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Tuesday, December 04, 2007


the onset of deflation

i've spent a lot of time analyzing the depth of the problems with respect to american banking as a result of the tremendous credit bubble of 2002-2007. going forward, i do definitely expect the resulting unwind to be a major event, very probably a deflationary event that may last several years, forcing a severe recession in the near term and probably entailing significantly lower prices in equity markets from high valuation levels (indeed, in asset markets of all kinds).

but this is also not the end of life as we know it. it is an economic event of terrific magnitude, and may be significantly worse in degree and duration than many people expect, but perspective is important. to that end, here is a synopsis of a recent creditsights report, which relates to treasury secretary hank paulson's proposed rate-freeze.

As a coalition of originators, servicers and investors guided by Treasury Secretary Henry Paulson finalize a plan to address the subprime mortgage ARM reset problem, CreditSights believes that most big banks will be able to handle expected increased markdowns in the next five quarters.

To bring major lenders together and create a joint solution that provides near term relief remains highly significant, CreditSights says, especially in light of the roughly $450 billion of mortgages facing rate resets by the end of 2008. “Moreover, the reported involvement of MBS/ ABS investors (including the American Securitization Forum) also represents a meaningful milestone in our view as it seems investors are acquiescing somewhat with respect towards reducing the level of interest payments in securitization trusts rather than potentially forcing immediate foreclosure actions.”

CreditSights says it seems that this is the beginning of a legitimate “sharing of the pain” solution to a systemic failure of checks and balances in the mortgage originating/investing businesses.

With so many homeowners possibly forced to leave their homes in foreclosures, a flushing of the system solution does not seem practical at this point in our opinion. Still, we believe that despite these prudential solutions, that mortgage-related loan losses should continue.

there are still open questions here for citi, much less countrywide and washington mutual. but many major banks will -- in spite of devastating mark-to-market realities, if a collective workout is mustered, probably with a robust government bailout involved -- come through to the other side heavily damaged but intact. and of course the future is full of unforseen, unforseeable and unintended complications that may well compound american and global economic problems.

but the world has seen extended deflationary periods before. i'm currently reading charles kindleberger's 'financial history of western europe', and it recounts episodes such as 1873-1896 and 1914-1945 (deep depressions bracketing the boom of 1921-29) where dynamics such as these take hold:

The psychological aspect of deflation and depression cannot be overstated. When the social mood trend changes from optimism to pessimism, creditors, debtors, producers and consumers change their primary orientation from expansion to conservation. As creditors become more conservative, they slow their lending. As debtors and potential debtors become more conservative, they borrow less or not at all. As producers become more conservative, they reduce expansion plans. As consumers become more conservative, they save more and spend less. These behaviors reduce the “velocity” of money, i.e., the speed with which it circulates to make purchases, thus putting downside pressure on prices. These forces reverse the former trend.

The structural aspect of deflation and depression is also crucial. The ability of the financial system to sustain increasing levels of credit rests upon a vibrant economy. At some point, a rising debt level requires so much energy to sustain — in terms of meeting interest payments, monitoring credit ratings, chasing delinquent borrowers and writing off bad loans — that it slows overall economic performance. A high-debt situation becomes unsustainable when the rate of economic growth falls beneath the prevailing rate of interest on money owed and creditors refuse to underwrite the interest payments with more credit.

When the burden becomes too great for the economy to support and the trend reverses, reductions in lending, spending and production cause debtors to earn less money with which to pay off their debts, so defaults rise. Default and fear of default exacerbate the new trend in psychology, which in turn causes creditors to reduce lending further. A downward “spiral” begins, feeding on pessimism just as the previous boom fed on optimism. The resulting cascade of debt liquidation is a deflationary crash. Debts are retired by paying them off, “restructuring” or default. In the first case, no value is lost; in the second, some value; in the third, all value. In desperately trying to raise cash to pay off loans, borrowers bring all kinds of assets to market, including stocks, bonds, commodities and real estate, causing their prices to plummet. The process ends only after the supply of credit falls to a level at which it is collateralized acceptably to the surviving creditors.

