Debt Deflation is Progressive

I have just enough time before the fiscal stimulus plan is passed to get this blog post in. It's a particularly important post for those with a liberal perspective (of interest to all though I hope). For all the legislative efforts to improve the living standards of the working poor and to create affordable housing it is actually the current financial crisis that may, with no small dose of irony, reverse the country's economic polarization. It is important also for those who consider progressiveness to be a good thing to consider the government's bailout, stimulus and inflationary posture and whether they can really support it.

Eco 101: What is Debt Deflation?

Economists often use the term deflation when they actually mean to say price reduction. Price reduction is when the price of a good drops because there is a productivity gain. This can come from technology (such as the price of sending a letter dropping to zero because of the development of email) or improved competition (such as when a generic drug causes the price of a brand name drug to be lowered). Economists sometimes call this "good deflation" because the net effect is that everyone can afford more.

We also hear about so called "bad deflation" which occurs when companies lower their costs amidst falling profits. Bad deflation is usually accompanied by overstocked inventories, consumer purchasing cutbacks, layoffs and business failures. Bad deflation strikes fear into the hearts of many as it is seen as the cause of the Great Depression. This is of course a myth to which, regrettably, many economists and non-economists still subscribe.

So is debt deflation "good" deflation or "bad" deflation? Neither, it is actual deflation (as opposed to price reduction). Debt deflation is the deflating of an economy. It follows that for something to deflate it must have first been inflated. In an economy this occurs through expansion of credit.

The credit cycle of an economy can essentially be visualized as a giant balloon. Like a balloon it inflates from two things: 1) the government can blow air into the balloon through loose credit (quantitative easing) and/or 2) the balloon can expand from the heat generated by the economy. In economic terms this comes from the combination of velocity and the fractional reserve banking system. (Note that without a fractional reserve system velocity actually works to reduce price levels, aka "good" deflation).

Again, much like balloons, credit expansions have theoretical limits. In practice the limit is difficult to find because the balloon and the limit are elastic. Like the balloon the credit bubble can be stretched just a little bit further if you blow ever so slowly and as the balloon becomes tighter it becomes more difficult to get additional air in without increasing the force of your breath. Once the balloon has reached its limit it can either pop or deflate. Imagine trying to stop a rapidly deflating balloon and you will understand the difficult position of the federal government.

In a credit economy deflation manifests itself as debt default. As credit expands our balloon, more money is floating inside the economy. This drives down the value of money and drives up the price of anything you might want to buy. If an economy is simultaneously seeing productivity enhancements then consumer product prices will be relatively steady while asset prices will climb dramatically.

The last statement of the previous paragrah is important to consider as this is exactly what we saw in the previous 6 years (the productivity enhancements primarily coming from trade with China). Anyone who was looking for inflation by watching the CPI was missing the picture. Inflation showed up in assets. Home prices rose at a 20% annual clip. Since, for the average citizen, housing is the single largest living expense it is very difficult to argue that inflation was absent. Indeed, the rapid rise in the price of oil in 2007 was the canary in the coal mine belting out a tune at the top of its lungs for those who would listen.

Debt default comes when an individual can no longer pay the mortgage on their home (or any other debt but mortgages are the lion's share of non-government debt). Default also occurs when mortgages are renegotiated because renegotiating is essentially a partial default. The net effect of each default is that air escapes from the balloon. There is less money in the balloon and therefore the value of everything in the balloon drops (particularly those things that were inflated the most due to the economic principals of elasticity and marginal utility).

Very important to consider is that when a homeowner experiences a foreclosure the probability of them re-entering the housing market is very small. They firstly are unlikely to have enough money for a down payment. They are also unlikely to be able to get credit to purchase another home even if homes have fallen to a price that may now be affordable. Those individuals will enter the rental market where they are much more likely to rent a smaller (cheaper) unit as they build up cash for a possible re-entry into the housing market several years down the line. The effect of foreclosure on a mass scale therefore is to dramatically increase inventory of homes and reduce the pool of individuals who may bid for them. This further drives down the prices of homes.

