Debt, Inflation, & Deflation

by Steve Puetz | September 9, 2009

The impact from a central bank’s credit policy is perhaps the most misunderstood factor in the study of economics. The majority believes easy credit from the Federal Reserve and expanding deficits by the federal government will quickly lead to price inflation. Because of this belief, and because of the Federal Reserve’s ballooning balance sheet, a large number of investors have recently embraced “inflationary hedges” and “inflationary investments” aimed at protecting their wealth against monetary depreciation.

The truth about Federal Reserve expansion policies; however, is significantly different from perceptions. A more correct assessment of expanding credit is this…. The United States has transformed its monetary system into one that’s credit-based. In such a system, the aggregate level of debt influences price trends. Furthermore, in a credit-based economy, a creditor lends money to a debtor. At that instant, the creditor holds a monetary asset that fluctuates in value. The debtor normally uses the proceeds to purchase goods, services, or investments. From the debtor’s perspective, the immediate impact from this loan is twofold: (a) Spending power is enhanced in the short-term, and (b) as loan payments begin, disposable income is reduced over the long-term.

When new credit being issued exceeds old credit being paid off, it creates inflationary pressure during the months immediately following the lending. Additionally, excessive lending creates steady, continual deflationary pressure once loan repayments begin. Over the long-term, every short-term inflationary benefit is offset by an equal and opposite looming deflationary force. That’s why, throughout history, great credit inflations (bubbles) always end with prices crashing back down to a level roughly equal to the level at the start of the inflation.

In the United States, the deflationary potential created from new loans has been deferred for several decades by both Congress and the Federal Reserve providing consumers, homeowners, and business owners with incentives to borrow (rather than save) anytime a deflationary threat became real. The repeated process of deferring deflation convinced the majority that government leaders can and will permanently prevent a serious deflation. However, that perception is based on incomplete thinking. The remainder of this letter will show why the long-delayed deflation is highly likely to strike in the coming months and years.

Led by Paul Tudor Jones, managers at the Clarium hedge fund have recently positioned their clients for deflation and depression rather than inflation and recovery. In a September 1 article entitled, Goldman Sachs Wrong on Economic Recovery, Macro Hedge Funds Say, Cristina Alesci explains part of the deflationary case:

“Paul Tudor Jones, the billionaire hedge-fund manager who outperformed peers last year, is wagering that Goldman Sachs Group Inc. and Morgan Stanley got it wrong in declaring the start of an economic recovery…. ‘If we have a recovery at all, it isn’t sustainable,’ Kevin Harrington, managing director at Clarium, said in an interview at the firm’s New York offices. ‘This is more likely a ski-jump recession, with short-term stimulus creating a bump that will ultimately lead to a more precipitous decline later.’ Equity and credit markets have rallied on hopes that government intervention is pulling the US out of the deepest economic slump since the Great Depression…. Tudor … told clients in an Aug. 3 letter that the stock market’s climb was a ‘bear-market rally.’ Weak growth in household income was among the reasons to be dubious about the rebound’s chances of survival, Tudor said. A focus on misleading indicators is driving markets, macro managers say…. The housing data isn’t as rosy as some see it, Harrington said. As existing U.S. home sales rose 7.2 percent in July from the previous month, distressed deals including foreclosures accounted for 31 percent of transactions…. Clarium, which oversees about $2 billion, is positioned for an equity bear market through investments in the U.S. dollar, Harrington said. Falling stock prices will strengthen the currency by forcing leveraged investors to sell equities to pay down the dollar-denominated debt they used to finance those trades, he said…. Macro managers’ pessimism is fueled in part by the U.S. government’s response to last year’s financial crisis, which they say fails to address the root cause. Banks still hold hard-to-sell assets on their balance sheets, the managers said…. The Financial Accounting Standards Board voted in April to relax fair-value accounting rules. The change to mark-to-market accounting allowed companies to use ‘significant’ judgment in gauging prices of some investments on their books, including mortgage-backed securities that plunged with the housing market. Banks are reporting better earnings because they haven’t been forced to account for their losses yet, Clarium’s Harrington said. ‘We haven’t fixed the problem,’ he said. ‘We’ve just slowed down the official recognition of it.’” [Alesci, 2009]

It seems that most investors have either forgotten or completely ignore the fact that banks hold hundreds of billions of dollars of toxic assets. These are assets that are valued on quarterly earnings at levels well above market-price. Even though bank executives were successful in pressuring regulators to changing accounting rules, they still hold the toxic assets. The financial crisis persists. The only factor that has changed is confidence. Investors and executives are more confident now – even though actual financial conditions have continued to deteriorate. It’s simply a matter of time before the newfound confidence reverts back to panic and deflation.

