Deflation

 Deflation: Economic environment characterized by declining values of commodity prices and in the collateral used to secure loans, "forcing...distress sales of assets, which in turn [leads] to further price declines..." Per Federal Reserve Chief Ben Bernanke in his book Essays on the Great Depression (2000 Princeton University Press)

DEFLATION IN THE REAL WORLD: Think back to when you were a kid, or even to New Year's Eve a few days ago. Someone gives you a helium-filled balloon—it makes you happy and excited as you watch it fly to the ceiling (or if you're like Pocket MBA, you untie it and suck down the gas instead, which makes you even more giddy.) Flash forward a few hours and that balloon starts to come down from the ceiling as the gas escapes; that makes you depressed and gloomy. And no matter what you do, short of putting more gas in the balloon, it won't rise back to the ceiling. And, as a kid, you don't quite understand why. Waaah. Deflation, a critical aspect of the current financial mess, is just like that balloon. Fear that deflation will lead to a Great Depression II is why on December 16, the Fed set the Fed Funds Target, see Vol. 5, No. 37, to a range between 0% and .25% and why it is promising to buy unlimited amounts of mortgage-backed securities, and perhaps even long-term Treasury securities and may even intervene to extend credit to consumers and small business, not to mention play for the Detroit Lions if that's what it takes for that team to ever win. All these efforts, save the latter, represent an attempt to "reflate" the market—that is to blow up that balloon.

At its most simple, if you bought a house in 2006 for $500,000, thinking you got a good deal, and the market for that house is now only $350,000 while you owe $425,000 principal on your mortgage (just making up those numbers) you are a victim of deflation, but at least you still get to live in your house as long as you pay the mortgage, though you may decide it's not worth it to continue paying more for less, or a bank may not let you refinance at lower rates without establishing substantially more equity. Then your lender becomes a victim of deflation, or as is more likely the case these days, the holder of the mortgage-backed security that includes your mortgage, becomes a victim.

If you bought the same house as an investment or you bought the mortgage as part of a securitized investment, then not only are you a victim of debt deflation, but you may want to get out of your investment as fast as possible or be forced to in order to cut your loss. Worse still, if you borrowed money, and your loan agreement requires that you maintain a certain level of assets or remain below a certain level of debt in order to continue to enjoy the loan, but accounting rules require you to value your assets based on the current market value, and that market value is falling, you will be forced to sell your assets at market price in order to pay your debt. Such asset sales begin to cause ripple effects and eventually a downward spiral in the value of assets throughout the economy—a spiral from which it is hard to escape. (This is why, when the history of the current crisis is written, the impact of mark-to-market accounting in forcing assets sales may play an outsized role. See PMBA, Volume 6, no. 15.)

Deflation is important, first, because it feeds on itself. According to Fed Chief Bernanke, falling prices force debtors "into distress sales of assets." As noted, this creates a deflationary spiral. Indeed, every move the Congress, Federal Reserve and Treasury have made (whether or not you agree with the moves) has represented an effort to undermine the deflationary spiral, to reflate, before it becomes exceedingly difficult to stop, as was recently the case in Japan and Argentina. The moves have included EESA with its TARP and the various bailouts and interest rate reductions, capped off by the December 16 Fed action. The idea behind reflation is that it would halt distress sales of assets because the market value of the assets would increase and credit would flow from banks to individuals and businesses. That reverses the processes described above. Deflation is important, second, because, uncontrolled, it can lead to economic depression.

Today, we're talking about the causes of deflations and how to avoid them, as if anyone really knows. But given the circumstances surrounding current economic conditions, Pocket MBA has taken a shine to Irving Fisher's famous Debt-Deflation Theory of Great Depressions, which argues that over-indebtedness leads to debt-deflation which leads to economic collapse. And Fed Chief Bernanke is at least a marginal adherent to Fisher's view since everything he has been doing of late to reflate comes straight out of the Fisher debt-deflation playbook. (Thank goodness he hasn't been using the Lions' playbook, or we'd never get out of this.) There are a plethora of theories about why the Great Depression occurred, but Fisher's tracks the current situation pretty closely, and since it is the theory Bernanke seems to be operating on, it's the one we need to understand.

First, let's distinguish between debt-deflation and mere price deflation (or disinflation). Consumer prices have been falling for months. But that, in itself, isn't the kind of deflation we're talking about. When Pocket MBA visited deflation on a prior occasion, back in 2003, see Pocket MBA: the Book, Vol. 1, No. 17, the discussion was about a feared deflation (actually disinflation, since the rate was always over 0%), which turned out to be a head fake--lower prices brought on by new technology accompanied by the continued unwinding of the great inflation of the 1970s—just like the great inflation of summer 2008 was a head fake on the way to where we are now. That kind of deflation doesn't tend to cause mass economic dislocation because it's temporary and doesn't involve the crippled balance sheets of actors across the economy.