Banks that are experiencing defaults will weigh their options: foreclose or renegotiate. If they believe that enough individuals with good credit exist to step in and purchase foreclosed homes then they will be more likely to foreclosure. If on the other hand they believe that there is a too small pool of capital for home purchasing and/or that pool will opportunistically wait for the bottom then banks will renegotiate mortgages (even several times in order to manage their risk downward at a controlled pace and avoid collapse). As the Case-Shiller data shows, the median price of homes has dropped from $253,000 in July of 2006 to $200,000 in January of 2009. That represents deflation of 20% (and is higher still in many cities).

Why Do I Care? Let the Banks Eat It.

A gainfully employed individual with some savings and a manageable mortgage might be forgiven for yawning at this point. Banks made foolish investments. Some people bought houses they couldn't afford. Let the banks take the losses. Yeah, well there's a problem with that. In the last section we described how the bubble deflates rapidly. That's what is happening currently. Let's describe what happens when the bubble pops.

The first thing to question is who exactly was dumb enough to lend $1,000,000 for a mediocre 2000 sq ft home somewhere in a suburb of California? Well the answer in all likelihood is you. See, when you deposit your hard earned savings in the bank it in turn lends it out. It's worse though. For every $100 you deposit the bank can actually lend out up to $900. Your small community bank can lend out even more! An analysis of money supply data shows that in actuality banks lent about $500. Paying attention now?

It gets crazier. The government agencies (Fannie Mae and Freddie Mac) lent money ($8 trillion) to home owners. They got this money by selling bonds (referred to as "agency" bonds). Those bonds are now spread all through the economy. Approximately half ($4 trillion) are owned by you (either directly; through mutual funds; in your pension plan; or by your state government). A quarter are owned by foreigners (mostly China). The final quarter is owned by banks, brokers and investment banks and is the only collateral that they have other than your savings (which is as good as the bank doubling their bet on your savings). In fact, about $800 billion of agency debt is owned by the agencies. This circular asset loop allowed the banks to lend past capital reserve requirements that would have slowed the pace of balloon growth.

Knowing this and looking at Wells Fargo's balance sheet you might get the urge to make a speedy bank withdrawal and mattress deposit. As you do so the bank teller is likely to talk you off the ledge by informing you that there is nothing to worry about: your deposit is insured by the FDIC! Those that have been paying attention will note how handily the FDIC has dealt with the recent wave of bank failures. Typically the FDIC will seize a bank before a bank run occurs because they have access to a bank's capital reserve ratios in advance of the general public. Over the past several months even mega institutions such as Wachovia, Merrill Lynch and Washington Mutual have been scrubbed and then quickly absorbed by other stronger banks. Of course each of these remaining strong banks (JP Morgan Chase, Bank of America, Wells Fargo, Citibank) have been stretched thin to the point that there is no bank that is now strong enough to absorb one of these banks if it fails. FDIC has about $26 billion in reserves. So what happens if one of the largest banks fails?

Pop! A bank with several hundred billion dollars in loans can only be absorbed by the government, a.k.a. nationalization. At this point any losses will be absorbed by the taxpayer. Of course, the taxpayer was already absorbing most of these losses through the TARP program and in reality there is no-one other than the tax payer who can absorb these losses (remember the banks have no actual money). The aggregate wealth of the Forbes 400 is less than a trillion dollars and most of this is in illiquid assets. Raising cash by selling the assets of the richest people in America would probably drop the value of those assets to a few hundred billion. Enough maybe to bail out one of the major banks.

It turns out in fact that the amount of available cash is the United States is a published finite number. Currently there exists $1.5 trillion dollars of currency. So if all the currency in the United States were used to pay off loans then we could cover the liabilities two of the major banks.

Suffice it to say that it would not be politically possible or practical to seize all currency. It would also not be politically possible or practical to tax the citizens to pay off their own debt. The federal reserve's solution to this problem would be to devalue the currency so that debt and savings would both be reduced. There is of course a limit to how much devaluation the fed can get away with. 

If they devalue too much then the rates on treasuries will rise (as investors demand more return to overcome inflation). Since adjustable mortgages are based on treasury rates they would adjust higher. That would lead to more defaults and a death spiral. Likewise the adjustables that are linked to LIBOR can reset higher if there is bank insolvency leading again to a death spiral. To counteract this the government must inject cash into the banks and buy agency debt so that the agencies can relieve the banks of their mortgages. Once the agencies have bought all the mortgages they can then the government can allow the agency debt to slowly climb without the risk of mass insolvency).

