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All about deflation, the quiet killer of modern economies

19 July 2010

Summary:  An oddity of the great recession is our obsession with the threat of inflation while debt deflation ravages the economy.   Asset prices fall, causing loan defaults and bankruptcies — while many guru’s warn of hyperinflation.  This is one aspect of the great forgetting, how we’ve forgotten so much knowledge of economics painfully gained during the Great Depression and afterwords.  Perhaps the tombstones of the western economies should read Killed By Ignorance.

A vivid description of debt deflation, and why it’s a very bad thing:  “Like a glacier descending a mountain, debt deflation flattens everything”, Paul Schulte, Nomura, 7 June 2010 — Excerpt:

Debt deflation harms everything in its path during a period when a country is trying to work off high debt levels AND trying to maintain stable growth rates. As the value of assets (homes, buildings and stores) goes down, liabilities (fixed-price callable debt) stay the same. The need to liquidate quickly to pay down debt — 

  • generates losses,
  • brings down collateral values,
  • causes deterioration in credit conditions and
  • causes strains on bank capital.

The strain on bank capital causes banks to restrict bank lending and a liquidity crisis morphs into a solvency crisis.

Write-offs of capital reduce the capacity of the banks to maintain the assets on its balance sheet — never mind lending more. The more a business (or a country) embarks on an asset sale or austerity to improve cash flow or pay down debt, the more it will tend to sow the seeds of its own demise. This is because the act of preserving creditworthiness through austerity actually aggravates downward pressure on prices and worsens overall credit conditions. This is because if too many businesses or people try to save more or spend less at the same time, no one buys from anyone else. Effectively, collateral values go down as debt burdens stay the same — this is ruinous. Creditworthiness is destroyed.

Furthermore, the system is then put under stress because people have questions about the value of collateral of other actors. Collateral prices stabilise if the market is allowed to work. (This would be the proverbial bottom). Currency regimes are under terrific strains. Some break under the heavy load of excessive debt. Until then, people only trust liquid and hard assets.

As balance sheet capital is eroded, the only way to buy assets is with cash. Imagine a cash buyer purchasing an item from someone who bought it with 10x leverage at US$100. That person only put out US$10 of his own money. The banks paid for the other US$90. A cash buyer is unable to match the same prices without liquidating other assets (or stock holdings?). A sale of a leveraged item to a person who merely has cash by definition is compressing prices. So, stocks are also under pressure. An explicit example of this is the way in which equity of banks is written off as asset prices go down. As these prices go down, debt levels actually remain the same. All and sundry have to pay more just to stand still. The buyer of last resort is the central bank. It has to intervene and restructure debt or buy assets. Another key function of central banks is to create inflation and prevent debt deflation. The Fed is trying both of these at the same time.

Low interest rates to combat low growth erase savings and the paradox of thrift aggravates savings problem

Something else happens. Savings rates fall through two invisible phenomena. Interest rates in deflation actually go down to zero while the cost of debt goes up as collateral values fall. So, interest income from deposits falls and interest expenses stay the same. This is a deflation tax. Secondly, the Keynesian “paradox of thrift” kicks in and people try to save more ALL AT THE SAME TIME. As a result everyone perversely gets poorer as the increase in savings causes the group to buy less of each other’s goods, thus bringing down prices and aggravating debt deflation.

Also, as deflation sets in, real wages actually go up, since even flat wages “rise” as prices fall. This is bad because with deflation, the prices of goods and services go down, so flat wages result in lower gross profits for corporates. This forces companies to fire people, cut wages or have people work fewer hours. This phenomenon is occurring in Japan. Workers are fired because they are too expensive — NOT because they are not productive. It is because prices were falling faster than their wages. So unemployment becomes chronically high.

What is Bernanke doing about this?

His body of writing over 25 years says that we should do whatever it takes to prevent debt deflation. It is clear from his book “Essays on the Great Depression” that debt deflation destroys land, labour and capital ALL at the same time — and destroys the currency in the process.

The inputs into capitalism are all put to the torch under debt deflation. As we saw previously, savings rates actually fall. Inflating asset prices or restructuring debt is the only way out. Bernanke put the blame for the Great Depression on policy makers who did not understand the insidious nature of debt deflation (and the size of the debt, especially margin debt) and so did nothing about it.

Many {believe} that restructuring of debt globally is inevitable. This is the next part of the Bernanke 10 Commandments. Debt restructuring needs to happen. Governments are tapped out in terms of the amount of money they can spend on bailing out financial institutions.

Other posts about deflation

  1. Miscellaneous news and thoughts about the financial crisis, 16 October 2008
  2. Debt – the core problem of this financial crisis, which also explains how we got in this mess, 22 October 2008
  3. A situation report about the global economy, as the flames break thru the firewalls, 26 January 2009
  4. Inflation or Deflation? Nobody knows what path will we take., 21 July 2009
  5. Economic theory as a guiding light for government action in this crisis, 10 March 2009
  6. Fetters of the mind blind us so that we cannot see a solution to this crisis, 1 April 2009
  7. A lesson from the Weimar Republic about balancing the budget, 10 February 2010

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