Some believe that future inflation is a foregone conclusion because government control over the banking system has been greatly enhanced as a result of the financial crisis. Smaller institutions have been failing in ever increasing numbers, while the rescued banks meeting the “Too Big to Fail” criteria now increasingly dominate all areas of the country. These large banks now operate under increased political control. In an August 28, 2009 Washington Post article, entitled Banks 'Too Big to Fail' Have Grown Even Bigger, David Cho describes various issues related to the new banking environment:

“When the credit crisis struck last year, federal regulators pumped tens of billions of dollars into the nation's leading financial institutions because the banks were so big that officials feared their failure would ruin the entire financial system. The crisis may be turning out very well for many of the behemoths that dominate U.S. finance. A series of federally arranged mergers safely landed troubled banks on the decks of more stable firms. And it allowed the survivors to emerge from the turmoil with strengthened market positions, giving them even greater control over consumer lending and more potential to profit. J.P. Morgan Chase, an amalgam of some of Wall Street's most storied institutions, now holds more than $1 of every $10 on deposit in this country. So does Bank of America, scarred by its acquisition of Merrill Lynch and partly government-owned as a result of the crisis, as does Wells Fargo, the biggest West Coast bank. Those three banks, plus government-rescued-and-owned Citigroup, now issue one of every two mortgages and about two of every three credit cards, federal data show…. But no consequence of the crisis alarms top regulators more than having banks that were already too big to fail grow even larger and more interconnected…. Regulators' concerns are twofold: that consumers will wind up with fewer choices for services and that big banks will assume they always have the government's backing if things go wrong. That presumed guarantee means large companies could return to the risky behavior that led to the crisis if they figure federal officials will clean up their mess…. The worry for consumers is that the bailouts skewed the financial industry in favor of the big and powerful. Fresh data from the FDIC show that big banks have the ability to borrow more cheaply than their peers because creditors assume these large companies are not at risk of failing. That imbalance could eventually squeeze out smaller competitors. Already, consumers are seeing fewer choices and higher prices for financial services…
[During the crisis] officials waived long-standing regulations to make [merger] deals work. J.P. Morgan Chase, Bank of America and Wells Fargo were each allowed to hold more than 10 percent of the nation's deposits despite a rule barring such a practice. In several metropolitan regions, these banks were permitted to take market share beyond what the Department of Justice's antitrust guidelines typically allow…. Last October, when the Fed was arranging the merger between Wells Fargo and Wachovia, it identified six other metropolitan regions in which the combined company would either exceed the Justice Department's antitrust guidelines or hold more than a third of an area's deposits. But the central bank thought local competition in each of those places was sufficient to allow the merger to go through, documents show. Camden Fine, president of the Independent Community Bankers of America, said those comments reveal the government's preferential treatment of big banks.... ‘To favor one class of financial institutions over another class skews the market. You don't have a free market; you have a government-favored market,’ he said. ‘We will never have free markets again if you have the government picking winners and losers.’" [Cho, 2009]

Does this new system of “government favored banks” really mean that inflation is a foregone conclusion? As a direct consequence, it does mean that the majority of financial assets and liabilities are now on the balance sheets of a handful of banks. The greatest risk lies on the asset side of the ledger. That’s where losses are being hidden and disguised in droves. To be sure, look at what’s happening to property values in the private sector. That ultimately represents the collateral behind bank assets. The liability side of the ledger also poses risk if depositors suddenly decide to flee banks in a big way. This threat is greatest among foreign depositors. These are both looming deflationary threats that are mostly being ignored for now.

Government officials always overlook the fact that a deflationary recession cleanses unstable debt from the financial system. Nonetheless, since the Great Depression, officials have remained paranoid of deflation. In particular, recent Federal Reserve chairmen, Alan Greenspan and Ben Bernanke, have publicly stated their knowledge of the Great Depression and their ability to avert a similar disaster. In a statement prior to becoming the Fed chairman, Bernanke said that if conditions became too desperate, the Fed could simply drop dollars from helicopters to re-inflate the economy – thus earning the nickname Helicopter Ben. Following the tendencies of his predecessors, Bernanke’s interventions again prevented the natural debt-cleansing process of free markets.

As a result, bad debt keeps building within our financial system. Excessive risk-taking is repeatedly encouraged. And allocation of credit becomes increasingly distorted and misplaced. In the final stages of a monetary-system built on ever-expanding credit, the debt problem becomes so huge that government efforts to stabilize the system repeatedly fail. That’s the stage the US economy now finds itself. At this point, even the combined efforts of the Federal Reserve and the US Treasury will fail to fix the debt-problem.

That’s because too many individual and businesses hold too many bad debts that have no hope of ever being repaid. A financial system built on ever-expanding debt is always doomed to fail – it’s simply a matter of time before the expansion reaches its breaking point.

By preventing a series of minor deflations spread out over a period of several decades, the Federal Reserve has created an environment that will force one massive deflation (striking within a relatively short period of time). By allowing bad-debt to continually build within the banking system, the Fed has created a situation that guarantees our government will completely loses control. That almost happened last autumn, and it’s guaranteed to happen sometime in the future. It’s only a question of when.