The fed also runs the risk of capital leaving the country. This is a euphamism of sorts because currency can never actually leave the country. All currency sits in banks. What happens when you buy a different currency is that you actually exchange currency. In effect you sell your dollars to someone who will in turn give you euros. If enough people try to do this then it will create a run on the currency and hyperinflation will be the result. So the fed cannot simply drop too many bills at a time from the helicopter without the risk of tipping the helicopter and letting all the money slide out at once.

So What is a Central Banker, FDIC Chairwoman and Secretary of the Treasury To Do?

The government's case is helped by the fact that there is nowhere else to hide. You hear this echoed in the notion that the dollar is a reserve currency which protects it. This is not really true though because the Yen and Euro are reserve currencies too. What keeps people in treasuries and agency bonds is the coupling of the world's economies. All economies are linked. All economies are suffering. All securities are devaluing. Where else to put the money? Those who are familiar with block trading know that if you want to sell a large quantity of stock that you have to sneak it out a few shares at a time otherwise the market will catch on and drive a hard bargain. Now imagine how long it would take to sneak out several trillion dollars worth of a security. If China tried to reverse its position it would end up with foreign investors owning half of China.

When one considers the natural boundaries that the economic system has erected (deflation, hyperinflation, capital flight, foreign investment) it becomes easier to determine the course of action that the government will take. They will take things slow and do whatever they can so that the air leaks out just a little at a time. That is, they will improvise. Again, when one considers the natural boundaries that the economic system has erected one can conclude that taking things one step at a time is the only possible approach. The government is rather like Sisyphus sweating bullets after the boulder has almost got away from him. While he may be inclined to start pushing up the hill again it is more likely that he will ease the rock down to the bottom and give himself a break. Indeed this seems to be the inclination of Treasury Secretary Timothy Geitner who is really more the crisis manager than theoretical economist. While the audience calls for stimulus I am betting on lip service to congress (fiscal stimulus plan) and instead an attempt to orchestrate a soft landing through step by step maneuvers as the situation develops.

While I know in a previous post I explained how Japan's lost decade cannot be used to decipher today's U.S. economy I nevertheless still believe that this sort of lost decade is exactly where we're heading. In the case of Japan, the government did everything possible to try to get out of the trap. In the case of the U.S. government the trap is actually home base. For anyone who is really concerned about extended periods of mild deflation and stagnant economic growth you should probably acquaint yourself with the deprivations experienced by the average Japanese citizen: here.

Smart investors will keep an eye on the treasury yield and agency debt yield. While a currency panic is unlikely, it is possible. People who have moved all of their money into gold are not crazy, they are prudent. However, at the current rate of debt deflation it would take an inflationary rate well above 10% in order for holders of cash to begin losing money. Investors who are savvy enough to know to buy gold are probably going to be able to spot an inflationary trend before it's too late and possibly avoid getting squeezed by further strengthening of the dollar. Yet gold is risky for U.S. citizens because of the previous arguments on the magnetitic pull of foreign governments into treasuries. (The yield spread between agency debt and treasury debt will be arbitraged away. In all likelihood foreign governments will slowly exchange agency debt for treasury debt so that they don't get caught flat footed when the banks finally become solvent. This should serve to close the yield gap in short order.)

Where's the Part About This Being Progressive?

Debt deflation is bad for those who have debt. This is why they default. If you bought a home for $600,000 and took out a $500,000 mortgage then you're probably upset if your home is now only worth $300,000. Does it mean you are ready to default though? Probably not. You won't want to give up the equity you've built up. You won't want to ruin your credit. If the payment remains affordable then you're really no worse off than before. Your relative wealth is drastically reduced but your standard of living is the same.

If you're in such a position, the bank is unlikely to refinance your loan. In all likelihood you probably can't even get a lower rate (if such a lower rate even manifests). You're pretty much stuck. If you lose your job then perhaps the bank will make a different risk assessment and in either case you will be more likely to make a purely economic decision and bail out. Those who bought big houses and have little equity are more likely to bail out but even still the black mark on their credit score and the pain of foreclosure are significant deterrants. So from an economic standpoint the default rate is likely to run in tandem with the unemployment rate. While growing, the pace still seems to be one that the government can manage down iteratively.

