The Future Deflation

From 1982 to 2008 debt levels grew exponentially in the United States, handily outstripping growth in gross domestic product (GDP). Accordingly, the ratio of total debt to GDP leaped from less than 170% to 375% over that period – a 2.2x increase. This kind of growth is inherently unsustainable because it leads to interest costs shooting far ahead of borrowers' ability to meet them. Debt growth was able to outstrip GDP growth for a such a long time, however, because the economy acquired elements of Ponzi scheme: once debt reached excessive levels, the economy (i.e., borrowers in the aggregate) began to service its debt by continually taking on new debt. This process was self-reinforcing: debt growth raised asset prices by increasing liquidity and monetary velocity. This asset appreciation gave borrowers the ability to further increase debt, regardless of whether existing debt could be serviced from cash flows. The housing bubble exemplified this: borrowers took out mortgages they couldn't afford on “investment” houses, assuming prices would continue to quickly increase and they would be able to sell or refinance into new, larger loans. The ever-increasing debt levels and asset prices also pushed economic growth above its normal rate. This fed back into debt growth and asset appreciation. As debt issuance expanded, recent borrowers had incrementally worse credit than earlier borrowers. Eventually debt growth reached the worst borrowers of all: subprime homebuyers. The terrible quality of subprime borrowers – many defaulted within a few months of getting loans – forced lenders to suddenly pull back. Since the debt Ponzi depended on continuously increasing debt levels to prop up asset prices, the subprime crisis proved to be its end. THE FUTURE: DEFLATION It took 25 years of exponential growth for debt to reach its current level. It will likewise take a long time for debt to return to a lower, sustainable norm. For the foreseeable future, expect the opposite of the recent past: instead of debt growth fueling economic growth and rising asset prices, expect debt reduction to limit economic growth and pressure monetary velocity and asset prices. This process, in light of its deflationary effects, is known as debt deflation. Like the debt Ponzi, debt deflation is self-reinforcing: by reducing asset prices (and thus the ability to borrow), debt reduction begets further debt reduction. A prominent feature of debt deflation is what Keynes called the paradox of thrift. The paradox occurs when many consumers and businesses simultaneously cut back on spending and investment (in this case, as a necessary step toward paying down debt). This creates a vicious cycle: when everyone cuts back, everyone also sees their revenue/income decrease because of others' cutbacks. This reduces economic activity without necessarily improving the capacity to service and repay debt. The Federal Reserve is trying to forestall debt deflation by creating bank reserves (which expands liquidity and would, under normal circumstances, have clear inflationary effects), and the overwhelming consensus on Wall Street is that it will succeed. I disagree for two reasons: 1. There are four major forms of liquidity: the monetary base (i.e., physical money and bank reserves), bank loans, securitized debt, and derivatives. The Federal Reserve exerts direct control over the

monetary base, and it has indirect control over bank lending. It does not, however, have control over securitized debt or derivatives, which together dwarf the monetary base and bank loans in notional value by a factor of 13. While these uncontrolled forms of liquidity don't meet the classical definition of money, they often have the same economic effects. As Friedrich Hayek wrote (and as originally posted on Zero Hedge): “There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money” (Prices and Production, 1935, p. 96). Derivatives and securitized debt are now contracting severely. Bank lending, despite the increase in reserves, has also begun to contract. This will outweigh any increases in the comparatively small monetary base. 2. Capacity utilization is at a 60-year low. Excess capacity has put a lid on pricing power, which will prevent monetary expansion from easily translating into higher price levels. For a more detailed explanation of this, I highly recommend Hoisington Investment Management's first-quarter economic review: http://www.hoisingtonmgt.com/pdf/HIM2009Q1NP.pdf EQUITIES Equities are residual securities – in other words, they get what's left over after debt and operating costs are paid – so they're first to feel the effects of any decline in profits or asset prices. Hence, equities are the asset class likely to suffer most under debt deflation. Recent history bears this out: in 1990, Japan entered a debt deflation from which it has yet to emerge. Japan's stock market reached its peak in 1989 and its nadir in 2003. In the intervening period, nominal GDP grew ~.5% per year and real GDP grew ~1% per year. Despite this slight growth, Japanese equities fell 80% over the same period, or 11.5% per year. Japan had lower debt to GDP in 1990 than the U.S. does now. Japan also had the benefit that its debt deflation was solitary: the rest of the world had escaped deflation, so the Japanese depression was ameliorated by continued strong exports. By contrast, today there are many countries besides the United States that suffer from incipient debt deflation. So it's possible that the U.S. market will fall even more than Japan's did, although there also are mitigating factors (the Japanese market traded at a higher valuation in 1990 than the US market at its recent peak). A few other points to consider: • To some extent, debt reduction will involve substitution of equity capital for debt capital (e.g.,