In an article entitled A Recovery Foundation Built on Sand, Michael Pento, the chief economist for Delta Global Advisors, describes how current government interference only prolongs financial agony, while never solving the underlying cause – which is excessive debt:

“Instead of allowing a cathartic and reconciling recession to run its course, the Federal Reserve (Fed) decided last year to again bail out the economy by greatly expanding the money supply. In this latest case of artificial intervention, the expansion in the monetary base was a record-breaking trillion dollars, but that intervention has abated in the last few months. What should become clear fairly soon is that the apparent recovery in the markets and the economy has been built primarily on the devaluation of the U.S. dollar, not from a healing of the economy’s fundamentals. That clarity will become evident once the dollar begins to make a brief rebound. For the last few months, the Fed has temporarily halted its assault on the greenback in the mistaken belief that the economic crisis has ended. Therefore, the most likely result will be a major correction in the market and a resumption of economic deterioration. Unfortunately, that should eventually cause the Fed to resume its misguided efforts to bolster growth by wrecking the currency. The Fed’s conundrum is this: whether he is aware of it or not, Fed Chairman Ben Bernanke needs to defend the dollar and raise interest rates to provide for a viable and long-lasting recovery. But the short-term effect would be a devastating recession which is, of course, politically untenable…. That’s because we just haven’t acknowledged the reality of our addiction to debt and inflation as the basis for economic activity. What I find most amazing about all this is how most in Washington and Wall Street fail to recognize what caused the crisis in the first place. The problem never was that there wasn’t enough borrowing, consuming and cheap money around. The problem was that the level of debt in the country had become unsustainable. In fact, as a country we are still actually increasing our level of debt. Therefore, all our perceived healing was predicated on the devaluing of the dollar, not from the paying down of our obligations or a repudiation of our past behavior. We just can’t escape the day of reckoning. The country will most likely go through a devastating bought of inflation to avoid a strengthening dollar and further erosion in asset prices. However, a protracted period of deleveraging is still needed as a nation. What we need is to return to a real economy based on a sound currency and reduced debt. That will certainly be painful in the short term, but the only way to provide a long lasting and healthy economy.” [Pento, 2009]

I agree with Pento on every point, except for one – a devastating bought of inflation is unlikely. In the United States, two camps of thought dominate the marketplace. The bullish camp believes that government interventions can be fine-tuned to hold inflation in-check, while allowing the economy to expand. The bearish camp believes that government interventions will eventually unleash uncontrollable inflation that will send the price of gold, oil, and other commodities soaring to sky-high levels – while sending the economy into a prolonged tailspin due to reduced purchasing power.

But more than likely, both camps are wrong. And the hyperinflation expected by the bearish comp is even more unlikely than the bullish viewpoint. Why? Throughout the world’s financial history, there has never been a case of hyperinflation in a country using a monetary-system based on credit. Hyperinflations only occur in countries that use currency for money. That’s an important distinction that cannot be overlooked.

A credit-based monetary system prevents severe inflation in two ways. (1) During times of rising inflation, investors avoid bonds in favor of hard assets. As a result, bond prices deflate, causing great losses for existing debt holders. (2) During times of financial stress, bonds backed by questionable assets deflate in value.

Hence, even though the par-value of outstanding debt may increase (leading some to believe that inflation will soon strike), the market-price of that debt can and will deflate substantially, depending on the conditions. This leads to loss of wealth and reduced purchasing power for creditors. If potential lenders become too alarmed by deflated credit values, they stop lending. That’s exactly what happened during the Great Depression, during the early 1980s, and once again during 2008. And that’s why credit markets froze.

And deflation of debt resides at the center of the toxic asset problem at the major banks. Bankers say their illiquid holdings should be valued close to par-value. Knowledgeable investors say they should be valued at market-price. Devaluation of credit has struck in a big way, and the deflationary repercussions continue to spread. Even though bankers gained accounting relief via political pressure, accountants don’t provide payments. But debtors and markets do. Eventually, bankers must face up to the distressed levels of their toxic assets.

Will the myriad array of government programs unfreeze the credit markets? Absolutely not! The only credit markets that remain completely unfrozen are the markets for government debt, agency debt, and private debt guaranteed by the government. However, in the process of opening its checkbook to firms with sufficient political clout, the ultimate bubble of all bubbles is now forming – a US government debt bubble. Identical to all other bubbles, the government debt bubble will eventually burst.

At some point, the ever-expanding supply of debt will simply overwhelm the market. No entity is bigger than the market, and markets always prevail over participants who abuse or attempt to corner trading. This applies to governments as well as individuals. Government cannot continue borrowing in large quantities indefinitely without paying a steep price for that luxury.

At the first hint that large holders are leaving the market, a mad scramble by other owners will severely deflate the value of bonds. More than likely, such a panic will start in the corporate sector first, and then spread to government bonds later. In this scenario, even substantial intervention by the Federal Reserve will fail to prevent panic. Why? History shows that when a monetary authority overpays for an asset in an attempt to halt a panic, private holders willingly dump a seemingly endless supply of assets onto the authority – eventually overwhelming the intervention attempt.

A close examination of credit conditions shows that recent interventions have failed to improve the private sector environment. This implies that our government is now throwing good money after bad at an alarming rate. And this increases the risk of pending failure of federal access to the debt markets. The ineffectiveness of government efforts can be inferred from an August 20 Bloomberg article, entitled Corporate Defaults Soar to $453 Billion, S&P Reports, Caroline Hyde and Paul Armstrong describe the latest news on the ability of corporations to repay their debts.