Here's the progressive part. For those individuals who do not yet own homes the current market may soon offer a once in a lifetime home purchasing opportunity. Historically the cost of a home has stood at 3 times the average income but has climbed over the past several years to 4.5 times (and in the worst hit of the bubble cities at upwards of 7 to 10 times). Certainly purchase of a home that is priced at 3x cannot be called a bad purchase but the current inventory glut and demand drop will likely offer home purchase prices even below those levels.

Such a situation has as much positive impact on lower income families as a progressive tax. This attached spreadsheet demonstrates the progressive effect of debt deflation. The analysis computes a cost of living for a family of four which is frugal (but not parsimonious). It projects a rather steep deflationary rate of 10% (anything less deflationary would create even more benefit to the lower income). It assumes that health care and gasoline will maintain their price even in the face of significant deflation (effecting a relative increase in the cost of living). So really with everything working against our consumer the spreadsheet shows how the cost of living still is reduced by debt deflation.

The average household income is $49,000. In the real world, after-tax income for such a family will range from $40,000 to virtually paying no tax at all depending on itemizations. For this analysis we assumed that the family is employed with some form of employer health insurance and paying a 15% effective tax rate. It assumes the same tax rate down to $30,000 and up to $70,000 so again in actual life the situation for the person making $30,000 is actually better than the spreadsheet and for the person making $70,000 a little bit worse.

We also apply the deflation rate to the individual's salary. Certainly in the real world many people will be able to maintain their salary but on the off chance that company leaders realize that pay cuts are possibly a better approach than layoffs we've assumed that the average citizen's earning potential is reduced just as much by deflation as their cost of living. So in effect, deflation has a neutral effect on the individual.

Under these conditions, in 2006 a person making $44,000 would be able to afford the average U.S. home and meet cost of living expenses. Fast forward to today when the average price of a home has dropped 20% and CPI has dropped 10% and we find that now someone making only $41,000 can now afford this standard of living!

If we extrapolate 20% ongoing debt deflation and 10% CPI reductions then at the next increment an individual making $40,500 can afford this lifestyle and if repeated once again then it drops to $40,000.

Astonishing in its irony, through the government's mismanagement of credit the dream of home ownership may actually become a more distinct reality for the country's lower income citizens. Some people within this demographic will for certain lose that dream in a foreclosure but others who have been waiting for a good while will now be able to buy those homes and stand in a much more secure position having gotten them at a non-inflated price. There will likely be a net uptick in lower income purchases than lower income foreclosures since the credit bubble caused about a year or two worth of overbuilding.

This runs in stark contrast to the reality that would be created if the economy was "stimulated" again. A reinflation of the credit bubble would serve to temporarily keep these homes out of the hands of people who are ready to purchase and cause those who will inevitably default to inject further equity that will be inevitably lost. If we allow the bubble to take its natural course and deflate the result will be similar to that of the overbuilding of fiber optic lines by Qwest or the launching of satellites by Iridium. Both of those companies overbuilt and went bankrupt but the infrastructure that they left behind became suddenly affordable and the basis of renewed productivity.

Feet to the Fire for the Self-Identified Liberal

Now that we've shown that the unwinding of the credit bubble will actually serve to have a progressive silver lining you have to ask yourself how you feel about that. It probably depends who you are. If you are that person who has a $500,000 mortgage on a $300,000 house you might feel duped. If your next door neighbor receives a principal reduction you might feel a ping of injustice. If a first time home owner now can afford the home next to you it may stir a feeling that some social justice has been achieved even if it has come at your expense.

The reality is that the economic collapse of the past year has been the single largest redistribution of wealth known to man. In short order, trillions of dollars of assets were devalued. The net result is a new affordability of those assets to people of lower income levels. At best this situation is a silver lining but it is, nevertheless, progressive. If that is enough for you then congratulations, you are true to your ethic. If however this explanation leaves you in some way philosophically or emotionally unsatisfied then consider the remainder of this article.

What if There Had Been No Bubble?