All it seemed to take to stop that deflationary fear was for everyone to get a tax cut and to get a Blackberry or three with the money provided by it. In 2003, PMBA opined, albeit in a most callow way, that the feared deflation would not materialize, and it did not. In any event, at the time, then Professor Bernanke advocated, and then-Fed Chairman Alan Greenspan executed, a reflation policy just in case. Indeed, some believe that those monetary responses to that deflationary fear, i.e., overly easy money policy, which seeded the sub-prime garden, has led us directly to where we are now—a period where the Fed is desperately trying to get people to spend money they don't have, and the Treasury is trying to get banks to loan money they don't want to loan even though the government gave them the money. That leaves it to the government and the Fed to do all the spending for us.

Still, on the surface, as Pocket MBA posited back in Volume 1, a little price deflation, by itself, would seem like a good thing. Who doesn't want a bargain? Since August 2008, oil prices have fallen by as much as 70%, leading to such a substantial drop in the price of gasoline as to make it actually cheap to drive, fly and deliver again. But note that nobody is biting—the fall in the price of gas hasn't resulted in an economic turnaround. Stores have chopped the price of clothes and other products to get people to spend, and they may have spent, but the profits of the stores are plummeting, which means they have no reason to hire new workers and may lay off more. And we all know what's gone on with the price of houses, which lies at the root of the problem. And that's how this deflation is different from that which was feared six years ago. Back then it caused people to spend.

Fisher would say that the difference this time around is this deflation arises out of over-indebtedness itself—the indebtedness engendered by the spending earlier in the decade—both entity- and consumer-based. That kind of deflation has no positive impact on the broader economy. Rather, it leads to a state of severe supply and demand disequilibrium—e.g., every drop in the price of oil and gas seems to prompt people to drive even less. The difference between mere temporary price disinflation or deflation and crippling debt-deflation is that in the former, when they make you an offer that's too good to be true, you take it; in the latter, you can't afford it.

As with last issue's questions concerning the future of the Free Market, Pocket MBA doesn't know the answer to the conundrum posed by deflation, obviously, since economists don't really know either. This 2009 debut issue merely seeks to explain the theoretical basis for debt-deflation induced market collapse and its cures.

So how does over-indebtedness cause deflation? For that, PMBA turns to its own financial situation (this is going to be so Oprah-confessional), along with a little help from Fisher and even the Debt Deflation Blog, of which PMBA has become a devotee. You can read Fisher's paper at the link above or below; it's fascinating, and PMBA could go into a long exegesis of it, but then you should just really read Fisher. We're here for quick answers. Prior to (and even after) Fisher's work (it was ignored at first), economists argued whether over-production or under-production; over or under spending, over or under saving or over or under investment were the cause of the severe dislocation that caused the Great Depression (or other financial collapses). For Fisher, none of that made sense (and yay for him, because it doesn't make sense to the rest of us either, at least insofar as it applies to today's situation), since in the economy, at any given moment, one or more or all of those things are occurring, and while they do cause economic dislocation, they never lead to collapse. Thus, Fisher hypothesized that

[i]n the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after; also...where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two.

According to Fisher, "[d]isturbances in these two factors...will set up disturbances in all, or nearly all, other economic variables. On the other hand, if debt and deflation are absent, other disturbances are powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929-33." And what do we know about our current economic situation? There is an inordinate level of debt, on individual, corporate and financial balance sheets.

For instance, on an individual level, PMBA knows that its own debt situation is such (and imagines many others are in a similar situation) that it is not in a position to buy stuff, even though the prices of that stuff are falling. In order for PMBA to want to take on more debt (or even use cash to purchase instead of paying debt), it wants an even lower price, and can't guarantee that if it sees that price, it will buy. In fact, PMBA is looking for ways to pay its debt faster, and has even considered selling assets to do so. But those assets are not worth as much as they were when PMBA bought them, even when they were assets purchased for eventual gain, so they don't pay off the debt. In fact, using the assets to pay the debt simply leaves PMBA with debt but even fewer assets to buy anything else, which means it needs even lower prices.

Of course, Fisher isn't concerned with little ol' Pocket MBA's debt. He's more concerned with the institutional level of over-indebtedness, which we also have. He calls this "going into debt for profit." So how do institutions become over-indebted?

