Thursday, 14 February 2013

The uncertain course of debt deflation

This post is written jointly with Frances Coppola.

I have been re-reading Irving Fisher's "Debt deflation"[1]. Short and immensely readable, it remains one of the best explanations of financial crashes and depression in economics literature. But I am puzzled. What is going on at the moment doesn't quite fit, somehow.

On the face of it, much of what has happened over the last six years fits all too well with Fisher's description of debt deflation. He identifies two prime causes of booms and busts - what he calls the "debt disease" and the "dollar disease". Over-indebtedness before the crash results in debt deflation after the crash - the "debt disease". And shortage of money in circulation leads to apparent over-production and crashing prices - the "dollar disease". The disastrous deflationary spiral experienced by the US in the Great Depression, and by several Eurozone countries at present, can be adequately explained by these two factors. 

But what is happening in countries such as the US and UK is much less straightforward. We had a crash, followed by sharp deleveraging in the private sector, distress selling, price crashes and bankruptcies. But then we propped it all up. Governments intervened to arrest the deflationary slide by taking distressed private debt on to public balance sheets, and central banks flooded the place with new money to prevent catastrophic price falls. The sharp deleveraging stopped and the price level stabilised - in fact in the UK the general price level actually rose. And yet we seem to be experiencing a number of features of Fisher's debt deflation spiral. 

Fisher identifies a chain of nine linked stages in debt deflation:

1) Debt liquidation causing distress selling leading 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....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 society leads the concerns which are running at a loss to make
6) A reduction in trade, in output and in employment of labour. These losses, bankruptcies and unemployment lead to 
7) Pessimism and lack of confidence, which in turn lead to
8) Hoarding and slowing down still more the velocity of circulation.
The above 8 changes cause
9) Complicated disturbances in the rates of interest, in particular a fall in the nominal (money) rates of interest and a rise in the real (commodity) rates. 

Now it is easy to see where in this sequence governments and central banks intervened. Clearly it was between stages 2 and 3 - exactly where Fisher says that reflation might interfere with the process. Bernanke and Geithner may not have read Fisher, but they did what he suggested. Consequently we have not seen a general fall in the price level and we have not had a spate of bankruptcies. But that's where the good news ends. 

There is no doubt that the financial crisis did severely disrupt trade, output and employment, despite the reflationary efforts of governments and central banks. And it is still doing so. Employment in Western nations is well below what it was before the crisis: in the US this shows itself as a stubbornly high unemployment rate, while in the UK it takes the form of substitution of full-time employment with part-time, short-term and casual work. Output is also significantly lower than before, to the extent that the UK's OBR pessimistically forecasts that it cannot return to its previous level. And both domestic sales and exports are reduced. The feeble nature of the economic recovery is the reason why Western central banks are still reflating their economies six years after the crisis. 

Evidently the reflation did not fully prevent stage 6 from occurring. And it seems to have had no effect at all on the subsequent stages. Pessimism and lack of confidence is evident throughout the economy: people are worried about their savings, their jobs and their incomes. People and businesses are cutting spending and saving like crazy: they are paying off debt and hoarding cash and other assets. Investors are moving their funds to safe havens - highly-rated government debt, traditional safe haven currencies such as the Swiss franc, government-insured deposit accounts. Even UK local authorities are under-spending their budgets and building up reserves. Yet the crisis itself is long over and did not cause the catastrophic deflation of the 1930s. What on earth is going on?

There is no doubt the prompt intervention of the authorities prevented a repeat of the 1930s disaster. We did not repeat the mistakes of the early 1930s, except in the Eurozone where the Euro straitjacket forced countries to maintain tight monetary and, latterly, fiscal policy, precipitating the classic deflationary spiral. Or - did we? Six years on, monetary policy is so loose it is practically in pieces and central banks are resorting to increasingly esoteric and untested tools to find ways of depressing interest rates further (actually this amounts to the "complicated disturbances in interest rates" that Fisher mentions, though not for the same reasons). But fiscal policy is another matter. In contrast to 2009, when governments worldwide collaborated to give substantial fiscal stimulus to the global economy as a whole, the general policy stance of Western governments now is that fiscal policy must be progressively tightened in order to reduce public deficits and - as the IMF puts it - "get public finances on to a more sustainable path". In other words, we are VOLUNTARILY undertaking debt deflation in the public sector. The only Western government that hasn't so far adopted fiscal austerity as a general policy is the US. But it clearly intends to. Even Obama talks about reducing the deficit , though whether he means short-term spending cuts or longer-term structural reform is unclear. 

The prevailing view appears to be that fiscal "reforms" - i.e. public debt deflation - can be conducted despite difficult economic conditions if monetary policy is supportive. But this ignores the fact that fiscal and monetary policies affect the economy in different ways. Monetary policy primarily affects the financial system: fiscal policy primarily affects the "real" economy. Or in US parlance, monetary policy influences Wall Street, fiscal policy Main Street. Obviously there are indirect effects: monetary easing depresses interest rates on variable-rate mortgages and on savings and investments, benefiting homeowners: taxation policy affects the nature and direction of money flows around the financial system. But the direct effects have more impact - and the direct effects of ANTICIPATED fiscal austerity and government spending cuts are sufficient in themselves to explain pessimism, lack of confidence and hoarding among the general public. Never mind that governments actually haven't done much fiscal tightening yet. All that matters is that people think they are going to. Public sector workers are worried about losing their jobs - and with reason, as there have already been significant job losses and further cuts to government departments are planned. Working-age people on low to middle incomes worry about tax rises and benefit cuts. US pensioners worry about cuts to Medicare: UK ones, about means-testing of benefits such as the winter fuel allowance. And there is clearly more to come. The UK government responded to the news that it would miss its deficit reduction target by announcing a further 3 years of cuts and austerity. Really they are stupid. Did they think people would react to that by going on a spending spree? Anybody with any sense surely could have foreseen that people would respond by increasing their savings level. The effect of the UK government's announcement must have been to depress the economic activity of average UK households. 

