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.
I wrote:
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.
Spot on.
“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.”
I would add that the best I would expect of governments is to not reduce or just moderately increase the numerator because unless governments have suddenly got better at allocating capital surely anything else would seriously impair their currency.
Spot on.
“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.”
I would add that the best I would expect of governments is to not reduce or just moderately increase the numerator because unless governments have suddenly got better at allocating capital surely anything else would seriously impair their currency.
“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”. That’s not true in the sense that QE reduces
public sector debt, while private sector net assets remain constant (because
government bonds held by the private sector are swapped for cash).
In fact any monetarily
sovereign country could wipe out its debt in no time simply by printing money
and buying back its debt. And if that proved too inflationary, no problem: just
raise taxes by enough to ensure that the deflationary effect of the extra tax
equals the inflationary effect of the money printing. The net effect on GDP,
numbers employed, etc would be zero. Meanwhile the debt disappears.
But that little piece of
macroeconomics is ten miles above the heads of the imbeciles that inhabit
Capitol Hill and other elected assemblies round the world.
You are confusing stock and flow. Net savings addresses the flow of debt inter temporily. What you are suggesting addresses the stock of debt, not the flow and does not alter the net savings/dissavings identity
Not ten miles above. Outer space.
“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”. That’s not true in the sense that QE reduces
public sector debt, while private sector net assets remain constant (because
government bonds held by the private sector are swapped for cash).
In fact any monetarily
sovereign country could wipe out its debt in no time simply by printing money
and buying back its debt. And if that proved too inflationary, no problem: just
raise taxes by enough to ensure that the deflationary effect of the extra tax
equals the inflationary effect of the money printing. The net effect on GDP,
numbers employed, etc would be zero. Meanwhile the debt disappears.
But that little piece of
macroeconomics is ten miles above the heads of the imbeciles that inhabit
Capitol Hill and other elected assemblies round the world.
You are confusing stock and flow. Net savings addresses the flow of debt inter temporily. What you are suggesting addresses the stock of debt, not the flow and does not alter the net savings/dissavings identity.
Moreover, you have just described an asset swap of bonds (debt) for reserves (also government liabilities). This does not alter the stock of government liabilities. It merely shifts the composition of them. Nor does it alter the total amount of net financial assets in the nongovernment sector.
Not ten miles above. Outer space.
1) Excessive private debt will take considerable time to be reduce because of how tight family finances are. There is very little excess to pay down that debt for the 95%
2) Bailing out the banks destroyed the Irish government balance sheet. If the banks had been allowed to collapse then created new banks from the remains it would have not deteriorated so badly. Yes there would be problems in the local credit market but at least there would be a floor. The new banks would have it tough for a while as asset prices find their floor, but at least the floor would approach rapidly. Once asset prices have a reached a floor it creates confidence, they cannot fall any further. Until then you have to be careful because you can still be vulnerable to losses. All we have done is drag out that fall in prices, much like Japan.
It does show that the route taken by most governments shows that their advisors appear to be clueless about sectoral balances and as such should be disqualified from their advisor roles. They all talk about exporting their way out of the crisis. That is a global zero sum game!
As you say the global macro perspective is the driver here. With so many countries cutting expenditure they are avoiding the increasing incomes for ideological reasons and so are destroying the economies that they are supposedly trying to rebuild. The issue will be who is the least destructive.
Indeed. Think of the billions used to bail out banks which get recycled into damaging the economy further, rather than those billions being directed toward infrastructure projects or paying down debt and reducing carrying costs. The cumulative effects of these malinvestments are staggering.
Three years out, we are most certainly in a worse position than we would have been if all global credit markets, banks and currencies collapsed simultaneously and were rebuilt from the ashes.
As more come to this inevitable conclusion, pressure to go ahead with the deleveraging will build and shape policy. It will happen eventually, but only after being delayed as long as possible – ensuring that the collapse is twice as painful as it should have needed to be. And of course, that collapse will not be organic but rather heavily managed, so that those most responsible are given enough warning and can be spared. /cynicism.
In many ways the recent response to the financial crisis has been the wrong response. In the thirties. Mellon said liquidate everything, and while people will criticise that, there are lots of good aspects to that. It deflates the bubbles very fast. It sets a floor to asset markets and allows more confidence in investing.
What we have now is confusion. Asset values are still overvalued and the debates are about inflation when the problem is deflation. Any new investor can expect a decade of the market going nowhere because the underlying fundamentals are not there and you could lose everything if the markets tank. House prices are still overvalued. Even in the US where they have fallen 40% I still think that there is some more scope for further falls. Analysts talk of prices getting back to the levels in the late nineties. Yet these could still be viewed as over valued compared to real prices from the mid seventies, when median wages stopped rising. Why should property prices keep increasing?
If we had refused to bail out the banks we would probably be no worse off. The huge cash balances that companies had would probably have been wiped out in the banking collapse and so they might be more amenable to reforms of banks. Small depositors would have had protection so would be no worse off. They would not be facing permanent zero interest rates. The stimulus would have been more effective as it would not have gone in propping up the bubbles. So yes I do think we took a wrong turn in 2007.
Spot on, David. You and are very much on the same page and I suspect Matt is too. The real problem/question is how to prevent the deflationary spiral from leading to civil unrest, nationalism, and geopolitical tension. My answer is the same as yours: fighting against austerity.
