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Thursday, April 03, 2008


why deflation is probable from here

yves smith relays an incisive article from martin wolf at ft and the analysis of ubs analyst george magnus.

Over-indebted individuals have just three choices: reduce spending below income, sell assets they own to somebody else or, if the worst comes to the worst, default. But one person’s debt is another person’s asset, one person’s expenditure is another person’s income; one person’s sale is another person’s purchase and one person’s default is another person’s loss.

If very many individuals reduce their spending, in order to pay down their debt, the economy slumps. If many try to sell assets they own, their prices crash. If many default on their debts, financial intermediaries implode. The economics of an entire economy are not the same as the economics of a single household. That was perhaps the most important point John Maynard Keynes made.

Thus, argues Mr Magnus, “there is a quite serious risk that the de-leveraging downturn could run amok: credit contraction causes economic contraction, which causes further write-downs and capital destruction, which leads to more credit contraction and so on”. On the upside, the fairy government-mother stood on the sidelines, applauding the enthusiasm of her charges. On the downside, she is dragged in, as risk-addiction turns into risk-aversion.

the bottom line:

Neither households nor the financial sector, as a whole, can de-leverage swiftly, other than via a calamitous mass default or by shifting their debt elsewhere, usually on to the government. For an entire economy, particularly a huge one, to recover from debt-addiction is hard. However much one may loathe the idea, a private-sector financial mania will finish up as public-sector pain.

i have personally questioned in the past the government's capacity to inflate from debt levels as high as this -- monetary base is so small in comparison to the size of the debt being written down that it cannot stand against the tide to make an inflation go. this is, it seems to me, the great lesson of not only japan but the nordic financial crises. again yves smith and his trenchant critique of some other views:

We are witnessing liquidity hoarding in the interbank markets. I already have economically literate readers who tell me that they are holding large cash balances at home our of fear of a bank holiday and are trying to find a bank they deem to be safe. A couple of bank failures and we could be well on the way enough withdrawals from banks to generate a money supply contraction, no matter what the Fed does with the monetary base.

many economists consider these deflationary events "mistakes". as i commented earlier at naked capitalism:

one of the most consistent features of the modern period is the conceit of the current -- a sort of background of antipathy for all that came before. it frequently presumes earlier incarnations of ourselves to have been some combination of stupid, uneducated and inexperienced. it isn't difficult to imagine why the prejudice is popular.

but i think a more nuanced reading of history backs a different view -- that eras are defined by philosophies and paradigms that are over time pushed, thanks to the positive reinforcement or earlier successes, to their breaking points and then beyond. the people operating within the paradigm are neither stupid nor uneducated nor inexperienced -- but they are operating under a set of assumptions that have succeeded heretofore in accordance with the paradigm of the era, and (it is taken as self-evident) will continue to work as expected ad infinitum.

they ignore (or perhaps are really incapable of properly interpreting, given the deeply-reinforced prejudices of the paradigm) that every imperfect paradigm must eventually fail because the imbalances that are part of its maintenance are at least fractionally cumulative -- and that the cumulative imbalance is ultimately unsustainable.

i have no idea if we've reached that point -- the end of the keynesian economic paradigm, as it were, for lack of a better label.

but prof. delong would seem here to deny that there is a paradigm at all -- that modern economics are not so much a set of temporarily-operable assumptions accruing imbalances that will ultimately undo the paradigm as simply Correct (capital C, to denote its holiness), subject only to the virtue of its high priests.

i would note that mainstream social thinkers in all previous periods believed exactly in the same manner of their contemporary paradigm. all considered it to be extremely sensible, generally invulnerable if properly managed, indeed the height of human achievement.

yet not one such paradigm has avoided its fate -- not as the result of "errors" but in spite of actions taken by authorities in harmony with the assumptions of the paradigm. nor will this one avoid a similar fate, i think it's safe to say -- because, as ever, too few appreciate the complexity of social systems and their ability to defy and destroy our necessarily simplistic assumptions about it and render everything we now believe we know about it null. *there* is where the error lies, i suspect.

UPDATE: a note (via bloomberg) from banking analyst meredith whitney articulates the severity of the contraction now underway.

UPDATE: more japan comparisons via yves smith. i have to admit, i find the similarities extremely compelling, even at some level of detail, such as the reluctance of japanese banking to get sucked into the american vortex. of course, rogoff and reinhart have made the commonalities clear to many now.

i further tend to agree with socgen's edwards -- the disbelief in the united states that things could be "that bad" is simply a form of denial without much basis in fact. it very certainly could be "that bad". some will point out the health of megacap corporate balance sheets in america today as compared to japan then, and i agree. but consumer debt in japan was absolutely nothing like the problem we have in the united states -- the first big difference between japan then and america now is that then it was a corporate/financial services debt and property bubble, whereas today it is a household/financial services debt and property bubble. i wonder which is worse, but it may not matter -- edwards is utterly correct to point out that the position of the united states today is aggravated by its heavy dependence on foreign capital inflows, whereas japan then was in the opposite situation. that is the second big difference, and it compounds and complicates our more mundane insolvency and deleveraging problems with a first-class currency crisis.

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An excellent, thought-provoking post.

Keep it coming!


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Great post! I appreciate especially your well expressed comments on the "conceit of the current". CS Lewis talked about this phenomenon a little in his book 'surprised by joy' and since reading that years ago it's been clear to me that this tendency has played into a collective refusal to recognize current economic similarities to the circumstances that led to the great depression, japan's lost decade, etc.

I'm impressed by your blog overall but can't find an RSS/atom feed -- if you have one it is well hidden...?

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"The economics of an entire economy are not the same as the economics of a single household."

Really? At what point in the aggregation of individual actions does the magical pixie dust enter the equation?

The irresistible urge to aggregate and then imbue the aggregate with special characteristics not found in any of the individuals or groups within it is the worst sort of unthinking metaphysical claptrap and why Keynesian economics and all its progeny has led to nothing but grief and confusion.

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dug -- i think the point wolf is making is that, essentially, if there is no one to liquidate to, there cannot be liquidation at anything like stable prices.

an household taken strictly by itself would be in a similar situation. but in a network of households, any individual household caught out in the rain can reduce leverage by selling to other, liquid households at something very like current prices. in this way, an individual deleveraging is possible without delivering a systemic shock. this sort of activity is what drives creative destruction in the best sense.

but when the entire network -- the economy -- is trying to reduce leverage simultaneously, there is no one to sell to. illiquidity becomes a problem, and liquidation can then only proceed by real price reduction -- which means insolvencies and defaults, which (when the defaults are nominal) means forced sales, which means yet lower prices, and so forth.

this dynamic does not present itself when a single household in a deep network of households is in trouble -- or, if it does, it tends to be a passing phenomena.

that is, unfortunately and thanks to the excesses of the credit boom from 1980 to 2007, not the situation we find ourselves in now.

perhaps wolf would do better to suggest that the economics of an entity enmeshed in a deep network are different from the economics of either the entity or the network in isolation.

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thanks bill -- glad i could be of some use!

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hbl -- technical incompetency leaves me at a loss. :) i can try to make one available, though.

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