Deflationary crisis responses
If you are a debtor who wants to cut your debt load for fear of a liquidity-induced insolvency, there are two ways to make your debt metrics improve. One is to increase revenue and the other is to shrink the debt.
Think of it this way: most analysts are concerned about relative debt metrics like debt/income for households or debt to EBITDA for businesses and debt to GDP for governments. These relative debt metrics are ratios that contain a numerator and a denominator. So, to decrease the ratio, one can either decrease the numerator (the debt) or increase the denominator (income, EBITDA, and GDP).
In our credit system, trying to increase the denominator is a reflationary response to a debt crisis, while decreasing the numerator is a deflationary response. For example, if I want to decrease my relative debt burden, I could save more and pay down debt or I could work nights and use the extra income to maintain the debt load with less risk. In practice, both methods are employed.
But the question is how the private sector and the public sector interplay here. Think back to when I was telling you about the origins of the next crisis in April 2010. The thrust of my argument was that this debt crisis originated as a private sector debt crisis and has morphed into a public sector one, in part because of the risk transfer to the public sector that both bailouts and recessions create.
Right now, everyone is fixated on the first path to reducing (both public and private sector) debt [paying down debts via accumulated savings]. I do not believe this private sector balance sheet recession can be successfully tackled via collective public sector deficit spending balanced by a private sector deleveraging. The sovereign debt crisis in Greece tells you that. More likely, the western world’s collective public sectors will attempt to pull this off. But, at some point debt revulsion will force a public sector deleveraging as well.
Here’s what you should take away from these two paragraphs:
- A recession borne out of typical business cycle dynamics started in 2007. A crisis started, however, as a re-assessment of private sector risk profiles began due to the US subprime situation. This crisis originated in the private sector, principally because of excessive household debt.
- Governments ran large deficits due to the loss of tax revenue and the increase in outlays associated with the downturn that accompanied the debt crisis. They also bailed out bank creditors due to legitimate fears of systemic collapse, but also due to the corporatism associated with regulator capture. This transferred risk onto the public sector.
- The household sector was not relieved of its debt burden by this risk transfer and attempted to save more and pay down debt. Companies attempted to save more and pay down debt too by cutting staff and investment expenditures. And so the downturn deepened.
- The public sector should take on some risk transfer since this countercyclical economic policy is what automatic stabilisers are all about. However, corrupted by corporatism, the public sectors across Europe and the United States, transferred too much risk onto public balance sheets. The loss socialisation was greatest in countries like the US, the UK and Ireland which experienced housing busts and bank sector distress. But the Netherlands, France, Germany, Spain, and Belgium all conducted their own bank bailouts.
- When Dubai World warned it would default in November 2009, a re-assessment of public sector indebtedness ensued. Debt revulsion forced a public sector deleveraging in addition to the private sector deleveraging, principally for the weakest debtors ie. government debtors with highest debt ratio, which could not create currency.
- Other government debtors, those that had low debt metrics but could not create currency, are now being infected by contagion from this debt revulsion and are being forced to cut expenses and save.
- Other government debtors which could create currency like the US and the UK have not cut as forcefully but have now begun to do so as well out of excessive fear that they could be infected by contagion from this debt revulsion.
So, what we therefore have is a crisis that originated in the private sector, but that has spread to the public sector and in which now every debtor is now taking the deflationary route in response. All debtors in the private and public sector are now focussed on reducing the numerator of the relevant debt metrics and increasing net savings.
If you know your financial sector balances, you know that an increase in net savings in one sector (government or nongovernment) must equal an equivalent decrease in net savings in the other sector. So, an attempt to increase net savings in the private sector cannot be met by an actual increase in public sector net savings. Analogously, an attempt to increase net savings in the public sector cannot be met by an actual increase in private sector net savings. Put another way, the public and private sector cannot increase their net savings at the same time because by definition the net savings of one sector equals the net dissavings of the other.
How does this get resolved then? The debt distress cuts spending in the private sector and this is met now by a cut in spending in the public sector. And as I predicted in the April post:
“And unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken. The question still up for debate is regarding systemic risk, contagion, and economic nationalism because when the first large sovereign default occurs, that’s when systemic risk will re-emerge globally.”
This is exactly how it played out in the 1930s and that’s where we are right now. Many analysts are focussed on the minutiae. However, the big picture is what is driving events. Global macro analysis tells you that this collective debt reduction, this mass deleveraging will be the critical aspect driving the train of events for a long time to come. Understanding global macro will be vital in today’s world to protecting your wealth.