Let the automatic stabilisers be robust and let them do their job until the writedowns have all been taken. That way we get a sharp break and reboot without everyone going destitute. The problem is allowing the bubble to deflate but then piling on by deflating the public sector at the same time. Don’t intervene, don’t cut spending, don’t cut rates, don’t do QE, and definitely don’t do cash for clunkers or that kind of palaver. If you want to do anything, invest in infrastructure. But this should be a given that it has nothing to do with the downturn.
I say let it happen but be damn sure you have robust enough of a social safety net before you do.
1) Excessive private debt will take considerable time to be reduce because of how tight family finances are. There is very little excess to pay down that debt for the 95%
2) Bailing out the banks destroyed the Irish government balance sheet. If the banks had been allowed to collapse then created new banks from the remains it would have not deteriorated so badly. Yes there would be problems in the local credit market but at least there would be a floor. The new banks would have it tough for a while as asset prices find their floor, but at least the floor would approach rapidly. Once asset prices have a reached a floor it creates confidence, they cannot fall any further. Until then you have to be careful because you can still be vulnerable to losses. All we have done is drag out that fall in prices, much like Japan.
It does show that the route taken by most governments shows that their advisors appear to be clueless about sectoral balances and as such should be disqualified from their advisor roles. They all talk about exporting their way out of the crisis. That is a global zero sum game!
As you say the global macro perspective is the driver here. With so many countries cutting expenditure they are avoiding the increasing incomes for ideological reasons and so are destroying the economies that they are supposedly trying to rebuild. The issue will be who is the least destructive.
Indeed. Think of the billions used to bail out banks which get recycled into damaging the economy further, rather than those billions being directed toward infrastructure projects or paying down debt and reducing carrying costs. The cumulative effects of these malinvestments are staggering.
Three years out, we are most certainly in a worse position than we would have been if all global credit markets, banks and currencies collapsed simultaneously and were rebuilt from the ashes.
As more come to this inevitable conclusion, pressure to go ahead with the deleveraging will build and shape policy. It will happen eventually, but only after being delayed as long as possible – ensuring that the collapse is twice as painful as it should have needed to be. And of course, that collapse will not be organic but rather heavily managed, so that those most responsible are given enough warning and can be spared. /cynicism.
In many ways the recent response to the financial crisis has been the wrong response. In the thirties. Mellon said liquidate everything, and while people will criticise that, there are lots of good aspects to that. It deflates the bubbles very fast. It sets a floor to asset markets and allows more confidence in investing.
What we have now is confusion. Asset values are still overvalued and the debates are about inflation when the problem is deflation. Any new investor can expect a decade of the market going nowhere because the underlying fundamentals are not there and you could lose everything if the markets tank. House prices are still overvalued. Even in the US where they have fallen 40% I still think that there is some more scope for further falls. Analysts talk of prices getting back to the levels in the late nineties. Yet these could still be viewed as over valued compared to real prices from the mid seventies, when median wages stopped rising. Why should property prices keep increasing?
If we had refused to bail out the banks we would probably be no worse off. The huge cash balances that companies had would probably have been wiped out in the banking collapse and so they might be more amenable to reforms of banks. Small depositors would have had protection so would be no worse off. They would not be facing permanent zero interest rates. The stimulus would have been more effective as it would not have gone in propping up the bubbles. So yes I do think we took a wrong turn in 2007.
Spot on, David. You and are very much on the same page and I suspect Matt is too. The real problem/question is how to prevent the deflationary spiral from leading to civil unrest, nationalism, and geopolitical tension. My answer is the same as yours: fighting against austerity.
Let the automatic stabilisers be robust and let them do their job until the writedowns have all been taken. That way we get a sharp break and reboot without everyone going destitute. The problem is allowing the bubble to deflate but then piling on by deflating the public sector at the same time. Don’t intervene, don’t cut spending, don’t cut rates, don’t do QE, and definitely don’t do cash for clunkers or that kind of palaver. If you want to do anything, invest in infrastructure. But this should be a given that it has nothing to do with the downturn.
I say let it happen but be damn sure you have robust enough of a social safety net before you do.
It is a very interesting article, but I disagree with some of your claims, mainly about the origins of the
crisis.
You say, “1…This
crisis originated in the private sector, principally because of excessive
household debt.” Let us analyze the data. The US household debt to GDP ratio was
around 92% in 2010. The household debt to household income ratio was around
120%. In other words, the median-income household $50,000 owed $60,000. Such a
household can clean its debt devoting 12% of its income during 12 years, a
monthly debt service of $500 out of $4,160 (income). From my point of view,
this is not an excessive debt level.
I would
rewrite number 1 as “This crisis originated in the private sector, principally
because interest rates jumped between 2002 and 2007. Subprime borrowers, mainly
with ARM and Interest Only mortgages (or hybrids) were not able to satisfy
their new loan payments and defaulted. Poor capital ratios and shadow banking
practices led to mistrust among financial corporations and drained credit to
non-financial corporations and households. House prices fell, households
balance sheets deteriorated, unemployment rose…”
What can we
do?
From my point of view, we do not have an excessive
debt problem but a debt-deflation and mistrust problem,…
https://www.realratemortgages.com/1/post/2011/11/a-response-to-deflationary-crisis-responses.html
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I see that you published newer comments than the one I sent to you. I think it is respectful and related to your post. If there is any problem, please let me know. Thank you.