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View Full Version : Mish's deflation argument: 1 interesting point



c1ue
01-04-08, 04:07 PM
It is well known that Mike Shedlock at globaleconomicanalysis.com believes the effect of the real estate bubble collapse will be deflation.

This is in direct contravention to the iTulip belief that there will be inflation to reduce the debt burden at financial institutions - because the financial institutions are connected to the Fed and will use the Fed for their own benefit.

There was one point he made recently, however, for which I'd like to hear some iTulip feedback on:

That inflation will bankrupt consumers, which will in turn force default on the debt. Thus inflation will not reduce the debt burden, it will instead accelerate the timing and amount of defaults thus forcing insolvency.

In this scenario - the assumption is that the debt held is ultimately traced to American consumers.

Comments?

WDCRob
01-04-08, 04:26 PM
That argument is assuming wage inflation doesn't keep pace with the price increases, right?

Spartacus
01-04-08, 04:45 PM
Metalman will probably have lots to add ; )


It is well known that Mike Shedlock at globaleconomicanalysis.com believes the effect of the real estate bubble collapse will be deflation.

This is in direct contravention to the iTulip belief that there will be inflation to reduce the debt burden at financial institutions - because the financial institutions are connected to the Fed and will use the Fed for their own benefit.

There was one point he made recently, however, for which I'd like to hear some iTulip feedback on:

That inflation will bankrupt consumers, which will in turn force default on the debt. Thus inflation will not reduce the debt burden, it will instead accelerate the timing and amount of defaults thus forcing insolvency.

In this scenario - the assumption is that the debt held is ultimately traced to American consumers.

Comments?

Lots of "ifs" are needed to cover all cases.

As is typical, some authors use inflation to mean different things at different times - they keep using the one term instead of being specific, maybe to leave some wiggle room. Why use the word inflation? It's known to be problematic - why not write the specfic thing you mean? I have not kept score, it's just an impression (IE, I could be very wrong, maybe Prechter or Puplava or Faber are worse) that Mish is particularly bad at this - turning the different definitions to his purposes when it suits him.

if prices of goods and services rise but wages in general do not, this would push many borrowers into default - unless they get bailed out.

but if wages keep pace with prices, (in other words, all-sector, all-goods, all-everything price increases, including wages) or if wages rise faster than goods and services, then debtors with fixed-rate loans (still the majority) ll be in BETTER shape because the same debt payment is a smaller and smaller fraction of their pay.

grapejelly
01-04-08, 07:31 PM
There is an error here...debt defaults are NOT deflationary.

If $100 is loaned to Able, Able spends the money. That is inflationary. Now if Able pays it back, that is deflationary.

But if Able defaults, no net gain or loss. It is not deflationary.

What will happen though is that the government will bail out the bank by making it oh-so-easy to loan into existence another $100...so debt defaults are INFLATIONARY.

I don't know what I am missing here...

bart
01-04-08, 08:17 PM
That inflation will bankrupt consumers, which will in turn force default on the debt. Thus inflation will not reduce the debt burden, it will instead accelerate the timing and amount of defaults thus forcing insolvency.

In this scenario - the assumption is that the debt held is ultimately traced to American consumers.

Comments?

Yes, there will be higher bankruptcies and yes there will be defaults and more solvency issues... but the government can and likely will come in with programs to "help", and the Fed will also show up on its white horse to "save" the day... after enough pain and fear and noise etc. has occurred.

c1ue
01-04-08, 11:43 PM
I don't know what I am missing here...

Grape, Spartacus,

What Mish is saying is not that defaults are de- or in- flationary.

What he is saying, I believe, is that the inflationary scenario assumes that debts continue to be paid back, yet that this assumption is not correct.

Thus under your examples - a normal inflationary cycle assumes that the financial institutions will have their (good or bad) debt repaid, but that even more debt will be issued. What Mish is saying is that if in fact rising inflation causes more debt to default, then the financial institutions will be forced to curtail new lending even more as their writeoffs increase.

As for wage increases keeping up with inflation - seriously, when has that ever happened in negative economic circumstances?

