situation changes I will have to review my thinking.

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Comments (8)
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  • expatsp
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    Comments (304) | Send Message
    Thanks for this update, Tom, and for correctly citing Adam Smith!


    A dose of mild inflation is the only logical outcome. I live in Brazil and can tell you, 4-5% inflation (as the U.S. had in the Reagan years) is no big deal. You can still grow quickly, people borrow and invest, etc.


    Of course, if we see a President Perry and Bernanke gets lynched, logical outcomes may be off the table for a time.


    29 Sep 2011, 11:28 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6300) | Send Message
    Author’s reply » I lived through the inflation of the late 70's and early 80's where Paul Volcker finally brought it down by pushing interest rates up to like 16% or 18%. The last few years were hell, I got to where I was spending money as fast as I could, spend it before it goes down.


    But something in the 3% to 5% area really helps, mortgages go down slowly but the value of your house increases fast enough to where you build up equity. It's like a certain amount of debt is necessary, in order to do things like buy a house (or a decent car) and if you have inflation coming along behind and reducing debt in real terms it cleans up the debt and makes it more manageable.


    Politicians and office holders get their knowledge of economics and their guidance on policy sometimes from think tanks, the right has more of them than the left, but they all have an agenda. I used to wonder, what is Larry Summers telling Obama...
    29 Sep 2011, 11:46 AM Reply Like
  • The Last Boomer
    , contributor
    Comments (1080) | Send Message
    I highly doubt the possibility of inflation. The fact that the Fed flooded the system with liquidity does not necessarily mean that there will be inflation. There is big demand for holding money balances and the velocity of money has slowed down a lot. The central bank has barely kept up with this process by providing more money. Overall, credit has contracted. Quote from Jason C:
    "The private financial sector has been contracting at epic rates - in the US, down $3.3 trillion overall and continuing to contract at a $1 trillion annual rate as of the 2Q of 2011. Expansion of government debt and central bank financing has barely matched this shrinkage. Total debt out has not moved at all in 3 years. Not up, not down, hasn't moved. For every dollar issued by the Fed, the banks have destroyed one repaying their own outstanding obligations. For every dollar of debt governments have issued as new financial assets, financial firms have retired a dollar of their own debts.


    And this is a change from the normal state of things, which is for broad total credit outstanding to rise every year by around $1.5 trillion, if not more."


    The battle between deflation and inflation is still unresolved but the bad thing is that the Fed has become too passive lately ensuring that further down the road we may have more money destruction than creation.
    29 Sep 2011, 12:12 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (6300) | Send Message
    Author’s reply » TLB,


    I'm still struggling with the implications for monetary policy, can't subscribe to the idea that the system needs another $1.5 trillion of debt, on an annual basis.


    My impression is that the liquidity made it into commodities and pushed them around for a while, hardly helpful, and it didn't even count as core inflation. Even as we speak some of it is being deployed in betting against the Eurozone. The money is in the wrong hands, somehow.


    I'm starting to wonder if raising interest rates would be helpful, just tell the market that rates are going up 0.25% a quarter, and make it happen.


    That, or the other idea which is anathema to free market ideologues, is set up some kind of minimal regulation, outlaw naked CDS, apply a financial transaction tax, aimed specifically at short term traders, the shorter the hold, the higher the tax, cut commodities futures markets down to what is necessary to support hedging, etc. Make all the speculative money do something useful, or at least stop manipulating the markets.
    29 Sep 2011, 12:59 PM Reply Like
  • jimmy46
    , contributor
    Comments (1817) | Send Message
    The basic premise is that excessive debt destabilizes the system, which reaches its tipping point when everybody attempts (or is forced) to deleverage at once."""""""""


    My belief is that all recessions are caused by excessive debt and at some point it becomes obvious that a fair portion will NOT be paid off.
    This causes others to retrench.


    As for Fisher, in 1929 people could buy stocks with just 10% margin.
    As stocks went down, margin calls went out fast and furious and caused a vicious spiral down.
    The Fed gov learned a small lession there,
    require at least 50% margin on stocks.