"Corporate defaults worldwide rose in 2009, surpassing the number for the whole of 2008, Standard & Poor’s said in a report today. A total of 201 issuers defaulted through Aug. 12, affecting $453.1 billion of debt…. That’s up from 126 defaults totaling $433 billion for all of last year…. The speculative-grade default rate reached 8.6 percent in July, up from 8.3 percent the month before…. The number of defaulted high-yield bonds is now 10-times the level recorded in November 2007 [when the current recession began]." [Hyde & Armstrong, 2009]

At the present time, most economists and investors greatly underestimate the deflationary impact from the intrinsic loss off wealth continually occurring in the corporate sector. Of course, these losses aren’t limited to businesses. The financial environment for homeowners continues to deteriorate as well. In an August 20 release entitled Delinquencies Continue to Climb, Foreclosures Flat in Latest MBA National Delinquency Survey, the Mortgage Bankers Association reports that delinquencies continue their record ascent:

“The delinquency rate for mortgage loans on one-to-four-unit residential properties rose to a seasonally adjusted rate of 9.24 percent of all loans outstanding as of the end of the second quarter of 2009, up 12 basis points from the first quarter of 2009…. The delinquency rate breaks the record set last quarter. The records are based on MBA data dating back to 1972. The delinquency rate includes loans that are at least one payment past due but does not include loans somewhere in the process of foreclosure. The percentage of loans in the foreclosure process at the end of the second quarter was 4.30 percent…. The combined percentage of loans in foreclosure and at least one payment past due was 13.16 percent on a non-seasonally adjusted basis, the highest ever recorded in the MBA delinquency survey…. As for the outlook, it is unlikely we will see meaningful reductions in the foreclosure and delinquency rates until the employment situation improves. In addition, in some areas where a number of borrowers have mortgages that are larger than the current value of their homes, any life events such a divorce or loss of a job are likely to translate into foreclosures until prices in those areas recover, not just flatten…. Finally, while the various loan modification programs continue to have an impact on holding foreclosure rates below where they otherwise would be, the issue is that many of the foreclosures involve homes that are vacant, borrowers who no longer have jobs, or loans where there was fraud involved. Therefore, in measuring the effectiveness of industry or government loan modification programs it is necessary to compare the results not with the total foreclosure and delinquency numbers reported here but with the smaller subset of borrowers who can and want to qualify.” [MBA: Kemp, 2009]

As the preceding press release indicates, overloading homeowners with more debt doesn’t improve their ability to repay existing loans, and it certainly doesn’t improve the prospects for the national economy. The current preferred solution (now used by the major banks) of extending more credit for troubled homeowners only buys more time while placing an increased burden on debtors.

In this case, extending loans increases the deflationary pressure throughout the economy. That’s because it fails to create additional buying demand (because proceeds from the increased mortgage flow back to the lender) – while the pressure to sell homes and other assets remains. On the paper-side of the equation, with an increased mortgage against an unchanged home-price, the intrinsic value of the mortgage actually deflates in value. (Note: To calculate the intrinsic value of a paper asset, divide the market-price of the hard asset that serves as collateral by the par-value of the loan.) If home prices continue to decline, the intrinsic market-value for outstanding mortgages deflates even faster.

The rising delinquency rate only reflects the start of a long sequence of related problems. More importantly, the following article highlights the fact that, in today’s economic environment, once a delinquency occurs, there’s virtually no chance of recovery for a lender. Executives at major banks are in complete denial of this fact. These executives claim they can recover most of the par-value of their toxic assets. An August 25 Wall Street Journal column, entitled Fewer Catching Up on Lapsed Mortgages, James Hagerty describes the darkening plight facing over-leveraged homeowners. This suggests that bankers are oblivious about the value of their troubled loans:

"Homeowners who fall behind on their mortgage payments have become much less likely to catch up again, a new study shows. The report from Fitch Ratings Ltd., a credit-rating firm, focuses on a plunge in the ‘cure rate’ for mortgages that were packaged into securities…. The cure rate is the portion of delinquent loans that return to current payment status each month. Fitch found that the cure rate for prime loans dropped to 6.6% as of July from an average of 45% for the years 2000 through 2006. For so-called Alt-A loans -- a category between prime and subprime that typically involves borrowers who don't fully document their income or assets -- the cure rate has fallen to 4.3% from 30.2%. In the subprime category, the rate has declined to 5.3% from 19.4%. ‘The cure rates have really collapsed,’ said Roelof Slump, a managing director at Fitch. Because borrowers are less willing or able to catch up on payments, foreclosures are likely to remain a big problem. Barclays Capital projects the number of foreclosed homes for sale will peak at 1.15 million in mid-2010, up from an estimated 688,000 as of July 1. Cure rates have sunk despite the Obama administration's prodding of banks to ease terms for millions of borrowers to try to prevent foreclosures. Without those loan-modification efforts, cure rates would be even lower…. What's more, because of widespread backlogs and delays in the foreclosure process, people who quit paying may be able to stay in their homes for more than a year before being evicted." [Hagerty, 2009]

In spite of efforts by both the administration and bankers to solve the foreclosure crisis, the darkening economic situation has proved too great to overcome. The plain truth is that few distressed properties fall into a category that permits assistance. In addition, recent publicity about the long-term eviction process may actually encourage people living on the edge to default. By doing so, a homeowner gains a year of rent-free living before being evicted. For financially troubled individuals, this can mean a savings of tens of thousands of dollars (causing at an equivalent loss to the lender).