From iTulip's list of inflationary scenarios, I'm pretty close to absolutely certain that wages did not keep up with prices in any of those places and time periods.

c1ue
01-04-08, 11:47 PM
Yes, there will be higher bankruptcies and yes there will be defaults and more solvency issues... but the government can and likely will come in with programs to "help", and the Fed will also show up on its white horse to "save" the day... after enough pain and fear and noise etc. has occurred.

Bart,

I understand your point, but if defaults rise to unmanageable levels, then the government can only either assume the debt (and erase it), or change capital requirements.

In the former case, I would think that this would kill the entire US$ bond market, likely also the treasuries.

In the latter, I'd think there would be backlash as all of the other banks around the world reciprocated (they'd have to).

FRED
01-04-08, 11:47 PM
There is an error here...debt defaults are NOT deflationary.

If $100 is loaned to Able, Able spends the money. That is inflationary. Now if Able pays it back, that is deflationary.

But if Able defaults, no net gain or loss. It is not deflationary.

What will happen though is that the government will bail out the bank by making it oh-so-easy to loan into existence another $100...so debt defaults are INFLATIONARY.

I don't know what I am missing here...

In a world where money is lent into existence, this is correct. Money creation begins when a bank lends to Able. (More precisely, it begins when various conditions are met which allow the lender and Able to complete a loan transaction.) A default on an existing loan is deflationary, as in the repayment of a loan with no new loan created to take its place on the lender's balance sheet (remember, a loan is a liability to or I, an asset to a lender). In both cases of default or repayment, the loan is extinguished. However, in the case of a repaid loan, the lender's ability to re-loan improves, whereas in the case of a default it is not.

Here is where the Fed can impact the conditions that allow lenders to extend new loans even though there have been many defaults. As Aaron Krowne found, in 1995 to re-start the seized up banking system, the Fed changed reserve requirements and allow banks to create sweep accounts. That particular method will probably not be used again. However, anyone who thinks the Fed does not have more methods has not been paying attention to what we've been writing here.

Next week when we publish our Comments on the Fed's Zero Interest Rate Economy Playbook we take a stab at a few additional Fed anti-deflation policies we see coming.

grapejelly
01-05-08, 12:41 AM
In a world where money is lent into existence, this is correct. Money creation begins when a bank lends to Able. (More precisely, it begins when various conditions are met which allow the lender and Able to complete a loan transaction.) A default on an existing loan is deflationary, as in the repayment of a loan with no new loan created to take its place on the lender's balance sheet (remember, a loan is a liability to or I, an asset to a lender). In both cases of default or repayment, the loan is extinguished. However, in the case of a repaid loan, the lender's ability to re-loan improves, whereas in the case of a default it is not.

No, default and payback are quite different. In default, the money has been spent. Able paid Baker and Baker paid Carol. In a payback, it is the other way around.

A payback of a loan is deflationary but a default is not.


Here is where the Fed can impact the conditions that allow lenders to extend new loans even though there have been many defaults. As Aaron Krowne found, in 1995 to re-start the seized up banking system, the Fed changed reserve requirements and allow banks to create sweep accounts. That particular method will probably not be used again. However, anyone who thinks the Fed does not have more methods has not been paying attention to what we've been writing here.

Next week when we publish our Comments on the Fed's Zero Interest Rate Economy Playbook we take a stab at a few additional Fed anti-deflation policies we see coming.


Mish's point is that where loans are defaulting, banks will be unable and unwilling to lend and in any event, deman for credit will drop. You can't force people to borrow, Mish says.

But what he misses I think is that there are many ways to create money, as you point out here, other than borrowing.

I think that retirement accounts will be next...a target somehow to unlock the money sitting in them to "jumpstart" the economy...and then there are government guaranteed loans for everything. And mailing checks to taxpayers. Helicopters.

Spartacus
01-05-08, 02:00 AM
My take on FRED's point is, we're talking about dynamic systems. Paying back a loan doesn't "destroy" money because these days

When it's paid back it doesn't STAY paid back - it gets re-lent, probably the same minute it's paid back.

