debt deflation october 2009

8/14/2019 Debt Deflation October 2009

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Debt-Deflation

David Meier

October 2009

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David Meier

Revision History

August 2009

Presented to MDP team; inflation vs. deflation

September 2009 Presented to Advisor Development; inflationvs. deflation

October 2009

Presented to CAPS Blog; debt-deflation

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Summary

The inflation vs. deflation debate rages on

I am in the deflationist camp

I believe debt-deflation is just starting This presentation contains the data that try

to support my claim

Is there a twist at the end?

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Inflation and Deflation

Two perspectives Prices and money

Inflation Rising prices and/or rising money supply

Deflation Falling prices and/or falling money supply

I believe the two are interrelated and I believe itstarts with money/credit supply

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Inflation

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One, over-simplified view:

Rising demand can cause arise in prices and output

What causes demand to rise?

AD1

AD2 AS

P1

P2

GDP1 GDP2

Prices

Output


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Deflation

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One, over-simplified view:

Declining demand can causea decline in prices and output

What causes demand to fall?

The Fed wants to prevent this

AD2

AD1 AS

P2

P1

GDP2 GDP1

Prices

Output


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And equations

The Quantity Theory of Money

MV = PY

M = money stock = monetary base * multiplier V = velocity

P = price

Y = output

Simplified view Prices can move with changes in the money stock

Complex, non-linear relationships

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Before We Start, Some Actors

Hyman Minsky Debt continuum

Instability and bubble models

Irving Fisher 9 links in the chain of debt-deflation

Ben Bernanke Dead set against deflation

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Minskys Debt Continuum

Hedge finance Debt that can fulfill all contractual obligations

using cash flows

Speculative finance Can meet interest payments on cash flows,but require a roll over to meet principalpayments

Ponzi finance Cash flows cannot meet interest or principle

obligations. Requires additional borrowing orasset sales or rising asset prices.

9Source: The Financial Instability Hypothesis, Hyman Minskyhttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=161024
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=161024http://papers.ssrn.com/sol3/papers.cfm?abstract_id=161024


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Minskys Bubble Model

10Source: Stabilizing and Unstable Economy, Hyman Minsky andManias, Panics, and Crashes, Charles Kindleberger

Displacement/Shock

Credit Creation/Reflation

Euphoria

Financial Distress

Revulsion

Where are we in this cycle?

Minsky believed that a free market economy is prone tobooms and busts when speculative and Ponzi financebecome too large as a percentage of outstanding debt.


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Stability Creating Instability?

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http://www.comstockfunds.com/files/NLPP00000/421.pdf


How much speculative and Ponzidebt are in the rise?
http://www.comstockfunds.com/files/NLPP00000/421.pdfhttp://www.comstockfunds.com/files/NLPP00000/421.pdfhttp://www.comstockfunds.com/files/NLPP00000/421.pdfhttp://www.comstockfunds.com/files/NLPP00000/421.pdfhttp://www.comstockfunds.com/files/NLPP00000/421.pdf


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A Minsky Moment?

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Source: dshort.com: Two Views of Inflations

http://dshort.com/inflation/inflation-since-1872.html?inflation-1872-present

Incredible stability

Creating instability?
http://dshort.com/inflation/inflation-since-1872.html?inflation-1872-presenthttp://dshort.com/inflation/inflation-since-1872.html?inflation-1872-presenthttp://dshort.com/inflation/inflation-since-1872.html?inflation-1872-presenthttp://dshort.com/inflation/inflation-since-1872.html?inflation-1872-presenthttp://dshort.com/inflation/inflation-since-1872.html?inflation-1872-presenthttp://dshort.com/inflation/inflation-since-1872.html?inflation-1872-presenthttp://dshort.com/inflation/inflation-since-1872.html?inflation-1872-presenthttp://dshort.com/inflation/inflation-since-1872.html?inflation-1872-presenthttp://dshort.com/inflation/inflation-since-1872.html?inflation-1872-presenthttp://dshort.com/inflation/inflation-since-1872.html?inflation-1872-present


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A Displacement/Shock?

