Sunday, December 14, 2014

The Powerful Menace of Debt-Deflation 2014

Global PPI
Debt-deflation poses the ultimate threat of economic pain. At its worst, the very viability (politically and economically) of capitalism itself can be called into question under the pain of debt-deflation. The Great Depression furnishes the most painful example of debt-deflation thus far in modern capitalist economies. In the US, unemployment soared to 25 percent and in the election of 1932 the communist and socialist parties attracted 1 million votes.

Why is debt-deflation so dangerous?

First, in a deflationary reality, people will rationally slow down all spending, constantly delaying purchases of all sorts to take advantage of lower prices. This spending slow-down then spirals, as firms respond to lower revenues by slashing costs, especially employees. As unemployment increases spending necessarily falls further, necessitating more spending cuts in the business sector. In an economy where about 70 percent of all economic activity is consumer-driven, as ours is today, it is easy to see that the threat of deflation can quickly spiral out of control leading to massive unemployment and macroeconomic pain for all.

Second, once deflation takes root, investment is bound to falter. During the Great Depression investment plunged by over 80 percent between 1929 and 1933. Falling prices, unemployment and reduced consumption simply do not inspire investment. Risk aversion becomes the norm as creditors will even accept negative interest rates as investment opportunities shrivel away and currency becomes more valuable over time. These negative rates both reflect and amplify dire investment options and ultimately lead to financial disintermediation as people opt for cash rather than even bank deposits. The withdrawal of capital from the economy then operates to further restrict growth.

Third, and most ominously, consider debt in a deflationary environment. Debt taken out in a non-deflationary environment (often during a bubble) becomes unsustainable in a deflationary environment because dollars by definition become more valuable and scarce. So, debt burdens soar in real terms. Defaults necessarily soar too, and the financial sector then succumbs to losses. Capital freezes, much like what occurred in the wake of the Lehman failure in 2008. Highly indebted societies feel the greatest macroeconomic pain from debt-deflation.

Three simple steps toward macroeconomic catastrophe.

Of course, it could never happen today, right? Wrong--it is happening as you read. As the chart above shows, the world has been flirting with deflation for years. Even before the oil price plunge of recent weeks, as The Economist shows, virtually the entire developed world was already perched on a deflationary precipice. Deflationary pressures are growing dramatically, as I demonstrated last week with this blog post.

Most particularly, the recent plunge in crude oil constitutes the greatest deflationary shock to the global economy since the failure of Lehman Brothers. A huge part of the decline is demand driven, as the International Energy Agency and others continually cut demand estimates, including on Friday which led to the stock market carnage. The price of oil is simply now in a free fall:

In fact, late last week the price fell off the above chart to $57 per barrel. The price drop reflects massive economic slow-downs across the world especially China, Germany, the Eurozone in general, and Japan. Now oil and other commodity price plunges are dragging nations like Norway, Russia, Venezuela, Nigeria into recessions. The deflationary spiral has begun. This deflationary price spiral bodes ill for the global economy.

Far worse, however, is its impact on asset values and accompanying losses in the financial sector. For example, both Russian and Venezuelan bonds seem headed for default. Energy now constitutes 16 per cent of the US junk bond market, up from 4 percent ten years ago. So, high yield debt markets are silently crashing. The fear is now spreading beyond energy. In fact, the flight to safety has turned into a mad rush--as evidenced by plunging yields in US Treasury debt.

So where precisely in the financial sector will those losses fall. Only the great derivatives wizard knows for sure but a good place to guess is the US megabanks who control 95% of the derivatives market in the US, as I will discuss in my next post.

Can this all be averted? Of course, through vigorous and broad based monetary and fiscal stimulus. I will address these mainstream solutions in a subsequent post.