    Too bad they didn't extend the idea to housing.
    When people had to put 20% down the market was stable,
    when banks started doing wraps where a person could have
    80% 1st mortgage and 20% 2nd. = zero down


    The result was a bubble with a Trillion dollar cost.
    And very high unemployment in the construction industry.


    As a saver, I don't like inflation, and the idea that 3-4% inflation every year compounded is good repels me.


    I think it just leads people to go into debt thinking inflation will bail them out, which is generally true, but puts the entire country at risk.
    And for what?
    So borrowers can profit at the expense of savers?


    That's what got us into this mess.
    29 Sep 2011, 04:50 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (6300) | Send Message
    Author’s reply » jimmy,


    There is somebody profiting at the expense of savers, but borrowers (as a group) may not be the offenders, more likely it is banks. For those who want FDIC insured security, you can't get any kind of a return at all on a CD, it's a crime.


    We have people who qualify for mortgages by any reasonable standard, but can't get approved. Meanwhile there are people out there with high rate mortgages that can't get refinanced. So the banks resist loaning out money at the lower rates, and refuse to pay depositors anything at all by way of interest.


    It gets down to real rate of return. After inflation, even at 2%, you could lose money investing in a CD or even 10 year treasuries.


    It looks to me like the government, or the Fed, is picking the winners, and it seems to be the banks, as a reward for getting us into this mess. Banks appear to have profitted at the expense of both borrowers and savers, if that is possible.
    29 Sep 2011, 05:16 PM Reply Like
  • 1987 wise
    , contributor
    Comments (16) | Send Message
    I think each major segment of our economy experiences the pain of de-leveraging in their own way. You may complain that bank policy is too greedy or unwilling to lend, but banks are under financial and regulatory pressure too. After all, if banks are financially strong, why are their stock prices so low? If the USA was alone in its debt problem, we could easily inflate our way out. However, most of the world shares in the problem of high debt. In this environment, I think it is impossible for the Fed to inflate in a sustained and controlled manner. They might be able to cause a short duration, inflationary panic, probably leading to unintended consequences, but I don't think they can increase the productive demand for more goods and services. Its the same old problem of pushing on a string.


    Nor do I think Gov't spending will increase domestic demand for goods and services. The economists I follow say that a dollar of Gov't spending today produces only about 60 cents of GDP. That kind of spending just increases the deficit. To get out of this economic ditch, Gov't must induce private investment into productive work. Gov't must create at least $1.40 in GDP for each $1 spent. How? The most bang for the buck is reduced regulation in ways that really matter. The second way is a streamlined tax policy that incentives productive investments. Its still true that the more you tax something, the less of it is going to be produced.
    7 Oct 2011, 03:53 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6300) | Send Message
    Author’s reply » 1987,


    I would be curious to see the names of the economists you follow, to see their data and the reasoning behind the assertion that 1 dollar government spening produces 60 cents of GDP.


    On regulation, I would remind you that our banks were in point of fact completely deregulated when they issued the debt which led to the GFC. Nobody stopped them, or checked anything they did, or offered any opposition to the orgy of greed. Adequate prudential regulation would have prevented the GFC.


    As far as taxes, the simple fact is that over any sufficiently long period of time government must take in as much in revenue as it spends on goods and services. And the types of goods and services to be used or provided by the government are a matter to be determined by a majority of voters in a democratic society. We the people have to agree on how much we want from government, and then agree on how it will be paid for.


    I believe that Financialism is the cause of our problems.


    The Business Revoluation That's Destroying the American Dream, Ed Hess, Forbes
    Financialization: What It Is and Why It Matters, Thomas I. Palley, The Levy Economics Institute
    Financialism: A Lecture Delivered at Creighton University School of Law, Lawrence E. Mitchell
    Jungle Ethics Financialism vs. Free Market Capitalism, Tom Armistead, Seeking Alpha


    Try locating and reading the items listed, you may come to the same conclusion.
    7 Oct 2011, 05:13 AM Reply Like
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