13FRBSF Economic Letter: U.S. Household Deleveraging and Future Consumption Growth (2009-16, 5/15/2009)http://www.frbsf.org/publications/economics/letter/2009/el2009-16.html

This chart frightens me

Debt levels exploded relative todisposable incomes

Stock wealth declined

Housing wealth declined

Disposable income declined

How far can the debt level fall?
http://www.frbsf.org/publications/economics/letter/2009/el2009-16.htmlhttp://www.frbsf.org/publications/economics/letter/2009/el2009-16.htmlhttp://www.frbsf.org/publications/economics/letter/2009/el2009-16.htmlhttp://www.frbsf.org/publications/economics/letter/2009/el2009-16.html


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Credit Creation/Reflation

Financing almost shut down for a shortperiod of time

The government filled the void withmassive amounts of liquidity

The FHA is insuring a large portion of newhousing loans

The government stepped in to fill the

financing void and to reflate asset prices

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Euphoria?

Is the rise in the stock market giving theall clear signal?

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Financial Distress?

Have the problems really been solved? Residential foreclosures rising

Toxic assets remain on banks balance sheets

Banks arent lending Consumers arent borrowing

Rising commercial real estate delinquencies

Unemployment continues to rise GDP supported by government spending and

imports declining faster than exports

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David Meier

Debt-Deflation Theory

Framework created by Irving Fisher The Debt-Deflation Theory of Great Depressions

http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf

I have not seen anyone run through this yet,so I thought I would

Lets march through the 9 steps and seewhere we are today

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http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdfhttp://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf


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Where We Are Today

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Historically high

debt burden

Sustainable?
http://www.comstockfunds.com/files/NLPP00000/421.pdfhttp://www.comstockfunds.com/files/NLPP00000/421.pdfhttp://www.comstockfunds.com/files/NLPP00000/421.pdfhttp://www.comstockfunds.com/files/NLPP00000/421.pdfhttp://www.comstockfunds.com/files/NLPP00000/421.pdf


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Fishers Debt-deflation

Step 1: Debt liquidation leads to distressed selling and to

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http://www.moremortgagemeltdown.com/download/pdf/T2_Partners_presentation_on_the_mortgage_crisis.pdf

Example:

Bad mortgagescontributing to fallinghome prices.

Speculative and Ponzifinancing (e.g.,

subprime, no doc, andnegative amortizationloans) have causedsome big problems.
http://www.moremortgagemeltdown.com/download/pdf/T2_Partners_presentation_on_the_mortgage_crisis.pdfhttp://www.moremortgagemeltdown.com/download/pdf/T2_Partners_presentation_on_the_mortgage_crisis.pdf


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Source: Whitney Tilson, T2 Partners LLC
http://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/09/11/elements-of-deflation-part-2.aspx


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Delinquencies begin torise in 2006

and prices start to fall.

(Data thru July 2009)

Source: Calculated Risk Blog


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Step 2: Contraction of deposit currency, as bank loans are paid off, and

to a slowing down of velocity in circulation.

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Deposits have not been contracting.


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Credit is contracting.Lets look inside the circle.


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Growth

Growth slows

Credit contracts


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Revolving and non-revolving creditcontracting. Lets compare to the past.


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M1 money supply increasedas the financial crisis started.


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But the M1 multiplier fell offa cliff. Why?

Th M l F l


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M1 is up but the M1multiplier is down becausebanks are hoarding cash inreserves and not lending.

Th M l F l


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Leveling off or going down?

Th M tl F l


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Source: John Mauldin


M2 velocitydecreasing

Th M tl F l
http://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/09/11/elements-of-deflation-part-2.aspxhttp://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/09/11/elements-of-deflation-part-2.aspxhttp://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/09/11/elements-of-deflation-part-2.aspxhttp://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/09/11/elements-of-deflation-part-2.aspxhttp://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/09/11/elements-of-deflation-part-2.aspxhttp://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/09/11/elements-of-deflation-part-2.aspxhttp://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/09/11/elements-of-deflation-part-2.aspxhttp://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/09/11/elements-of-deflation-part-2.aspxhttp://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/09/11/elements-of-deflation-part-2.aspxhttp://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/09/11/elements-of-deflation-part-2.aspxhttp://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/09/11/elements-of-deflation-part-2.aspx


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Step 3: #1 and #2 cause a fall in the level of prices, in other words, a

swelling of the dollar.