3B - Distressed Properties.bmp

For all practical purposes, single-home owners with a mild delinquency qualify for assistance, and that’s it. Abandoned homes, vacation homes, second homes, and investment properties fail to qualify for help. Once a homeowner becomes delinquent, there’s still a small chance of recovery – even after a home reaches the pre-foreclosure stage. However, information from foreclosure.com shows that only 20% of all distressed properties fall into the pre-foreclosure category. The other 80% fall in the more serious categories of foreclosures, sheriff sales, bankruptcies, and tax lien sales. See Chart Daily17.

Furthermore, homeowners must want assistance before the administration’s modification program provides benefit. Increasingly, homeowners deep underwater prefer to walk away from their mortgage rather than continue efforts to salvage their residential investment.

In addition to difficulties that are directly visible because of widespread reporting by the media, some less visible financial problems brew beneath the surface. In a September 3 Wall Street Journal article, entitled The Reluctant Landlords, M.P. McQueen describes circumstances that have forced many homeowners to become landlords:

“With housing prices still in the dumps, many Americans are finding themselves in the uncomfortable position of landlord. Some have been forced to relocate for a job and can't sell their houses. Others have moved, but are holding on to their previous homes, hoping for prices to rebound before selling. Many are finding that rent checks don't come close to covering their mortgage payments. Hard data are scant on how many homeowners are renting out their homes, but anecdotal evidence suggests numbers are up. In one indication of the trend: More homeowners are converting their homeowners insurance to landlord policies that cover the additional risks of leasing out a home. Allstate Corp., the second largest home insurer in the U.S., reported a 27% increase in conversions in the first quarter from the previous year…. [As one example] in Frederick, MD, Realtor Jim Bass says that because of rising demand, a couple of months ago his real-estate group started offering property-management services, tending to the rented homes of absent owners. Mr. Bass says a client recently rented out his 4,700-square-foot house after failing to sell his home, which he listed for $790,000. Now a tenant pays $2,995 per month—a shortfall of $2,000 from the $4,995 mortgage payment. The homeowner ‘feels that two years from now, the market will improve to the point where he can recapture that,’ Mr. Bass says." [McQueen, 2009]

McQueen’s article provided several more examples – all with different circumstances, but all with the same underlying problem. Specifically, all of the reluctant landlords receive insufficient rent from their property to cover their existing mortgage – not even considering insurance and maintenance costs. Additionally, all of the landlords believe that if they can just hold out for another year or two, home prices will recover enough to bail them out of their financial mess. Yet, markets seldom accommodate the majority when their finances sit on the edge of insolvency. The extend-and-pretend mentality has stretched far beyond the banking system. This dormant inventory of homes (from reluctant landlords) means that the real supply of homes for sale is much larger than the official numbers show.

The bottom line is that home prices remain too high to justify renting. Residential properties must decline by at least half of their current value to bring solid investors into the rental market. Of course, if home prices fall that far, a whole new set of issues will emerge. Similar to inflation, once deflation becomes entrenched, it becomes exceedingly difficult to stop its momentum. Deflation only stops once the majority of debtors become relieved of the debt causing the burden. In the United States, the process has already begun in most areas of the private sector. The public sector will be forced into a similar liquidation once the federal debt bubble bursts.

In addition to reluctant landlords, Anne Marie Chaker penned an article in the September 3 issue of the Wall Street Journal exposing another financial problem. Entitled Students Borrow More Than Ever for College, Chaker described the higher-education issues:

“Students are borrowing dramatically more to pay for college, accelerating a trend that has wide-ranging implications for a generation of young people. New numbers from the U.S. Education Department show that federal student-loan disbursements — the total amount borrowed by students and received by schools — in the 2008-09 academic year grew about 25% over the previous year, to $75.1 billion. The amount of money students borrow has long been on the rise. But last year far surpassed past increases…. The sharp growth is ‘definitely above expectations,’ says Robert Shireman, deputy undersecretary of the Education Department…. The eye-opening increase in borrowing is largely due to the dire economic environment, which is causing more people to seek federal loans, he says.” [Chaker, 2009]

With parents increasingly unable to assist in educational expenses, students are relying on debt more than ever to get through college. Nonetheless, job prospects for graduates are diminishing. A large number of these loans will assuredly end in default. Yet, this is an area of the credit market that remains open – but only because of its federal association.

At this point, the two-tiered marketplace – of federal-related credit markets remaining open and turning out loans full blast while private sector credit markets remain exceedingly tight and undergoing moderate contraction – creates a conflicted environment with deflation occurring in the private sector while inflation continues at the government level. Which of these two conflicting forces will prevail?

The numerous (and intensifying) negative factors listed on the previous pages far outweigh political and banking efforts to contain the ongoing crisis. Looking at total debt levels, if derivatives are included on the liability side of the equation, private sector debt exceeds government related debt by a factor of anywhere from 10 to 20 times. So the developing deflationary trend in the private sector will more than offset soaring government debt for the next few years. Inflation may eventually become a problem, but not for years to come – and not until liquidations relieve consumers and businesses of the majority of their outstanding debts.

To make a long story short, no painless way exists to relieve debtors from their plight once they’ve reached the maxed-out stage. And in the United States, we may be approaching the point where 50% of all consumers, homeowners, and businesses have maxed-out on their credit. This has created a tremendous deflationary force that has become next-to-impossible to contain.

