Deflation is a term that means different things depending on whom you ask. The Wikipedia definition says “deflation is a decrease in the general price level of goods and services”.1 Robert Prechter defines deflation as “a contraction in the overall supply of money and credit”. In this theory, decreasing prices are simply the result of the aforementioned contractions. This is one of the few definitions that reflects the reality that the inflation/deflation argument must incorporate credit in the equation, not just money supply. The U.S. and the global economy for that matter, are heavily reliant on credit and the way credit can transmit throughout the economy with the multiplier effect. But those conventional thinking assumes that there is an assumed condition that lenders will always be demand for credit and that borrowers will always be 1- willing to and 2- able to repay this debt. Economic activity over the past couple years has started to question this and may indicate a paradigm shift in basic financial theory.
Demand for Credit
Most economic models suggest that there will always be demand for credit, given availability. Over the last few decades, we’ve certainly seen this as global binging on debt has been well documented. The amount of U.S. dollar-denominated debt has ballooned to over $200 trillion, worldwide.
In addition to debt for housing and financial securities, we’ve seen an astronomical rise in debt in for student loans and subprime auto sales. Further, a recent report from Card Hub noted that the average American household is indebted with $7,813, the highest amount since 2008 with the total amount of credit card debt is projected to reach $900 billion by the end of 2015. Credit card, student loan and subprime auto debt has been securitized and sold to investors of all kinds, hungry for higher yields to meet their benefit obligations or required rates of return. Like the mortgages of the financial crisis, these new ‘asset backed’ loans are sliced up and sold as structured products known as asset-backed securities (ABS’s).
Signs the Demand is Lagging
We see the demand lagging in some sectors, notably in the commercial sector. A CNBC article from Tuesday showed that banks are reporting a drop in demand for loans to businesses through a chart from the Federal Reserve’s Senior Loan Officer Survey. Much of this can be attributed to the commodity crash, as mining, manufacturing and agriculture sectors are being hit.
While this may not seem noteworthy on the surface, factoring in that interest rates have never been lower and unemployment rate at 5% right on the brink of what’s described as “full employment”, it is a powerful signal.
Signs the Ability to Repay are Lagging
U.S. economic growth is simply not running at the level necessary to be able to repay all the debt outstanding. This is what keeps the Federal Reserve doing their best to keep rates low. If we go into another recession, deflation is inevitable since our ability to repay our debts through productive output will be further hampered and defaults will increase. A monstrous gap has developed between our Gross Domestic Product (GDP) and U.S. dollar-denominated debt.
Economic expansion in the U.S and around the world had better keep up since that’s the only way debt will be repaid. If interest rates rise and economic growth slows this debt is virtually guaranteed not to be repaid.
Signs the Willingness to Repay is Lagging
Maybe no sector is as potentially dangerous as student loan debt. We see that 7 million people with student loans are in some stage of default. An article from the Wall Street Journal claims that 17% of all borrowers are severely delinquent on their student loans, most of which are federally backed. Here is that headline:
This comes at a time when the unemployment rate just reached a low of 5.0%. With rates low and a rebound in the economy, there appears to be another theory simmering-that the student loan debt will be restructured across the board or forgiven. Some simply aren’t paying now because they hope the debt will be legally discharged someday. This might commence in ways similar to the mortgage relief programs, such as HARP. Certain loans taken out on for-profit college educations are already allowed to be discharged.2
Please Forgive Me
There is a clear trend towards debt forgiveness, which could continue to come from political candidates appealing to populist sentiment. You also have Pope Francis appealing to the masses and warning that money is the ‘devil’s dung’. This is also deflationary, because there becomes less debt outstanding if existing debt is forgiven. Either way, the debt is gone. A CLO (collateralized loan obligation) somewhere has a pile of these loans, potentially in your ‘safe’ money market account or backing an insurance policy of yours.
We’ve seen some measure of debt forgiveness for housing, (short sales, HARP programs) sovereign debts (Greece, ECB restructurings), to student loans (once thought non-dischargeable even in bankruptcy). Debt collectors are already reviled and credit card companies could eventually get tagged as predatory lenders. All of these trends are deflationary and will result in lower prices for the items the debts represent- houses, tuitions, even financial instrument prices like stocks and bonds. The long-time sentiment that prices only go up could be replaced with the feeling that prices will keep getting cheaper. This is the deflationary mindset. If this sentiment entrenches, prices will follow downward.
Evidence of Deflation
Low velocity of money
Despite unprecedented quantitative easing, the velocity of money continues to drop. Money is simply not circulating through the economy as hoped. What is happening to the money multiplier effect?
The fact that Central Banks have monetized to the tune of $10 trillion globally and there is no signs of inflation to be found, much less hyper-inflation as was a popular idea which helped send gold soaring to almost $2,000 an ounce.
Low interest rates
We also see negative interest rates for 2 out of the three major central banks in the world. Two-year German bunds just touched -0.50% yield this morning. Governments are trying everything to goose lending and penalizing saving is certainly one way to do that. The consequences of this down the road could be very dangerous as savers and investors have the unenviable choice of 1- paying increasingly punitive negative rates for the ‘privilege’ of allowing a bank to custody their money or 2- lending more money to questionable borrowers and increase the amount of non-performing loan growth. A third option, which is quite inconvenient, is to take money out of the banks and store it elsewhere, like a safe. This option is really only plausible for individuals. This could bring about capital controls and the inevitable cash ban that only a fiat money system could guarantee.