Source: Federal Reserve Bank of Cleveland

Disinflation: the level of

inflation decreases

Deflation: prices decline

Th M tl F l


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Step 3: #1 and #2 cause a fall in the level of prices, in other words, a

swelling of the dollar.

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http://www.clevelandfed.org/research/data/updates/past_detail.cfm?m=8&y=2009

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http://www.clevelandfed.org/research/data/updates/past_detail.cfm?m=8&y=2009http://www.clevelandfed.org/research/data/updates/past_detail.cfm?m=8&y=2009


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Step 4: Assuming, as above stated, that this fall of prices is not

interfered with by reflation or otherwise, there must be a still greaterfall in the net worths of business, precipitating bankruptcies and

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Stock market values of declinedsharply from their peak, despite thegovernments reflation efforts.

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As of 10/24/09, 106

banks have failed.How high will thisnumber go? 200?500? 1000?

Source: Calculated Risk Blog

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Step 6: A reduction in output, in trade and in employment of labor.

These losses, bankruptcies and unemployment, lead to

39http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

The U.S. government has stepped in as the lender of last resort and alarge consumer in the economy.

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http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htmhttp://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm


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Government spending and net

exports are the only thingkeeping GDP afloat right now.

The Motley Fool


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Took a dip and is recovering.Well see if it continues.

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Growth

Growth slows

Consumption declines


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Exports have declined asglobal demand is lower. Will a

weak dollar help exportsincrease?

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GDP increasedbecause imports fell

faster than exports.

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Unemployment is currently9.8%. Many economists

expect it to grow to >10%.

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Unemployment isnt the only

problem. The average weeklyhours worked has decreased,too.

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e ot ey oo

David Meier


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Source: David Rosenberg, Chief Economist and Strategist, Gluskin-Sheff

https://ems.gluskinsheff.net/Articles/Coffee_Muffin_with%20Dave_080509.pdf

And wages are falling.

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https://ems.gluskinsheff.net/Articles/Coffee_Muffin_with%20Dave_080509.pdfhttps://ems.gluskinsheff.net/Articles/Coffee_Muffin_with%20Dave_080509.pdfhttps://ems.gluskinsheff.net/Articles/Coffee_Muffin_with%20Dave_080509.pdf


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y

David Meier


Step 7: Pessimism and loss of confidence, which in turn lead to

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Rising but still low.

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y

David Meier


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The Conference Board Consumer Confidence Index Dips in SeptemberSeptember 29, 2009

The Conference Board Consumer Confidence Index, which had improved inAugust, dipped in September. The Index now stands at 53.1 (1985=100), downfrom 54.5 in August. The Present Situation Index decreased to 22.7 from 25.4. TheExpectations Index declined to 73.3 from 73.8 last month.

Low and falling slightly. So which

one should we considered?

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y

David Meier



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Those dont look like confident consumers.

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y

David Meier


Step 8: Hoarding and slowing down still more the velocity of circulation.

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Talk about a change of heart


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Treasurers and CFOs conserving hoarding cash

Even as government reports show that the first global

recession since World War II may be easing, corporatetreasurers are raising cash as fast as they can, wary of

losing access to capital.

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Step 8: Hoarding and slowing down still more the velocity of circulation.

Article on businesses hoarding cash:http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aKArtbx5GFHw

The Motley Fool
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aKArtbx5GFHwhttp://www.bloomberg.com/apps/news?pid=newsarchive&sid=aKArtbx5GFHw


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Step 9: The above eight changes causecomplicated disturbances in the rates ofinterest, in particular, a fall in the nominal,

or money, rates and a rise in the real, orcommodity, rates of interest.

The Fed is keeping rates low on purposeto try and prevent demand from falling.