By preventing deflations during previous cycles, the Federal Reserve and the US Treasury have dammed-up negative monetary forces into a swelling reservoir of deflationary potential. During the summer and autumn of 2008, the deflationary dam nearly burst. Yet, the patchwork system put in place to relieve debtors has only caused the deflationary potential to grow larger and more unruly – as it has allowed some businesses and individuals, as well as the government, to become more deeply indebted. Nonetheless, these past few pages show glaring signs that the deflationary dam cannot be contained much longer.

On Tuesday, August 25, the markets cheered news that Ben Bernanke will be re-appointed chairman of the Federal Reserve. Indeed, mainstream economists almost unanimously credit Bernanke with single-handedly saving the US financial system from implosion last year. Yet, the chairman of Morgan Stanley’s Asian operations, Stephen Roach, views Bernanke’s tenure in a more realistic light. On the same day as the Bernanke news broke, London’s Financial Times published Roach’s assessment of Bernanke in an article entitled The Case Against Bernanke:

“Ben Bernanke will be nominated for a second term as chairman of the Federal Reserve. This is a very shortsighted decision…. It is important to remember that his pre-crisis actions played an equally critical role in setting the stage for the most wrenching recession since the 1930s. It is as if a doctor guilty of malpractice is being given credit for inventing a miracle cure. Maybe the patient needs a new doctor…. He was deeply wedded to the philosophical conviction that central banks should be agnostic when it comes to asset bubbles. On this count, he stood with his predecessor – serial bubble-blowing Alan Greenspan – who argued that monetary authorities are best positioned to clean up the mess after the bursting of asset bubbles rather than to pre-empt the damage. As a corollary to this approach, both Mr. Bernanke and Mr. Greenspan drew the wrong conclusions from post-bubble strategies earlier in this decade put in place after the bursting of the equity bubble in 2000. In retrospect, the Fed’s injection of excess liquidity in 2001-2003, which Mr. Bernanke endorsed with fervor, played a key role in setting the stage for the lethal mix of property and credit bubbles…. [Also,] Bernanke was the intellectual champion of the ‘global saving glut’ defense that exonerated the US from its bubble-prone tendencies and pinned the blame on surplus savers in Asia…. Asia’s surplus savers had nothing to do with America’s irresponsible penchant for leveraging a housing bubble and using the proceeds to fund consumption. Mr. Bernanke’s saving glut argument was at the core of a deep-seated US denial that failed to look in the mirror and pinned blame on others…. Notwithstanding these mistakes, Mr. Obama may be premature in giving Mr. Bernanke credit for the great cure. No one knows for certain as to whether the Fed’s strategy will ultimately be successful…. the sustainability of any post-bubble recovery is always dubious. Just ask Japan 20 years after the bursting of its bubbles. While financial markets are giddy with hopes of economic revival – in part inspired by Mr. Bernanke’s cheerleading at the Fed’s annual Jackson Hole gathering – there is still good reason to believe that the US recovery will be anemic and fragile…. It would be the height of folly to reward Mr. Bernanke for the recovery that never stuck. Yet Mr. Bernanke’s apparent reward is, unfortunately, typical of the snap judgments that guide Washington decision-making…. Mr. Bernanke … reacted strongly after the fact in taking actions to avoid the pitfalls highlighted by his own research. But he lacked the foresight and courage to resist the most reckless tendencies of the era of excess. The world needs central bankers who avoid problems, not those who specialize in post-crisis damage control. For that reason, alone, he should not be reappointed.” [Roach, 2009]

Unfortunately, Bernanke’s current solution of massive credit extension (including credit given to unworthy borrowers) mirrors the extend-and-pretend method now being employed by bankers for delinquent homeowners and commercial real estate investors. During recent post-bubble mop-up periods, the Fed inadvertently created new bubbles. Once again, it’s engaged in the same type of bubble blowing. The new bubble is quite obvious – at least, for anyone willing to take the time and effort to analyze the situation.

This time, a huge bubble in government-related finance is occurring. Credit-risk is being massively transferred from the private sector of the economy to the public sector. Outstanding debt is expanding at alarming rates for the federal government, its agencies, the government-guaranteed private sector, and the Federal Reserve.

While credit to the private sector and to state-and-local governments remains severely constrained, borrowers with a direct or implied guarantee from the federal government still enjoy (at least for now) virtually unlimited ability to issue new debt. Nonetheless, similar to other great bubbles, the federal government debt-bubble will burst as well.

And when it does, the financial backstop of our “lender of last resort” will immediately evaporate. At that point, nothing will remain to stop the long-delayed deflationary correction. Unlike previous crises, federal officials will hold no weapons to fight the looming deflation. If by chance, the government tries to fight the deflation with increased deficits (which it probably will for a while), the marketplace will deflate the value of its existing debt at a rate faster than it can issue new debt – thus causing more deflation. Inflation has little chance of taking hold until our credit markets are totally destroyed – then inflation becomes a distinct possibility.

Once the federal-debt bubble bursts, even potential purchases by the Federal Reserve will fail to revive the bond market. If the Federal Reserve attempts to mop up excessive government debt by monetizing it, holders of existing debt will readily give their paper to the Federal Reserve at a price that will surely be “above market price”. By paying prices above fair-value, the Fed will be swamped with offers to sell, and it will quickly “bankrupt” itself (as any buyer would) by repeatedly paying prices that are too high.