companies issuing stock and using the proceeds to pay down debt). Because of equities' residual nature, they tend to carry higher returns than debt. Hence, equity-for-debt substitution will increase companies' cost of capital. The flip side of this is declining asset prices. Equity-for-debt substitution will be merely one of many factors behind debt reduction and declining asset prices. Nevertheless, it should have an outsized impact on investor psychology due to the speed with which it changes capital structure and cost of capital (versus gradual paydown of debt) and its increasing prominence in the public securities markets. • If businesses are forced to give debt reduction priority, dividends to equity holders will be pushed out into the future, reducing the present value of equity dividend streams. • If equities were cheap by historical standards, they might make for a good investment in spite of debt deflation. Unfortunately, they aren't. One of my favorite valuation tools is the ratio of stock market capitalization to GDP. The advantage of this is that GDP is much less volatile than other economic series such as corporate earnings. Since the 1920s, the stock market has traded at an average market cap to GDP ratio of 60%. During major recessions, the ratio has frequently gone below 35%. By contrast, as of today (June 26th), the ratio is 85%. Even at the market's March lows it remained above 60%. It's absurd to see equities trade at an above-average multiple in the face of both a severe recession and a secular rise in the cost of capital. COMMODITIES Like equities, commodities fare poorly in debt deflation. In this instance, commodities will fare particularly poorly because they underwent an extreme bubble in recent years. As Frank Veneroso details in his 2007 World Bank presentation (http://www.venerosoassociates.com/Reserve Management Parts I andII WBP Public 71907.pdf), the notional value of outstanding commodity derivatives surged beginning in 2004, eventually coming to exceed the value of above-ground commodity stocks by a large multiple. Veneroso mentions that the bubble was particularly dramatic in the metals group. In the aggregate, industrial metals (copper, lead, zinc, etc.) rose more this decade than in any other period in both nominal and – especially – real terms. Today, even after a broad commodities sell-off, most metals trade at 2-4 times their historical average prices. Oil and many agricultural commodities are at similar multiples to their historic averages. As with equities, it's absurd to see commodities trade at above-average prices in the face of a severe recession. To the extent that the derivatives build-up has been responsible for high commodity prices, debt deflation will engender lower prices. Microeconomic factors such as substitution will do the same. CURRENCIES The dollar fell inexorably from 2002-2008, driven by three related phenomena: 1. Debt levels grew at an increasing rate, from already high levels. This was a worldwide phenomenon, but the amount of debt was particularly large in the U.S. and a lot of incremental foreign debt was

denominated in dollars. 2. The U.S.'s debt build-up necessitated running a large current account deficit (CAD), putting technical pressure on the dollar. 3. Foreign countries, especially emerging markets, experienced a surge in trade because of the U.S. CAD. Many investors noticed this strength and began favoring foreign-currency-denominated assets over dollar-denominated assets. Debt deflation has reversed this process, leading to a nascent decline in U.S. private debt and corresponding declines in the CAD and in enthusiasm for emerging-market assets. This process should accelerate as deflation continues, with the upshot being a stronger dollar. The U.S.'s high ratio of debt to GDP is typically seen as a negative for the dollar, but I believe it's actually a technical positive. Debt growth increases the effective money supply, reducing the value of money relative to the value of real assets. Debt deflation has the opposite effect: it reduces the effective money supply, increasing the value of money relative to the value of real assets. Since the U.S. has more debt, proportionally, than other countries, worldwide debt deflation should benefit the dollar. And while the United States has a high ratio of total debt to GDP, most foreign economies have higher rates of debt growth and depend more on debt to generate GDP growth. Most foreign economies also have a higher level of financial liabilities as a percentage of GDP than the U.S. (the level is twice as high in the Eurozone, for instance). Consequently, debt deflation is more likely to cause a financial crisis in these economies than in the U.S. As James Clayton writes, “It appears that a rapid buildup in private debt can create more risk than an already high level of debt that has been adequately funded” (The Global Debt Bomb, 2000, p. 79). FOREIGN EQUITIES The prospect of a stronger dollar makes foreign equities less attractive than U.S. equities. Beyond that, two things make me wary of foreign stocks: 1. As mentioned above, many foreign economies have higher financial leverage than the U.S. Specifically, the typical European bank has twice the ratio of assets to equity as the typical U.S. bank. European banks also have much higher exposure to emerging markets than their U.S. counterparts and have been slower to take writedowns on toxic structured assets. 2. Most foreign economies have higher operational leverage than the U.S., in the form of a higher ratio of exports to GDP. Many leading economies (China, Germany, Japan) are geared toward exporting manufactured goods, while many others (Australia, Brazil, Canada, numerous Middle Eastern countries) are geared toward exporting commodities. During the Great Depression – the best-known instance of debt deflation – export-oriented economies experienced much deeper contractions than consumption-oriented economies.