The Great Credit Contraction & Deflation

Lew Rockwell posted a piece by Bill Bonner which strongly supports the deflationist view:

“In a fundamental shift, consumers are saving rather than spending,” notes the Los Angeles Times.

This is the shift we’ve been talking about for months. The great credit expansion of 1945–2007 is over. Now cometh the great credit contraction.

During the bubble years, more and more credit produced less and less real prosperity. It was as if you were borrowing more and more, to invest in your business or merely to increase your standard of living, but your income didn’t rise fast enough to keep up with the interest payments.

In 2005, Americans saved nothing. Not even aluminum foil or string. Now, the savings rate is approaching 5% of disposable income – a big turnaround.

We know from logic and experience that saving money – not spending it – is the key to getting wealthier. Saving money gives you capital. And it’s capital accumulation – in the form of factories, roads, ships, buildings, machines…and raw savings – that gives people the ability to produce more. It may take a man with a shovel a whole day to dig a decent grave. Give him capital – in the form of a backhoe – and he can bury everyone in town. That’s why capitalism works. It rewards the fellow who saves his money.

Yet every yahoo economist in the year of our Lord 2009 takes news of rising savings rates like the death of Michael Jackson. If households don’t consume, they reason, how can a consumer economy grow?

The problem is that you can’t really grow an economy by borrowing and spending.

Recent history proves it. Despite the biggest splurge of borrowing and spending in history, the US consumer economy barely grew at all.

“In the five years to December 2007,” reports Grant’s Interest Rate Observer, “America’s credit market debt climbed by nearly 57%, to $18 trillion. However, in the same half-decade, nominal GDP was up by only $3.3 trillion.”

For every five dollars people borrowed, they only increased their incomes by $1. Imagine that the borrowing had an average effective interest rate of 10% (credit card debt can be much more expensive). At that rate half of the additional income earned between 2002 and 2007 had to be used just to pay the interest.

“Companies, households and banks all want to pay down debt and…prefer to hold cash rather than assets, partly because the outlook for those assets is poor and partly because after a decade of excess, everyone now looks a bit over-extended.

“This is exactly what happened in Japan during its lost decade, when a balance sheet recession, one characterized by the paying down of debt and liquidations of assets, was self-reinforcing and very difficult to stem.”

And now this from David Rosenberg:

“The ultimate question is where all this cash is going to be deployed, and we believe it will ultimately be diverted toward debt repayment.”

Let’s see. We can figure this out from the numbers above. American consumers must have added about $7 trillion in extra debt during the Bubble Epoque, 2002–2007. Now, instead of buying things, they use their money to pay it down. The average household has about $43,000 worth of income. Let’s keep the math simple by saying there are 100 million households in the United States…and that they save 5% of their income. And let’s say they use every penny of savings to pay down debt. Hey…it will only take about 30 years to pay it off! Get ready for a long, long slump.

Yesterday, stocks went nowhere. Oil went nowhere. And the dollar went down as gold went up.

The reason for the dollar’s decline and gold’s rise was given in the front-page headline of yesterday’s Financial Times. China launched a “new dig” at the dollar, it says. As near as we could tell, China merely stated the obvious – that the world is going to have to find a better monetary system. The US dollar won’t be king of the hill forever. And China, which is up to its neck in dollars, would like to find a solution sooner rather than later – that is, before the dollar goes the way of all paper.

The dollar will eventually give way to inflation and devaluation, but probably not soon.

“I’m absolutely worried about inflation,” says John B. Taylor.

But it is not inflation that worries us…it’s the lack of it. Making a long story short, as long as the feds see no inflation they will continue trying to create it. In the end, they will get more than they wanted.

Though, right now, instead of inflation, we have deflation. Yesterday’s New York Times tells us that deflation in Ireland has reached 5.4% – the highest since the Great Depression of the ’30s.

You know the reasons for deflation as well as we do. The world suddenly has too many people who borrowed too much money to buy too many things they really didn’t need and really couldn’t afford. This caused the world’s producers to greatly over-estimate the “real” demand. Their customers began to disappear in 2007. Their factories are still standing.

I may add: Who says that Americans will only want to pay down the recently amassed $7 trillion in debt during this downturn. As I explained in Inflation & Deflation Revisited, the total debt load in the US is at around $60 trillion, if one includes unfunded government obligations it is more like $120 trillion. That is not to say that all that debt needs to be paid off as part of this contraction, but it is reasonable to assume that a more significant portion will have to be paid. On the other hand, his estimate of an ongoing saving rate of 5% is a bit too low.I believe US households will be saving a lot more in the decades to come, more like 10% which is a historical average.

But in general this piece is consistent with what I wrote a while ago in Delevaraging, Contraction, Imploding Consumer Credit & Increased Saving – The Long Term Outlook:

How much deleveraging?

Since the start of the U.S. recession in December 2007, household leverage has declined. It currently stands at about 130% of disposable income. How much further will the deleveraging process go? In addition to factors governing the supply and demand for debt, the answer will depend on the future growth trajectory of the U.S. economy. While it’s true that Japanese firms and U.S. households may differ in important ways regarding decisions about paying down debt, the Japanese experience provides a recent example of a significant deleveraging episode that took place in the aftermath of a major real estate bubble and is useful as a benchmark.

The Japanese stock market bubble burst in late 1989, followed soon after by the bursting of the real estate bubble in early 1991. Nearly 20 years later, stock and commercial real estate prices remain more than 70% below their peaks, while residential land prices are more than 40% below their peak.

Figure 3 compares Japan’s nonfinancial corporate sector with the U.S. household sector over 10-year periods before and after the leverage-ratio peaks. In both countries, leverage ratios rose rapidly in the years before the peak.

After Japan’s bubbles burst, private nonfinancial firms undertook a massive deleveraging, reducing their collective debt-to-GDP ratio from 125% in 1991 to 95% in 2001. By reducing spending on investment, the firms changed from being net borrowers to net savers. If U.S. households were to undertake a similar deleveraging, their collective debt-to-income ratio would need to drop to around 100% by year-end 2018, returning to the level that prevailed in 2002.

And how much less we will have to consume to support such level of savings I explained in True Consumption as Percentage of GDP:

us-true-consumption-as-percentage-of-gdp-1929-2008

…the red line is the average over the past decades to which we will have to return during this contraction, maybe consumption will go even lower since corrections always undershoot regular levels.


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