Friday, December 12, 2014

Greece and a Gathering Perfect Storm in Financial Markets

Events have turned suddenly around the world in a way that promises to spawn macroeconomic disruptions. Basically, several powerful deflationary pressures now grip the global economy. Let me simply survey the worst storms that seem to be emerging around the world:

1) Greece and the possibility of a Grexit from the Euro Zone is back in the news. The Greek Prime Minister has called a snap election that could derail the bailout of Greek debt. The Athens financial markets literally crashed in the wake of this development. The Parliament in Athens will vote first on December 17, and if the government loses there then a general election will follow shortly thereafter. Worst case scenario: months of uncertainty followed by catastrophe.

2) The Euro Zone is in terrible shape and appears to be worsening. The ECB appears totally sidelined by the Germans at this point. It would be hard to imagine that the Euro Zone could withstand an event like a Greek exit from the Euro Zone. Even without an exit, it seems destined to suffer a recession and to export deflation worldwide. This is a key reason commodity prices are crashing.

3) China apparently racked up a mountain of bad debts that initially helped fuel its stellar growth but now leaves it with a massive hangover of underutilized assets and loan defaults. The future is not looking good across the Pacific. China is also exporting deflation as its slowdown (of unknown proportions) is clearly causing commodity prices to plunge across the world.

4) In fact, the Bank of International Settlements recently warned that many nations (Russia, Venezuela and a host of others) and private firms face declining revenues and soaring debt burdens because commodity revenues are shrinking as dollar-denominated debt increases in cost due to a surging dollar that is a natural outcome of the commodity bust. This could lead to a rash of defaults.

5) Meanwhile, in the US a dramatic fall in oil prices poses an existential threat to the highest growing part of our economy--energy. Jobs in the oil patch account for virtually all job growth in America over the past five years and new jobs beyond energy pay little. Much of the American high yield debt market is centered in the oil patch. With oil in a literal free fall this sector of the US economy may well be doomed. Can the US economy withstand the job losses and loan defaults implicit in very cheap energy?

There are more threats. Banks across the world still need to deleverage, raise capital and therefore reduce lending. Ukraine faces financial collapse. These problems are manageable alone. The above issues are in combination far more dangerous.

All of this suggests that despite an apparently buoyant US  stock market (now standing at 17,411) caution must temper any optimism. "This week's financial headlines sound like a recap of the horror stories of the last six years." There is an increasing probability that a major financial crisis looms as deflationary pressures overwhelm an increasingly fragile global economy.

Wednesday, December 3, 2014

Ferguson, Eric Garner and Occupy Wall Street

     A New York grand jury has decided not to indict the police officer who choked Eric Garner to death in Staten Island.  I was too young to march with civil rights leaders in the 1960s.  I am too old to demonstrate with the young people who have protested against the Ferguson grand jury’s decision and have kept the issue of police criminality, brutality and implicit bias in the headlines.  I can’t demonstrate with them, but I’m proud of and grateful for them.


     As many others, including Roland Martin, have said, these protesters have started a movement.  It is a movement precipitated and inspired by the string of young men across the nation who died at the hands of police officers and vigilantes like George Zimmerman. 


     I was proud also of the demonstrators who participated in the Occupy Movement.  I even went to observe and encourage the Occupy Wall Street protesters in Zucotti Park in lower Manhattan.  I am profoundly disappointed that the Occupy Movement has all but disappeared.  Many accused the Occupiers of being unfocused, and disorganized with no meaningfully unifying concept.  The recent protests about police brutality and the targeting of Black men are focused and unified in a way that the Occupiers never achieved.  I thank God for them.  This latest movement makes me hopeful that we will see a resurgence of political and social activism – including a rebirth of Occupy Wall Street.


     I teach law at St. John’s University.  The day after the Ferguson grand jury’s decision was announced, several students of African descent stopped by my office to discuss the decision.  They told me they felt powerless, helpless.  They are now studying for exams.  I can only imagine how they feel as future lawyers trying to earn a law degree as Black vulnerability – physically, emotionally, economically (this is why Occupy Wall Street was so important)—increases exponentially.  The protesters, I hope, inspire them.  Like me, they may not decide to take to the streets, but they will engage in some type of activism in their communities, and at our law school.