This silver lining in the burst bubble begs the question: are we are in fact better off with bubbles? I would posit: no, we would have been better off without the bubble. This includes those in lower income demographics.

Credit bubbles appear to cause overinvestment. The housing supply along with the examples of Qwest and Iridium seem to indicate this. In actuality though something much more subtle is happening. Some economists refer to the effect as malinvestment. Businesses began to chase the quick gains that were available in the expanding bubble rather than the gains from providing goods to choosy customers. The somewhat predictable result is the FIRE economy (Finance, Investment, Real Estate). People ended up employed in those industries that chased the money.

Absent a bubble we could predict how differently our economy might look. The millions of people employed in the FIRE economy would have ended up a different industry. Since we were coming off of the tech boom in the 90's it is unlikely that they would have ended up in that industry. The most likely industry I could see would be health care. Health care is certainly a business that offers premium margins and growth for the next several decades. In all likelihood we would by now have a significantly increased number of health care professionals. Back office clerks would possibly have been trained as nurses. The geniuses who invented CMOs might have instead invented financing for expensive surgeries or recruited capital to build new hospitals or in the development of new drugs. So the credit bubble has in all likelihood caused us to lose a decade in terms of innovation and supply growth in health care.

Would lower income individuals not get their homes? I believe that homes would still have been built at a solid pace. While we would not have seen the oversupply of homes that we have now we would probably have seen a relatively larger supply of smaller homes. Without a credit bubble, homebuilders would need to innovate in order to lure new home buyers. The lower income demographic offers a compelling marketplace outside of a credit bubble environment and it is more likely that homebuilders would have made the effort to penetrate that market. Unfortunately with a credit bubble in motion, home builders were incented to build houses of increasing size in order to grab the maximum amount of credit fueled dollars as quickly as possible.

Who is to Blame?

Demogogues on both sides of the aisle (1) (2) blame predatory lendors for the mess. This charge however is easily refuted. A lender is on the hook for the debt and therefore would have no incentive to lend money that would be lost. For all the talk of passing on risk to investors through CMOs this turns out to be a minority percentage of bad mortgages. Only the amount of low tranche CMO gobbled up by foreign banks and the small amounts passed on to pensions and individual investors can be blamed on any sort of predatory action and that amount is certainly not large enough to cause an economic collapse.

Likewise the blame does not lie with those who bought homes they could not afford. Perhaps they were individually irresponsible or individually naive but it is also highly unlikely that most individuals would buy a home knowing that they would lose their closing costs, downpayment and credit rating. Again, a small number of home buyers were opportunistic or negligent but not enough to bring about an economic collapse. The vast majority of buyers were, and remain, largely unaware that they could not afford their home by any reasonable measure because all reasonable measures were distorted.

Many like to blame greedy bankers, traders and the wealthy elite with their oversized bonuses and callous perspectives. Again though, while the pursuit of money can blind people to their actions it is highly unlikely that the CEOs of banks or investment houses would willingly put themselves in a position where they risked losing the majority of their net worth. While they made millions in bonuses they had far more wealth in stock along with the inestimable value that comes from being a master of the universe. Again, some were opportunistic and angled within a system that would enrich them and damage others but not enough to cause an economic collapse.

Some would like to blame congress for creating the agencies and pushing the agenda of home ownership. Clearly the agencies boosted demand but these companies were public institutions. The same logic applies to their leaders as the leaders of investment banks. The public willingly bought the debt and bought the stock of these agencies - without which there would have been no money to lend regardless of how much congress stamped its feet.

Finally, many would like to take the approach that all share some part of the blame. This is to some extent true and it is fair to say that they were all part of the system and the system is to blame. Who is to blame for the system though?

It is admittedly unusual when it is possible to pinpoint blame but in this case the smoking gun continues to smolder, leading us right to the culprit. Ultimately the blame lies squarely with the current regime of monetarists who, in partial response to the whims of politicians and partially out of their own hubris and misguided theories, continually inflate credit bubbles that generate a mirage of productivity but leave wreckage and uncertainty in their wake. One can only wonder to the extent that a central banker realizes that he is playing a high stakes game of musical chairs while every living soul on the planet waits to see what will happen when the music stops.