Interestingly, the Federal Reserve now finds itself in the middle of a losing lawsuit. While the practice of hiding losses may fool some of the people some of the time (and it may have aided in averting financial crises in the past), the Fed’s long-term practice of repeated deception only spawns distrust of bankers and our banking system. This distrust will surely intensify as a result of the Federal Reserve’s recent refusal to release details of its emergency loans. In an August 27 Bloomberg article entitled Federal Reserve Says Disclosing Loans Will Hurt Banks, financial writer Mark Pittman describes the battle between Bloomberg and the Fed:

“The Federal Reserve argued yesterday that identifying the financial institutions that benefited from its emergency loans would harm the companies and render the central bank’s planned appeal of a court ruling moot. The Fed’s board of governors asked Manhattan Chief U.S. District Judge Loretta Preska to delay enforcement of her Aug. 24 decision that the identities of borrowers in 11 lending programs must be made public by Aug. 31. The central bank wants Preska to stay her order until the US Court of Appeals in New York can hear the case. ‘The immediate release of these documents will destroy the board’s claims of exemption and right of appellate review,’ the motion said. ‘The institutions whose names and information would be disclosed will also suffer irreparable harm.’ The Fed’s ‘ability to effectively manage the current, and any future, financial crisis’ would be impaired, according to the motion. It said ‘significant harms’ could befall the U.S. economy as well…. The Fed has refused to name the financial firms it lent to or disclose the amounts or the assets put up as collateral under the emergency programs, saying disclosure might set off a run by depositors and unsettle shareholders…. ‘Our argument is that the public interest in disclosure outweighs the banks’ interest in secrecy,’ said Thomas Golden, a lawyer with New York-based Willkie Farr & Gallagher LLP who represents Bloomberg…. ‘What has the Fed got to hide?’ said Senator Bernie Sanders, a Vermont independent who sponsored a bill to require the Fed to submit to an audit by the Government Accountability Office. ‘The time has come for the Fed to stop stonewalling and hand this information over to the public.’” [Pittman, 2009]

What is the Fed hiding? And why? Why do Fed officials think revealing the details of their emergency loans will cause depositors to withdraw funds from troubled banks? Perhaps the Fed’s refusal to reveal the information indicates that major banks are in much worse shape than the Fed admits publicly. This is a very curious situation. Instead of handing over the documents to Bloomberg, by pursuing an appeal, the Fed risks a backlash. Investors and depositors are already edgy about the lack of transparency within banking circles. The Fed’s refusal to hand over documents can only increase that distrust.

When a financial bubble bursts, millions of citizens lose faith in their leaders and institutions. This lost faith adds to the difficulty of re-inflating the economy. To better understand this fact, Japan serves as a great example. Failed attempts to re-inflate the Japanese economy warn of equivalent events in the United States. In an August 28 Bloomberg article, entitled Japan’s Jobless Rate Hits Record 5.7% in Blow to Aso, Toru Fujioka and Mayumi Otsuma describe the consequences of the post-bubble environment in Japan:

"Japan’s unemployment rate rose to a record 5.7 percent in July and deflation worsened, dealing a blow to Prime Minister Taro Aso on the eve of an election that polls indicate his ruling Liberal Democratic Party will lose…. Yukio Hatoyama’s Democratic Party of Japan may end the LDP’s 54-year grip on power as jobs vanish in the wake of the country’s worst postwar recession. Household spending slid 2 percent last month, indicating Aso’s cash handouts as part of a 25 trillion yen ($267 billion) stimulus plan are failing to spur demand among consumers whose wages are falling…. Companies from Toyota Motor to Japan Airlines are scaling back and cutting jobs as sales weaken at home and abroad. Exports fell 36.5 percent in July, a tenth monthly drop, as demand from all of the nation’s major markets deteriorated…. More than $2 trillion in stimulus plans worldwide helped the world’s second-largest economy grow at an annual 3.7 percent pace last quarter, the first expansion in more than a year. Economists expect growth will weaken in coming quarters once the government cash injections are exhausted…. The jobs-to-applicants ratio, a leading indicator of employment trends, fell to a record 0.42 in July, meaning there are only 42 positions for every 100 candidates, the Labor Ministry said today. The number of unemployed rose by 200,000 from June, the biggest increase since March. ‘We are very far from a solid recovery,’ said Yuichi Kodama, chief economist at Meiji Yasuda Life Insurance Co. in Tokyo. ‘There’s a high risk for a more serious labor adjustment going forward’ as companies offload workers they no longer need, he said…. The jobless rate would be around 12 percent if all of Japan’s excess workers were considered unemployed, according to Takahide Kiuchi, chief economist at Nomura Securities Co. in Tokyo…. Last month’s drop in prices excluding fresh food, which matched economists’ estimates, was the steepest since the survey began in 1971. ‘Nothing can stop prices from falling now, given that demand has deteriorated so much,’ said Masaaki Kanno, a former central bank official and now chief economist at JPMorgan Chase & Co. in Tokyo…. Bank of Japan board member Atsushi Mizuno said last week that policy makers should ‘be prepared to fight a long-term battle’ with deflation. The central bank, which has cut the key interest rate to 0.1 percent, has few tools to prop up inflation and economic growth in the short term, he said." [Fujioka & Otsuma, 2009]

