Saturday, May 08, 2004

BonoboLand - Does Deleveraging Equal Deflation?

BonoboLand - Does Deleveraging Equal Deflation?
Check out all the comments at BonoboLand above.

I don't mean to pour water on others' fires, but global shipping figures at GeoHive show China and S.E. Asia to be a much larger influence on global markets than many have thus far stated, including Andy Xie. As Stephen Roach stated global trade is now 25% of global GDP, and these figures clearly show China and S.E. Asia to be a very powerful player in the global trade marketplace, far beyond mere commodities, luxury goods, and such. I believe Marshall Auerback comes closer to nailing down the true global picture, although Xie's older post should be taken very seriously.

I'll post some of Marshall's article and urge reading the link to the entire post. I also urge reading Karol Gellert's article on Fisher's debt deflationary spiral, as she interpreted it for a college paper.

The “inflation/deflation” debate has been ongoing virtually since the start of the 21st century. Rising commodity prices, rapidly recovering economies (in both America and Asia, notably China) and the ongoing generation of one mini-bubble after another, particularly in the US, has until recently shifted the collective weight of investment opinion toward the great reflation trade. The basis of the Great Reflation Trade, as we have repeatedly identified, lies in an unqualified conviction the government can and will, "by any means necessary" to quote Governor Bernanke's seminal November 2002 speech, drive the economy, corporate profits, asset prices higher – all to ward off the prospect of a Japanese style deflation emerging on American shores.
As we all know, by the late 1980s Japan had an asset bubble. It was accompanied by a private debt bubble. By 1991 the asset bubble began to burst. But the outstanding debt, fixed in nominal Yen, did not go away. Even though the Bank of Japan took policy rates to zero and even though the fiscal balance went from a 3% of GDP surplus to a 10% of GDP deficit, the Japanese economy stagnated.

Stagnation in the Japanese economy has widely been attributed to the burden of private debt built up in the 1980’s. Faced with greatly reduced collateral, private firms and households reduced expenditures and sold assets to reduce their debt burden. This in turn reduced aggregate demand.

As the 1990’s progressed, matters got worse in Japan. Unemployment rose. Low inflation gave way to outright price deflation. The economy fell into two successive recessions with little recovery between them. Again the attempt by firms and households to reduce high debt is widely cited as the cause of the greater economic weakness of the 1997-2002 period.

During the latter part of the 1990s, firms did finally begin to significantly reduce their debt. This can be attributed to the emergence of a debt deflation dynamic that emerged at the time. Deflation raises the de facto real interest rate, even if policy rates are zero, and it raises the real debt burden. Private economic agents recognised this. They moved to reduce debt and their actions contributed to recession and more price deflation. Together high debt and price deflation threatened a debt deflation spiral. Asset prices, including equity prices, kept on falling in this environment, even though short tem interest rates were zero.

How close are we to this debt deflation dynamic in other parts of the world today? Certainly, events over the past week have engendered a rapid reversal in investor psychology away from inflation. Abrupt falls in base metals, commodity-based currencies (notably the Australian and Canadian dollars), gold and silver, have all contributed to a revival of fears which predominated during the 2000-2001 period, in which “deflation”, brought about by ongoing deleveraging pressures, was said to be the major underlying threat to the global economy.

It may seem hypocritical to decry the dangers of massive debt build-up, and then to warn when the process of paying down such debt appears to have commenced in earnest. As always, however, context is very important. The Japanese experience demonstrates that debt repayment against a backdrop of a huge financial bubble that has burst can be highly deflationary, especially if there is no offsetting monetary or fiscal stimulus. Of course, a crucial distinction has to be made between the experience of Japan, where the monetary authorities took firm steps to burst their asset bubble, in contrast to the Fed which, for all its talk about being “vigilant about inflationary pressures”, has done nothing but talk about electronic printing presses and helicopter money to lift asset prices and the inflation rate to avert debt deflation.

The dynamic between debt and price deflation was best analysed by Irving Fisher in the early 1930’s during the great depression. Fisher argued that the great depression was the result of two economic events – the emergence of high private debt in the 1920’s and the onset of significant price deflation in 1929. He referred to these as the debt disease and the dollar disease. Price deflation swells the real value of the dollar and thereby the real burden and cost of private debts. If private debt is low (no debt disease) price deflation is not disastrous. But if private debt is high, price deflation sets off a vicious downward economic spiral which Fisher called debt deflation. Because the onset of price deflation raises the real burden of debts, firms and households shed assets and reduce expenditures in order to pay down debt. But these acts of liquidation by all economic agents push prices yet lower, which in turn raise the real debt burden further. Fisher emphasised: the more economic agents individually try to repay their debts, owing to consequent price deflation, the more they owe.

The crowded nature of the Great Reflation Trade amongst the leveraged speculating community, and the subsequent process of exiting it against a backdrop of huge international debt build-up, manifests elements of this Fisherian dynamic. The massive declines seen in the precious metals, bond and forex markets over the past few weeks, show how fast and destabilising market conditions can be when all begin to rush for the exits simultaneously.

The “man in the theatre” said to have yelled “Fire” this time around is China. For months, Chinese authorities, led by Premier Wen, have been making increasingly hawkish comments to the effect that China was committed to using “effective and very forceful measures” to slow growth. This culminated with last week’s Bloomberg story reporting that Chinese banks have been asked to stop lending. The story cited a loan officer at the Pudong Development Bank (amongst others) as saying, “We have already been told to suspend all our loan business…It’s a decision from the very top.” ...Link