The Razor’s Edge – Inflation vs. Deflation

Deficit spending has been touted as a potential driver of inflation, because only with devalued (inflated) currency can we hope to erode the real value of our mounting levels of government debt. Continuing to print U.S. dollars, it is claimed, can only lead to too many dollars in the system, and hence a devalued dollar. We should be so lucky.

A few years ago, in Sept. 2007, in a post entitled “Inflation vs. Deflation,” I cited a recent (at the time) quote from Paul Kasriel, an economist with The Northern Trust Co. in Chicago. He explained the danger of deflation quite well, describing what happened in Japan:

“Japan experienced a deflation in recent years because the bursting of its asset-price bubble in the early 1990s created huge losses in its banking system. The Japanese banks had financed the asset-price bubble. When it burst, the debtors could not keep current on their loans to the banks and therefore were forced to turn back the collateral to the banks. The market value of the collateral, of course, was less than the amount of the loans outstanding, thereby inflicting huge losses of capital to the Japanese banks. With the decline in bank capital, the Japanese banks could not extend new credit to the private sector even though the Bank of Japan was offering credit to the banks at very low nominal rates of interest.”

Another way to put this is as follows: Liquidity is a function of two factors, money supply and collateral. But the impact of available collateral is far more critical to maintaining liquidity than the money supply. Let’s suppose the entire privately held asset base of the United States is 25 times GDP – it’s probably worth much more than that, but let’s use these multiples – this suggests that the total private collateral in the U.S. is worth nearly 400 trillion dollars. On the other hand, let’s suppose the combined deficit spending – otherwise known as “stimulus” spending – in the U.S. is 10 trillion dollars per year – it’s much less than that, at least so far. Yet this 10 trillion dollars, in terms of liquidity, is a mere trickle compared to the value of the collateral, which is the basis of credit lending. What happens if entire sectors, such as the housing sector, decline in value by 50% or more? What if the entire asset base of the U.S. declined by 50%? Can a ten trillion dollar annual trickle of newly minted dollars make up for a decline in the borrowing base (the asset base) of 200 trillion dollars? No chance. This is what happened in Japan in the 1990s, this is what happened in the United States in the 1930s, and this is the specter we face today. Deflation is the devastating scenario that every fiscal and monetary policymaker in the United States is doing everything they can to avert. Inflation would be a cake-walk by comparison.

To further understand why deflation looms as a greater threat to the U.S. economy than inflation, consider what additional bubbles still remain in the U.S. economy. Two huge sectors come immediately to mind – the municipal bond market, and the commercial real estate market. Municipal bonds are at risk of default because public entities, nearly everywhere in United States, are on the verge of bankruptcy. The reason they teeter on the edge of bankruptcy is because these public entities have negotiated pension and compensation plans for public sector workers that are far more generous than anything available to ordinary workers or professionals in the private sector, and these inordinately expensive personnel costs have now far outstripped the willingness or the capacity of taxpayers to pay through even higher taxes. Barring dramatic and immediate reforms – lowering compensation and benefits in order to eliminate these deficits – municipal entities in much of the United States are on a collision course with bankruptcy. If they default on their bond payments, the value of municipal bonds will collapse. Meanwhile, investment has been pouring into bonds as the returns on equities have corrected. The bond market in general, and the municipal bond market in particular, is a massive asset bubble that is on the verge of bursting.

The commercial real estate market is in similar danger. Currently landlords are enduring high vacancies but are, in general, refraining from releasing space at lower rates. They know that if they lower leasing rates for their space, this will cause the value of their commercial property to be reassessed, reducing the amount of collateral their property will support. This reduction, in turn, will trigger calls for principal reduction payments by banks who service the mortgages on these properties, since lowered property values can put property owners into default on their loan covenants. A similar situation already exists with residential properties, except in this case instead of tolerating vacancies to keep rates high, banks are holding foreclosed properties to avoid flooding the market which would cause the price of residential real estate to drop even further. It is difficult to overstate the threat of deflationary impacts if any these precarious situations snowball, once a breach occurs.

Another potential bubble of staggering magnitude is the public employee pension funds. It is ironic, that public sector unions, who pretty much control the messaging in elections (which they buy, using taxpayer’s money), in our public schools, and through their supporters in the media, have taught the gullible among us to loath capitalism, resent private wealth, and vilify Wall Street, yet their public employee pension funds are now engaging in perhaps the most irresponsible example of casino capitalism yet. Rather than support reducing the bloated pension benefits they are currently obligated to fund, and rather than accept a conservative real rate of return on their investment portfolio of 3.0% per year, the public employee pension funds are engaging in investment activity that is riskier than ever in a desperate attempt to reflate their asset base. Read this from Pension Pulse’s Leo Kolivakis, written on March 9th, 2010, in a post entitled “Public Pension Funds Doubling Up to Catch Up“:

“Private pensions are in no mood to crank up the risk, but public pension funds are back to business as usual, and even looking to leverage up to obtain their magic 8%. Many public plans are still sticking to the motto that more private market assets will lead them out of their troubles. They’re in for a nasty surprise. Last January, I wrote that the alternatives nightmare continues, and I don’t see it getting much better. In fact, as mighty endowment funds like the Harvard Management Company look to unload real estate and other private equity holdings, private markets will likely suffer a long drought, especially since public markets are not going to deliver anything close to what they delivered in the last 30 years. So what are public pension funds doing? Cranking up the risk, investing in failed banks, leveraging up, shoving more money in private equity and hedge funds, whatever it takes to achieve that insane 8% average annual return they’re all still fixated on.”

Bonds, real estate, and pension funds, ultimately, are all collateral – the primary engine of liquidity. Over the long-term, the only way to stabilize the value of collateral is to establish a sustainable positive cash flow. When the financial history of early 21st century America is written, it is interesting to wonder how historians will characterize the behavior of public sector unions, who were indifferent to deficits, who were incestuous with Wall Street, who rode the waves of unsustainable debt and deficit-fueled phony booms to guarantee their members would enjoy magnificent benefits calibrated on bubble values, but contracted to endure even after the bubbles burst. Will the refusal of all-powerful public sector unions to embrace fiscal reform be seen by future historians as contributing to the collapse of the bond markets, the pension funds – and under the burden of new taxes instead of reform, property values, as the nation’s collateral imploded? At the least, it is fair to say that what today’s leadership of public sector unions decide – whether they embrace concessions for the sake of the nation, or not – is one of the biggest opportunities remaining to avert further financial calamities.

4 replies
  1. John says:

    Thank you for expressing so clearly the main issues we face. Can you send this to Congress and other leaders and let them in on the problem :)??

  2. jshaef1 says:

    This is the best explanation of debt destruction and the relationship to collateral that I have read on the web to date. Really tells it like it is and exposes the folly of “stimulus.”

  3. Davis says:

    As long as the Fed is able to re-inflate faster than the standard of living is declining, everyday prices will remain relatively stable with perhaps the exception of certain catagories of assets such as housing prices. But once the standard of living starts declining faster that the Fed is able to re-inflate, all but the most basic essentials, as well as nearly all asset catagories, will start to deflate rapidly.

  4. Vincent Christian says:

    Inflation isn’t a significant issue in the US, however it’s a major issue in China & India. As a rule, excessive increases in the money supply ultimately lead to significant increases in inflation—but this is not occurring because of high unemployment, banks reluctant to lend, and the housing market still in limbo.

    Monetizing the government’s debt is not the answer. We need to go back to the ” Clinton Years” when he cut federal spending as a share of the GDP by over four percentage points. We all remember the prosperity of Mr Clinton’s eight years in office—cutting spending stimulates the economy.

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