"default and fear of default" following one of the most massive credit expansions in the history of mankind is where we are now, and it will be important to watch for signs in popular psychology of a developing deflationary mindset. it's also important to note that paulson's rate-freeze proposal amounts to restructuring -- the second sort of debt-retirement, better than default but also not repayment and still thoroughly deflationary. so, for that matter, is the other paulson proposal of the super-siv.

one can find a chart of deflationary years in the united states here. deflation was pervasive from 1814-1843, again from 1865-1896, and again from 1921-1937.

this 2005 edition of marc faber's newsletter further analyzes the inflation cycle and points to signs that the united states is at or past the point where asset class inflation gives way to consumer price inflation -- and is now verging on the final phase of the cycle, that of asset class deflation and currency devaluation working simultaneously to effect a debt repudiation. but as to outright deflation:

What if the deflationists are correct and a major asset deflation comes about as a result of tight money or a total debt collapse? I have to say that this major deflation is not very likely to occur in dollar terms. If we look again at Figures 1 and 10, we are left with the impression that with the inflated household net worth and a colossal debt as a percentage of GDP, the American Fed, which created this mess, will have no option other than to put the Bernanke & Co. money printing press in charge of a massive re-liquefaction of the system. Such extraordinary monetary interventions usually lead to extreme currency weakness, very high inflation and interest rates, a collapse of the bond market, and, at a later stage, to a collapse of society and the entire economic system. It is likely that in such an environment some sort of relative deflation of asset prices would occur, as consumer inflation and interest rates would rise and the smart money would move their funds out of the US.

i fail to understand how the united states government would be able to -- in a situation where narrow money supply (m1) is ~$1.4tn and base money stock is under $900bn but m3 plus credit is closer to $40tn and m3 plus bank credit plus government debt is near $50tn -- print enough cash to offset the unwinding of lending.

i cannot say faber is wrong; indeed, he is forecasting something similar to what the united states experienced between 1966 and 1982, where the financial system deleveraged and asset classes declined severely in real terms while maintaining modest nominal declines or even gains. i simply suspect that the federal reserve bank's electronic printing press cannot be used so effectively as to forestall a decline in both the broadest measure of money supply and the velocity of money such that deflation does not become a problem with debt loading so large as we now have -- a vastly greater proportion of gdp than in the late 1960s, as seen in faber's figure 10. in the early 1970s, m1 was about $220bn and m3 plus bank credit plus government debt was about $2.5tn -- a ratio of about 11 times. today that ratio is 36 times, or over three times higher.

at some point, it seems to me, a critical mass of debt is accumulated beyond which printing money is essentially ineffectual. if such a mass limit exists, we're certainly beyond it now.

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Economist Michael Hudson seems to think that much of the talk of hyperinflation or Deflation is silly in the sense that it won't be monetary or economic policy that decided the outcome, but rather political decisons made.

Any comments?

P.S that was a well written blog i enjoyed it very much.

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i've not read much of hudson's work, cpic, so it's tough to comment.

i really tend to think of such outcomes as less reliant on policy decisions (or who makes them) than the zeitgeist in which the decisions are made. all policy is reactionary -- we're certainly seeing that now -- and shaped by the context of events.

the reaction now will of course be to inflate/reflate as best they can -- but the spirit of events will intervene upon plans and ultimately chart the course. reflation could easily be curbed/halted by an international debt repudiation. or the reflationary measures the government undertakes could simply end up insufficient in scope and timing to counter credit contraction from a truly massive high.

i won't pretend to know the outcome, of course. but i do suspect that reflationary measures will be surprisingly ineffective in the united states going forward -- indeed the primary beneficiaries will be overseas, imo, as money supply continues to migrate to asia. i think in some respects that aspects of secular deflation began as early as 1998, and that reflating against the tide using credit expansion is becoming harder and harder almost regardless of the policy measures taken.

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one of the particularities about the bush proposal that i find interesting is that, to a considerable extent, what he's proposing could be quite deflationary.

the idea is to give money to downscale consumers and have them spend it. that's great politically, but it's poor economic intuition.

the united states is experiencing a credit overload and revulsion, particularly among the consumer class. this is still in an early stage, but i would wager that by june recession will have deepened and people will be actively conserving (relatively speaking, of course). if you hand them $800 in that mindset, their use of the money is not going to be to blow it on three ipods.

if they don't need food, they're going to pay down their credit card or send it to their mortgage servicer. and the effect will be to reduce the velocity of money (or money multiplier), which will serve to slow economic activity yet further.

for those who use it to buy food, i'd suggest they're already defaulting on debts -- which is another, more sudden form of slowing money.

those who don't have debts to pay or food to buy will likely stuff it in a bank -- where the bank can sit on it for them, raising their reserve and capital ratios.

deflation in the aftermath of a credit revulsion is a very difficult problem for government to solve. they will try what they can, but there's no guarantee that it will work.

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