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Bernanke: Deflation/Depression Hawk

Bernankes November 2002 speechoutlines his deflation-fighting plan http://www.federalreserve.gov/BOARDDOCS/

SPEECHES/2002/20021121/default.htm

1. Prevention Use monetary and fiscal policy to stimulate

spending and keep deflation in check

I think we are past prevention

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http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htmhttp://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htmhttp://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htmhttp://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm


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A Curious Quote

Janet Yellen, President of the San FranciscoFederal Reserve Bank

Ill put my cards on the table right away. I think thepredominant risk is that inflation will be too low,not too high, over the next several years.

Shes not the only Fed governor worryingabout this

Why does she think thats the biggest risk?

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2. Kill deflation before it multiplies

Maintain an inflation buffer zone, i.e., target

higher than normal inflation

Reason: to protect against falling aggregatedemand and higher borrowing costs

Is this Janet Yellens fear? We may be past this, too. But Bernake

remains committed to fight it.

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Bernankes deflation-fighting playbook

Maintain financial stability

Opened the Feds discount window

Use aggressive policies very early

Dropped rates to near 0%

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Use the printing press Increase the dollars in circulation reduce the value of the a dollar in term of

goods and services to generate higher spending

and hence positive inflation. Make asset purchases

Increase the magnitude of asset purchases Increase the scope of asset purchases

Inject money directly into banks Offer low-rate loans to banks Make equity purchases

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Isnt Inflation on the Way?

Milton Friedman thought inflation is always andeverywhere a monetary phenomenon

Turning those bank reserves loose on the economy

Quantitative easing: the Feds printing press

Monetizing the debt Buying assets: asset-backed securities, foreign debt

The Fed signals higher than normal inflation

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/July+2009+Global+Central+Bank+Focus+McCulley.htm

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http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/July+2009+Global+Central+Bank+Focus+McCulley.htmhttp://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/July+2009+Global+Central+Bank+Focus+McCulley.htmhttp://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/July+2009+Global+Central+Bank+Focus+McCulley.htmhttp://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/July+2009+Global+Central+Bank+Focus+McCulley.htmhttp://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/July+2009+Global+Central+Bank+Focus+McCulley.htmhttp://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/July+2009+Global+Central+Bank+Focus+McCulley.htm


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Can the Deleveraging Force Be Stopped?

Bernanke is using all of the tools. Will they be enough?

Think of deleveraging as having inertia A body in motion tends to stay in motion

Richard Koo notes that Japanese businesses and consumersdelevered for years despite near-0% interest rates

Bernanke is pulling out all the stops to prevent the effects ofdeleveraging

unless acted upon by an unbalanced force.

Can the Fed generate enough counter-momentum? Were starting from an historic debt level

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The Potential Outcomes

Deflation sets in Declining M*V and/or decline in prices

Inflation sets in

Are the wheels are in motion?

Bernanke perfectly balances the forces and thingsgo back to normal

Goldilocks (This ones just right) is possible

What are the probabilities?

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Positioning a Portfolio

For a deflationary environment

Cash

Cash rich companies with no debt

Low-cost manufacturers who can withstandfalling prices

Niche companies with important products and

services Other ideas?

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Positioning a portfolio

For an inflationary environment

Treasury Inflation-Protected Securities

Debt-laden companies that can survive

Commodities and commodity-related

companies

Other ideas?

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Positioning a portfolio

If Bernanke can balance the forces

A rising tide lifts all yachts

Get 100% invested?

Could this create another instability in thefuture?

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Theres Always a Catch

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This charts would say unless inflation stays low, were likely to see the

markets P/E ratio contract with inflation or deflation

Source: Crestmont Researchhttp://www.crestmontresearch.com/pdfs/Stock%20Inflation%20&%20PE.pdf

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http://www.crestmontresearch.com/pdfs/Stock%20Inflation%20&%20PE.pdfhttp://www.crestmontresearch.com/pdfs/Stock%20Inflation%20&%20PE.pdfhttp://www.crestmontresearch.com/pdfs/Stock%20Inflation%20&%20PE.pdf


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Summary

The U.S. is highly leveraged

Consumers, businesses, and the government

Lots of speculative and some Ponzi debt

Created an instability

Ample evidence of debt-deflation

Looks like it may just be starting

Investors should be prepared

Market P/E ratio could easily contract

debt deflation october 2009

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