The over-indebtedness hitherto presupposed must have had its starters. It may be started by many causes, of which the most common appears to be new opportunities to invest at a big prospective profit, as compared with ordinary profits and interest, such as through new inventions, new industries, development of new resources, opening of new lands or new markets. Easy money is the great cause of over-indebtedness. When an investor thinks he can make over 100 percent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with borrowed money.

Sounds familiar, right? Of course, the public gets sucked into this, as well. Thus, "the public psychology of going into debt for gain passes through several more or less distinct phases":

a) the lure of big prospective dividends or gains in income in the remote future;
b) the hope of selling at a profit, and realizing a capital gain in the immediate future;
c) the vogue of reckless promotions, taking advantage of the habituation of the public to great expectations;
d) The development of downright fraud, imposing on a public which had grown credulous and gullible.

Check, check, check and, with the exclamation mark of the Madoff scandal, checkmate. Simply apply that list to the recent institutional investing market (and the Internet bubble to boot), and even if you can't quite explain what has happened, you can get a feel--from sub-prime loans to asset backed securities.

This entire chain of events is exactly what Fisher describes as causing depressions, which is why so many commentators were screaming during the latter half of 2008 about the dangers of us going into a second Great Depression and why the Fed acted so precipitously on December 16:

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.

The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

Thus, "debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way." The problem is that nobody knows if the current monetary answer to this conundrum, reflation, will work or if it contains the seeds of future problems either by delaying the deflation (which results from starting the cycle again) or by substituting future inflation (trading one bubble for another) instead of necessarily curing the problem. The idea is that by reflating assets, you solve a large part of the indebtedness. If your house goes back up in value, your equity returns, and you lose your desire to bail. Then the mark-to-market value of securitizations can return to a level that will take financial institutions off the hook. Commodity prices should begin to rise (as they have begun to do), allowing producers to pay their extraction and production costs, etc. on down the line. The trick is for the Fed to know when the economy reaches the tipping point between reflation and hyper-inflation. At that point, the Fed has to take back some of its raflation, i.e. withdraw liquidity from the market. Or maybe the reflation won't work at all.

Fisher even notes that the "starter" of over-indebtedness "may, of course, be wholly or in part the pendulum-like back-swing or reaction in recovery from a preceding depression..." So far, the reflation the Fed has undertaken hasn't worked. Borrowing rates were at 0% even before the Fed acted, and still, the economy has been stuck. Of course, the only option we know of other than reflation is to let the free market work its magic via bankruptcy and egregious economic dislocation, which as PMBA noted in Volume 6, No. 46, we find untenable. It seems to PMBA, again by its own callow observation that the only real solution, if Fisher is correct, is to eradicate the over-indebtedness (not to be confused with healthy levels of debt, which are necessary for business expansion). And that simply takes time...a whole lot of time, though a good bout of inflation would make the time pass more quickly.

Now, there are other theories besides Fisher's. You can search them on the web. There are even advocates of Fisher who have adjusted his theory to account for globalization and those who discount Fisher because he doesn't take into account globalization. Still others think the aging baby boom generation represents a long-term deflationary force, as aging boomers begin to spend less and less. Pocket MBA doesn't know if any are right or wrong, but then again, neither do they. Anyway, if you want a full summary of Fisher's theory of debt deflation, the original Debt-Deflation Theory of Great Depressions does it best. You'll find it in paragraph 48 of his work:

1. economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclical oscillations of innumerable kinds;
2. among the many occasional disturbances, are new opportunities to invest, especially because of new inventions;
3. these, with other causes, sometimes conspire to lead to a great volume of over-indebtedness;
4. this in turn, leads to attempts to liquidate;
5. these, in turn, lead (unless counteracted by reflation) to falling prices or a swelling dollar;
6. the dollar may swell faster than the number of dollars owed shrinks;
7. in that case, liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better, as indicated by all nine factors;
8. the ways out are either laissez faire (bankruptcy) or scientific medication (reflation), and reflation might just as well have been applied in the first place.

[i]n the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after; also...where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two.

According to Fisher, "[d]isturbances in these two factors...will set up disturbances in all, or nearly all, other economic variables. On the other hand, if debt and deflation are absent, other disturbances are powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929-33." And what do we know about our current economic situation? There is an inordinate level of debt, on individual, corporate and financial balance sheets.

For instance, on an individual level, PMBA knows that its own debt situation is such (and imagines many others are in a similar situation) that it is not in a position to buy stuff, even though the prices of that stuff are falling. In order for PMBA to want to take on more debt (or even use cash to purchase instead of paying debt), it wants an even lower price, and can't guarantee that if it sees that price, it will buy. In fact, PMBA is looking for ways to pay its debt faster, and has even considered selling assets to do so. But those assets are not worth as much as they were when PMBA bought them, even when they were assets purchased for eventual gain, so they don't pay off the debt. In fact, using the assets to pay the debt simply leaves PMBA with debt but even fewer assets to buy anything else, which means it needs even lower prices.

