There is no doubt that the world is dealing with a credit/debt deflation of historic proportions. It is worth spending a little time understanding how such events are precipitated. An economy, as in personal households, corporations and other entities, is financially sound when expenditures are less than incomes. The difference can be saved and invested to produce additional income and capital growth in the future.
When debt is introduced into the system, a different dynamic emerges. We are not talking about self-cancelling debt but new consumer debt which is spent in the economy. This results in expenditure exceeding income and delivers a boost to the nation's GDP. In the initial stages the boost to GDP is quite large but as time goes by and the debt total climbs higher, the cost of servicing that debt reduces the economic benefit received from new increases in the debt mountain.
A continuing supply of easily available and cheap debt leads to speculative bubbles in one or more of the following areas: real estate, financial assets, commodities and collectibles. Once a bubble gathers momentum, a positive reinforcing feedback loop develops. More debt pushes up asset prices and this higher collateral value permits more borrowing which in turn pushes up asset prices which provides collateral for further increases in borrowing, and so on.
Eventually when debt becomes excessive, reaching extreme and unsustainable levels, an extraneous event occurs that shatters confidence and destroys the rationale that was underpinning the bubble. This results in assets being sold to repay debt and a downward reinforcing feedback loop develops. Asset sales reduce the prices of those assets, which diminishes their collateral value, which causes lenders to demand more security, which causes more asset sales, and so on. Weaker lenders go bankrupt and the economy starts to collapse into recession and possibly depression.
It is impossible to time the peaks of these debt bubbles as they can develop a life of their own that continues for longer than any rational person would think possible. In the recent debt binge we were blessed (cursed?) with bubbles in all four categories, real estate, financial assets, commodities and collectibles. Combined debt in the USA has been estimated to have exceeded $50 trillion, which is 3.5 times the estimated $14 trillion GDP level of that country. This is at least a 30% greater ratio of debt to GDP than was achieved in 1929 just prior to the last great debt deflation.
Once debt becomes excessive, and there is little doubt that this status was achieved some time ago, debt cannot be repaid out of savings and must be repaid in one of the following ways:
There are 3 major differences between the present debt deflation and prior episodes. They are very important differences and will probably impact on whatever new decisions our political leaders take to ameliorate the crisis. These new factors are:
If the modern global banking electronic interconnectivity system breaks down, world commerce will grind to a halt and the world will almost certainly be pitched into an economic depression. The continued operation of the system requires banks to have confidence in each other and knowledge that the overall system works.
One area where the system is breaking down is in large international trades for which special settlement systems called Irrevocable Letters of Credit (ILC) are used. There are special difficulties when the physical transactions are large in quantity and value, when the buyer and seller are in different countries and when lengthy sea voyages are required. The buyer does not want to pay for the shipment until he is certain that he will receive it and that it meets specifications. The seller, on the other hand, does not want to ship the goods until he is certain that he will be paid.
The solution is for the buyer to go to his local bank and open an ILC in favour of the seller's bank, or possibly his bank's agent bank in the seller's country. Irrevocable means just that, it cannot be cancelled once it has been issued. It is effectively a guarantee by the buyer's bank to the seller's bank that once the shipment arrives in the buyer's home port and is of correct specification, the seller's bank can pay the seller under the ILC and claim the money from the buyer's bank.
What has happened in recent months is that these international trades are grinding to a halt because sellers are saying to buyers: "We don't trust the ILC from your local bank. Go and get an ILC from a bank that we trust". This is why international trade has hit a brick wall recently and why the Baltic Dry Goods index, which measures the shipping costs for dry cargoes, has declined incredibly by 90% in just a few months! It is also the reason for the most recent sharp decline in commodity prices.
It is like trying to pay for your restaurant meal in a foreign country and the restaurant refusing to take your credit card because their local bank is not prepared to do business with the bank that issued your credit card.
Stimulus packages and bailouts are helpful but will prove to be of no avail unless confidence in the banking systems of the world is restored. It cannot be stressed strongly enough: it is imperative to restore confidence in the banking systems around the world. If this is not done quickly, world trade will grind to a halt and the world economy will do likewise. How does one achieve this resurgence of confidence in an environment of debt deflation with proliferating bankruptcies?
There seems to be only one option. Governments will have to take control of their national banking systems and be responsible for all the bad debts, including the unquantifiable OTC derivative losses.
Nationalisation is anathema to those bred in a free enterprise system. Economists of the Austrian school argue that the deflation should be allowed to run its course. They say that this would speed up the process of debt liquidation and reduce the pain in the longer run. The immediate consequences of this would be horrific and would certainly bring down the world's banking systems in the current environment. The issue at the moment is not whether the Austrian school is correct or not, but rather what our leaders will do and what the consequences of their actions will be.
Unfortunately, some form of nationalisation or Government guaranteeing of banks around the world seems to be the logical expectation. Short of this, we are headed for a depression of the 1930's variety, or something worse, and nobody wants to experience that.