Actually, in the US deflationary prospects are much greater than in Japan. In Japan, consumers mostly live within their means. In the US, the adjustment needed to reduce spending to a level that doesn’t required continual borrowing and stimulus has only begun on a limited scale. Much deeper cuts are required. Overseas lenders won’t continually lend to a country that repeatedly over-consumes. Our best hope is that overseas lenders and producers are ignorant enough that they will continue to toil and labor at their expense to provide US consumers with goods for our enjoyment – and all we have to do is continue giving them electronic promises that will never be repaid. But such a work-free outcome seems unlikely to last much longer. Foreign officials and investors are increasingly grumbling about US spending habits. Eventually, they seem certain to do something more serious than grumble – for example, they may soon refuse to buy new dollar-denominated debt, and they may begin selling the dollar-denominated securities they already own.

Government efforts to improve the financial condition of the US economy will continue to fail – at least until a deflationary collapse arrives. A deflationary crash will benefit the masses in two ways: (1) It will forcibly relieve debt burdens, and (2) it will bring home-prices and consumer-prices down to more reasonable levels – levels that allow our citizens to buy necessities at levels that don’t require massive debt burdens. These two benefits are virtually ignored as policymakers continually work in the direction of inflating our economy.

Policymakers incorrectly view deflation as a bad thing and inflation as a good thing. True. Deflation usually results in rising unemployment, but that is offset by the benefits of keeping debt-loads in balance and by keeping prices at affordable levels. Current views toward deflation must be discarded to allow our nation to return to a balanced economy. In order to attain long-term prosperity, markets must return to a pricing mechanism that allows deflation – free from government interference.

In addition to the debt monster working against the government, the long-term EUWS cycles (such as the 172-year, 57-year, and 19-year cycles) suggest that confidence in government policies will continue to erode as time passes. Gaining political support for new spending programs will become increasingly difficult. This difficult political environment clearly shows in the administration’s struggling efforts to legislate health-care.

Once the inevitable deflationary crash concludes, which is probably several years from now, the US economy will finally reach a stage where long-term recovery becomes a possibility. In the process, the holders of existing debt – including banking institutions, pension funds, mutual funds, foreign governments, and other investors – will be financially decimated. A deflationary crash is inevitable.

By the end of the crash, the Dow Jones Industrial Average should trade well below the 1,000 level – about 1/10 of its current price.

References for Debt, Inflation, & Deflation.

Alesci, C., [2009]. Goldman Sachs Wrong on Economic Recovery, Macro Hedge Funds Say. Bloomberg, September 1, 2009. http://www.bloomberg.com/apps/news?pid=20601009&sid=auGWGWlnohNo

Chaker, A.M., [2009]. Students Borrow More Than Ever for College. The Wall Street Journal, Sept. 3, 2009.
http://online.wsj.com/article/SB10001424052970204731804574388682129316614.html?mod=rss_US_News

Cho, D. [2009]. Banks 'Too Big to Fail' Have Grown Even Bigger. Washington Post, August 28, 2009. http://www.washingtonpost.com/wp-dyn/content/article/2009/08/27/AR2009082704193.html

Fujioka, T.; Otsuma, M. [2009]. Japan’s Jobless Rate Hits Record 5.7% in Blow to Aso. Bloomberg, August 28, 2009. http://www.bloomberg.com/apps/news?pid=20601080&sid=aASW1DJWcbho

Hagerty, J.R. [2009]. Fewer Catching Up on Lapsed Mortgages. The Wall Street Journal, August 25, 2009. http://online.wsj.com/article/SB125113686930654371.html

Hyde, C.; Armstrong, P. [2009]. Corporate Defaults Soar to $453 Billion, S&P Reports. August 20, 2009, Bloomberg. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aM9Q_6ozzhMU

MBA: Kemp, C. [2009]. Delinquencies Continue to Climb, Foreclosures Flat in Latest MBA National Delinquency Survey. Mortgage Bankers Association, Washington, DC, August 20, 2009.
http://www.mbaa.org/NewsandMedia/PressCenter/70050.htm

McQueen, M.P., [2009]. The Reluctant Landlords. The Wall Street Journal, Swptember 3, 2009.
http://online.wsj.com/article/SB10001424052970204731804574388683272200844.html?mod=rss_US_News

Pento, M. [2009]. A Recovery Foundation Built on Sand. Chief economist, Delta Global Advisors, August 17, 2009. http://prudentbear.com/index.php/guestcommentaryview?art_id=10261

Pittman, M. [2009]. Federal Reserve Says Disclosing Loans Will Hurt Banks. Bloomberg, August 27, 2009. http://www.bloomberg.com/apps/news?pid=20601103&sid=aAOhgVw78e3U

Roach, S. [2009]. The Case Against Bernanke. Financial Times, August 25, 2009.
http://www.ft.com/cms/s/0/a2ba2378-9186-11de-879d-00144feabdc0.html?ftcamp=rss

Contact Information

Steve Puetz | The Unified Cycle Theory | Honolulu, HI USA | Email | Website