Perversely, the effect of monetary easing can also be to reduce spending and increase savings rates. Pensioners on fixed incomes cut their spending in anticipation of poorer returns on their investments due to depressed interest rates. And people who are suffering erosion of their capital due to negative real interest rates don't necessarily spend the money instead - certainly not if it is money they are saving up for their old age. No, they try to make good the difference. They cut discretionary spending and save even more. 

The effect on businesses of anticipated fiscal austerity is slightly different. Businesses generally don't suffer directly from fiscal tightening, unless governments raise corporation taxes. They suffer indirectly, because of demand reduction caused by households suffering reductions in real income and/or opting to save instead of spend. Resilient (or even improved) private sector profitability has been the surprising story of this financial crisis, but it has largely been driven by the ability of some businesses to bleed existing assets (increasing rents) while cutting investment in future projects (holding back innovation causing artificial scarcity). Unfortunately because incomes are being squeezed by a combination of inflation and corporate cost cutting this will likely prove a temporary state of affairs. Indeed we are already seeing a growing number of corporate profit warnings.

The problem then is what companies do with their surpluses. If fiscal policy is still a driver of uncertainty then there is very little incentive for them to start investing as they rationally assume demand will be further undermined. But the alternatives are not very compelling either – sitting on cash (or cash-equivalent assets) with interest rates around zero and above-target inflation mean they are already losing significant amounts in real terms. Moreover, contrary to what a number of investors have been advocating for, committing to paying it out as dividends is also problematic as at best it can only buy time unless the business can achieve meaningful organic growth.

Yet their reluctance to spend is helping to intensify the economic downturn and undermining central bank attempts to reflate. This has created a destructive cycle whereby businesses try to anticipate the demand impact of government cuts by building up surpluses, increasing the actual impact of the cuts when they occur. The burden is then shifted onto central banks to mitigate the shortfalls by trying to reflate the asset base, even as the spillover effects of unorthodox monetary policy erode returns on safe assets and prop up inflation above average wage rises. It hardly makes a compelling case for banks, which are under regulatory pressure to de-risk, to start increasing lending to the real economy.
They too are sitting on what little profits they are able to make, refusing to take on risk and lobbying government in the hope of reducing regulatory threats.

Debt deflation doesn't follow a predictable sequence: it meanders in an uncertain and unpredictable manner, depending on the situation of each economic agent. So the relationships between Fisher's nine linked stages are complex, and the effect of later stages can be to recycle earlier ones. So, for example, the effect of private sector hoarding is to reduce economic activity, depressing trade, output and employment and causing bankruptcies. Businesses that aren't highly indebted and are able to cut costs may survive depression of customer demand, but businesses that have significant amounts of debt and/or high fixed costs may go right back to stage 1) - debt liquidation, distress selling and bankruptcy. This includes banks. There have been calls for banks to reduce "forbearance", where they do not foreclose on bad loans, because it maintains businesses that should be allowed to fail, preventing growth of new, more viable businesses. But when the banks have balance sheets stuffed full of loans to zombie businesses and underwater homeowners, their own solvency is at risk if they foreclose on those loans. Forbearance is a self-protective hoarding strategy on the part of banks. Without it, banks would go bankrupt. 

The effect of banks desperately hanging on to bad loans in order to avoid bankruptcy is that new lending, particularly to business, is severely curtailed - as Fisher forecast. They cannot afford the risks that these businesses represent. They have quite enough risk on their balance sheets already. But the effect is that small and medium-size businesses, particularly, are starved of the essential finance they need to grow. And as Fisher also forecast, debt deflation in general and hoarding behaviour in particular (including forbearance and lending restriction) has disruptive effects on interest rates. Interest rates on assets perceived as "safe" crash through the floor, while interest rates on finance for productive activity head for the moon. 

So the picture we have is one of continuing, though slow, debt deflation and significantly disrupted price mechanisms despite - and to some extent because of - central bank attempts to reflate. It seems that the supportive effect of monetary easing is cancelled out by both the reality and the threat of fiscal austerity. We are locked into the same deflationary spiral as the US of the 1930s, but at a much slower pace. Now, slow may be better - it may avoid the appalling hardship described by Steinbeck and evident in reports from today's Greece. But it does mean that recovery is not going to happen for a very long time. 

Whether softening the fiscal stance, delaying public sector financial reforms and allowing reflation to do its job would stop the debt deflation spiral and allow economies to recover I don't know. There are a lot of very worried people out there. It may be that the biggest problem now is not the debt, not the economic problems, but people's hearts and minds. The world is a frightening place at the moment. Everyone is desperately trying to protect what they have rather than risking it in the hopes of better to come. But risk-taking is essential for economic growth. While risk aversion remains the dominant paradigm, there can be no lasting recovery. 

[1] Irving Fisher – Debt Deflation:

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