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Deflating a Weak Argument Against Deflation

January 15, 2024

Reader Scott Baker took issue last week with my unsettling prediction of a deflationary bust. The mountain of debts that I believe will cause this is really no big deal, says Baker. He quotes economist Michael Hudson to back him up: “Debts that can’t be repaid, won’t be.” That certainly doesn’t sound very menacing. So who will lose if a global banking system holding $2 quadrillion in hyper-leveraged securities implodes?  According to Baker, the pain will fall mainly on supposedly sophisticated investors who failed to perform due diligence.  And fortunately for them, the damage won’t be nearly as bad as I’ve calculated, he says, since the value of all derivatives is probably less than half of the $2 quadrillion figure that is accepted widely, if not universally. Well, okay, I’ll give him a little slack on that. But even if one allows that the size of the market is ‘merely’ $1 quadrillion, that’s still nearly ten times as much as the world produces in goods and services. That can only mean that the collateral backing the market is dangerously thin.  Baker believes the economy could survive the hit anyway, but for a reason that sounds like something Yogi Berra might say: ‘Because derivatives are on all kinds of things…they literally cannot fail all at once.’

A Debt Bomb

The clock is ticking on this debt bomb, and optimism is not going to prevent it from triggering. Nor will any of us escape the effects. The late C.V. Myers, whom I’ve quoted here before many times, has provided the simplest explanation of why deflation is so likely:  Ultimately every penny of debt must be paid — if not by the borrower then by the lender.  To understand why, you need only consider that if, say, students skip out on $1.8 trillion in college loans, or Biden ‘forgives’ them, it is the bondholders who would take the hit. And if you walk way from a house whose value has fallen below what you paid for it — ‘leave the key in the mailbox,’ so to speak — it is your mortgage lenders who will take the loss, as well as every other party to the loan. The derivatives market effectively ties all of us to the loan, even if Baker (and, apparently, many economists) seem not to understand this.

My friend and frequent contributor Richard Charles, of Alpine Capital, clearly does. Here’s what he had to say in response to Baker’s comments:  “Consider the talented man who received the first PhD in Economics from Yale. Joseph Schumpeter described him as ‘the greatest economist the United States has ever produced,’ an assessment later repeated by Nobel laureates James Tobin and Milton Friedman. Irving Fisher declared proudly at the Harvard Economic Club, nine days before the 1929 Wall Street Crash, that stock prices had ‘reached what looks like a permanently high plateau.’ Gifted as he was, it still took Fisher years to figure out what ruined his wealth, business and academic reputation — namely debt default deflation.

Booms and Depressions

“His paper is still fascinating and relevant, with citations from his 1932 work Booms and Depressions. It is interesting that his Econometrica link came from the St Louis Fed, hinting they may recognize a ghost of markets past. On page 367, Dr Fisher, a master of charts, shows collapsing financial indicators at the beginning of the Great Depression, save one: gold stocks. He noted a lag between changes in real and nominal interest rates and business-cycle failures, as well as erratic swings in unemployment such as we have had over the last several years,

‘I do venture to stress most,’ wrote Fisher, ‘the theory that when overindebtedness is so great as to depress prices faster than liquidation, the mass effort to get out of debt sinks us more deeply into debt. I would call attention to new investment opportunities as the important starter of over-indebtedness. Finally, I would emphasize the important corollary of the debt-deflation theory — that economic depressions are curable and preventable through reflation and stabilization.’ ”

Charles thinks there is still time to deal with the threat of deflation.  “It is entirely possible that current market leaders contracting [as stimulus unwinds] may at first lead to more ‘screwflation’ until things stabilize. Historical data for U.S. debt, credit, derivatives and unfunded liabilities suggest it may take a long while to produce a Second Great Depression. “We are in no hurry. As Will Rogers once quipped, it is not so much the return ON investment we should care about, but the return OF investment. Another piece of Rogers’ wit and wisdom: ‘If it ain’t going up, don’t buy it, and if it’s going down, sell it.’ “

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