Having nationalised (or guaranteed) the banks, the problem of how to handle the debt will still remain. If we accept that option 3 above - part deflation of debt and part inflation of the currency - is the aim, one could postulate a situation where the US debt mountain has deflated to say $35 trillion and that the massive new funding required to instil confidence in the system produces a five-fold increase in money and prices. In this situation, nominal GDP would have increased from $14 trillion to $70 trillion. Real GDP will remain unchanged, it is just the purchasing power of the currency that will have been reduced by 80%.
A $35 trillion debt level is manageable with a GDP of $70 trillion.
This seems to be the best "middle road" route that we can hope for. Much will depend on how our politicians and central bankers handle the situation. There is still plenty of scope for the situation to get out of hand at either extreme, resulting in either a deflationary depression or a hyperinflation.
In conclusion, I would like to discuss how the world got into this situation. We have been bombarded by views that it was caused by Greenspan's excessive liquidity and low interest rates, combined with weakness in regulation, rating agency mistakes and obfuscation from Wall Street. Even the OTC derivatives have been blamed for part of the problem.
These issues are all valid but to use a medical analogy, they are secondary cancers. They could not have existed without a primary cancer being the underlying cause and stimulus. So what was the primary cancer, the one which made it possible for all the other problems to exist?
We need to go back to basics. This subject was dealt with in the article "Chaos Chronicled."
This article explains how the fractional reserve banking system works.
Briefly, the fractional reserve system requires approximately 10% of new deposits to be lodged with the Federal Reserve or Central Bank. Thus if a new deposit of say $1.0m of fresh money arrives in the banking system, the bank receiving the deposit must put $100,000 with the central bank and can loan the balance of $900,000. When that loan arrives as a deposit with another bank, $90,000 must be placed with the central bank and $810,000 can be loaned out. That in turn will arrive as a deposit elsewhere and $81,000 must be placed with the central bank and $729,000 can be loaned out, and so on. Finally when all these iterations are complete, the central bank ends up with $1.0m as deposits from the banks that have made loans of about $9.0m.
At this point new loans can only be made from profits generated within the economy. This is important as the banking system will have reached a period of stability which will remain until a fresh deposit of newly created money appears in the system from somewhere. That new money will allow the banking system to generate loans of approximately 9 times the amount of new money.
What happens if there is a money tap open somewhere in the system and each day a large dollop of newly created money enters the system? Very soon the banks will be awash with deposits and desperately seeking new secure loans.
As lions kill instinctively in order to survive, bankers make loans instinctively in order to survive. Eventually in these circumstances of excess deposits, lending standards deteriorate and new loans are made to less credit worthy borrowers. In time, anyone with a good story gets a loan.
It is this desperate search for secure new loans by the banking systems of the world that is the primary cancer referred to earlier in the medical analogy. It allowed Wall Street to develop racy new products which were gobbled up by banks around the world in the belief that they were secure investments.
This is what actually happened in the real world. There was an open tap pouring large dollops of newly created money into the world banking systems over many years that created the insatiable appetite for new banking loans and investments.
What is important to understand is that without this insatiable demand for secure loans and investment by banks, it would not have been possible for all the other irregularities to have taken place. Credit standards would have remained robust and the banks would have avoided the bulk of the toxic waste that they got involved with.
What was the money tap that was left running? It is a flaw in the international monetary system which allows the USA to pay for its trade deficit using newly created US Dollars. This has been going on for two decades but has mushroomed in recent years. Ten years ago, the US trade deficit was of the order of $100 billion per annum. This number grew steadily until a couple of years ago it was running at $800 billion per annum. An injection of $800 billion into the world's banking system could accommodate new loans of nine times that amount, or $7.2 trillion in a single year!
Recently the US trade deficit has been averaging $700 billion per annum, allowing new loans of the order of $6.3 trillion per annum to possibly be created. These numbers are in addition to other sources of new money which individual countries injected into their local monetary systems to stimulate their economies.
The simple fact is that the world's banks were awash with deposits looking for anything that resembled a reasonable loan or investment. Wall Street created the products required to meet that demand, resulting in the huge debt bubble that recently came to an end. In addition, banks (prompted by the large availability of new deposits) made many unwise loans across national borders which are now creating problems in countries in Eastern Europe and South America.
The problems are manifold, but the most pressing one is to restore confidence in the banking systems of the world. Failure to do so will measurably increase the odds of a deflationary depression. The power of the modern electronic money creating machine suggests that the odds still favour an inflationary outcome, hopefully of the category 3 type referred to earlier.
Disclosure and Disclaimer Statement: In the interest of full disclosure, the author advises that he is not a disinterested party in that he has personal investments gold and silver bullion, gold and silver mining shares as well as in base metal and energy companies. The author's objective in writing this article is to interest potential investors in this subject to the point where they are encouraged to conduct their own further diligent research. Neither the information nor the opinions expressed should be construed as a solicitation to buy or sell any stock, currency or commodity. Investors are recommended to obtain the advice of a qualified investment advisor before entering into any transactions. The author has neither been paid nor received any other inducement to write this article.