When it's defaulted, the bank has to take charges or if the default is part of an upswing in decfaults, the bank has to set aside more money (that may not be lent) for loan loss provisions.

In the dynamic situation, a default reduces monetary units - shrinks what the bank may lend
a normal loan pay-off does not shrink the bank's lend-able pool - a pool the banks work hard to make sure stays almost entirely lent


No, default and payback are quite different. In default, the money has been spent. Able paid Baker and Baker paid Carol. In a payback, it is the other way around.

A payback of a loan is deflationary but a default is not.

Mish's point is that where loans are defaulting, banks will be unable and unwilling to lend and in any event, deman for credit will drop. You can't force people to borrow, Mish says.

But what he misses I think is that there are many ways to create money, as you point out here, other than borrowing.


The actual default itself does impair bank balance sheets, no question.
Whether the FED will allow this impairment to cascade is the question.

And, yes, I think given a sweet enough deal, US borrowers WILL borrow, Mish's opinion notwithstanding. If your only options are bankruptcy or rolling over your old loans on good terms, a lot of people will choose to roll over. The recent bail out plans have nust not had good enough terms.


And no doubt the FED will soon invent some more ways to create money.


before August 2007

bart
01-05-08, 10:44 AM
Bart,

I understand your point, but if defaults rise to unmanageable levels, then the government can only either assume the debt (and erase it), or change capital requirements.

In the former case, I would think that this would kill the entire US$ bond market, likely also the treasuries.

In the latter, I'd think there would be backlash as all of the other banks around the world reciprocated (they'd have to).


As Fred and others have noted, there are more than just those two alternatives. Bernanke is on record multiple times as saying he won't allow deflation.

Also and in spite of many statements to the contrary, the Fed has a huge amount of power. There's a very large difference between the power that they have and the power that they have used.

dbarberic
01-05-08, 12:18 PM
I believe that Mish does not think of the Fed as a political institution. He seems to believe that the Fed plays within a very defined "box" of rules of what they can and can not do to prevent deflation. He often repeats, "The Fed can not make people borrow". It is this limited view of the Fed, is where I believe that Mish makes an error in his beliefs.

On the other hand, iTulip views the Fed as a political institution with a symbiotic relationship with the government and the FIRE economy. This view implies that there is no defined "box" of rules and that every option is on the table to prevent deflation (Fed policy, taxing policy, federal programs, Wall Street, etc). We've seen some of this already in the Dallas Fed's "Monetary Policy and a Zero Interest Rate Economy". The Fed can simply move restricted feasible instruments from the Not Allowed to the Allowed side.

I'm in the iTulip camp. There are no bounds to the schemes and tools that the Fed, the government, and the FIRE economy can come up with either in combination or independently to prevent deflation. Will there ever be deflation? Perhaps someday, but we are not at the end game yet.

c1ue
01-05-08, 03:24 PM
I think that retirement accounts will be next...a target somehow to unlock the money sitting in them to "jumpstart" the economy...and then there are government guaranteed loans for everything. And mailing checks to taxpayers. Helicopters.

I agree there are many ways for the Fed to play games - the question is how the ROW would view it. I still cleave to the belief that there is a level of shenanigans beyond which FDI will leave for good.

As for retirement - while Americans certainly are more aggressive in their finances, I think the twin Y2K/Internet and real estate bubbles popping would likely give all the boomers some pause to consider their impending retirements - and not take more risk than necessary.

The legendary saving ability of Japan is in part due to the retirement phenomenon; it is amazing how many Japanese pay close attention to their government's fiscal state; in most other aspects Japan has a very strong social net but retirement is something many older Japanese are concerned about.

The other question I have is the iTulip belief that the Fed will do what is best for their financial sponsors.

I agree that the Fed will do what their sponsors want, but there are numerous examples in the past where said sponsors did not make the right choice - or more correctly made the wrong choice for the right short term reasons.

With economic policy, it is not that easy to turn around a ship once at speed heading for the rocks...