Of course, Fisher isn't concerned with little ol' Pocket MBA's debt. He's more concerned with the institutional level of over-indebtedness, which we also have. He calls this "going into debt for profit." So how do institutions become over-indebted?

The over-indebtedness hitherto presupposed must have had its starters. It may be started by many causes, of which the most common appears to be new opportunities to invest at a big prospective profit, as compared with ordinary profits and interest, such as through new inventions, new industries, development of new resources, opening of new lands or new markets. Easy money is the great cause of over-indebtedness. When an investor thinks he can make over 100 percent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with borrowed money.

Sounds familiar, right? Of course, the public gets sucked into this, as well. Thus, "the public psychology of going into debt for gain passes through several more or less distinct phases":

a) the lure of big prospective dividends or gains in income in the remote future;
b) the hope of selling at a profit, and realizing a capital gain in the immediate future;
c) the vogue of reckless promotions, taking advantage of the habituation of the public to great expectations;
d) The development of downright fraud, imposing on a public which had grown credulous and gullible.

Check, check, check and, with the exclamation mark of the Madoff scandal, checkmate. Simply apply that list to the recent institutional investing market (and the Internet bubble to boot), and even if you can't quite explain what has happened, you can get a feel—from sub-prime loans to asset backed securities.

This entire chain of events is exactly what Fisher describes as causing depressions, which is why so many commentators were screaming during the latter half of 2008 about the dangers of us going into a second Great Depression and why the Fed acted so precipitously on December 16:

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.

The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

Thus, "debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way." The problem is that nobody knows if the current monetary answer to this conundrum, reflation, will work or if it contains the seeds of future problems either by delaying the deflation (which results from starting the cycle again) or by substituting future inflation (trading one bubble for another) instead of necessarily curing the problem. The idea is that by reflating assets, you solve a large part of the indebtedness. If your house goes back up in value, your equity returns, and you lose your desire to bail. Then the mark-to-market value of securitizations can return to a level that will take financial institutions off the hook. Commodity prices should begin to rise (as they have begun to do), allowing producers to pay their extraction and production costs, etc. on down the line. The trick is for the Fed to know when the economy reaches the tipping point between reflation and hyper-inflation. At that point, the Fed has to take back some of its raflation, i.e. withdraw liquidity from the market. Or maybe the reflation won't work at all.

Fisher even notes that the "starter" of over-indebtedness "may, of course, be wholly or in part the pendulum-like back-swing or reaction in recovery from a preceding depression..." So far, the reflation the Fed has undertaken hasn't worked. Borrowing rates were at 0% even before the Fed acted, and still, the economy has been stuck. Of course, the only option we know of other than reflation is to let the free market work its magic via bankruptcy and egregious economic dislocation, which as PMBA noted in Volume 6, No. 46, we find untenable. It seems to PMBA, again by its own callow observation that the only real solution, if Fisher is correct, is to eradicate the over-indebtedness (not to be confused with healthy levels of debt, which are necessary for business expansion). And that simply takes time...a whole lot of time, though a good bout of inflation would make the time pass more quickly.

Now, there are other theories besides Fisher's. You can search them on the web. There are even advocates of Fisher who have adjusted his theory to account for globalization and those who discount Fisher because he doesn't take into account globalization. Still others think the aging baby boom generation represents a long-term deflationary force, as aging boomers begin to spend less and less. Pocket MBA doesn't know if any are right or wrong, but then again, neither do they. Anyway, if you want a full summary of Fisher's theory of debt deflation, the original Debt-Deflation Theory of Great Depressions does it best. You'll find it in paragraph 48 of his work:

1.                               1. economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclical oscillations of innumerable kinds;

2.                               2. among the many occasional disturbances, are new opportunities to invest, especially because of new inventions;

3.                             3.  these, with other causes, sometimes conspire to lead to a great volume of over-indebtedness;

4.                              4. this in turn, leads to attempts to liquidate;

5.                               5. these, in turn, lead (unless counteracted by reflation) to falling prices or a swelling dollar;

6.                              6.  the dollar may swell faster than the number of dollars owed shrinks;

7.                              7.  in that case, liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better, as indicated by all nine factors;

8.                              8.  the ways out are either laissez faire (bankruptcy) or scientific medication (reflation), and reflation might just as well have been applied in the first place.

And that's how a balloon comes down from the ceiling. You're better off just sucking the gas from the get go.

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