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That Sinking Feeling

In October 1933, the great American economist Irving Fisher published an article in Econometrica entitled The Debt-Deflation Theory of Great Depressions.  It is a brilliant article.  It is easily found on the internet.  Everyone should read it.  It explains why the global economy is at risk of collapsing into a new great depression today.  Once the dynamics of the debt-deflation spiral are understood, then it is easy to see why government policymakers have enacted the policies that they have in order to prevent that from occurring. 

Fisher wrote:

“…as explanations of the so-called business cycle, … I doubt the adequacy of over-production, under-consumption, over-capacity, price-dislocation, maladjustment between agricultural and industrial prices, over-confidence, over-investment, over-saving, over-spending, and the discrepancy between saving and investment.

I venture the opinion, …that, in the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominate factors, namely over-indebtedness to start with and deflation following soon after; also that where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two.” 

Irving Fisher described the dynamics of the post-boom deflationary spiral:

1. Mild Gloom and Shock to Confidence
   Slightly Reduced Velocity of Circulation
   Debt Liquidation


2. Money Interest on Safe Loans Falls
   But Money Interest on Unsafe Loans Rises


3. Distress Selling
   More Gloom
   Fall in Security Prices
   More Liquidation
   Fall in Commodity Prices


4. Real Interest Rises; Real Debts Increase
   More Pessimism and Distrust
   More Liquidation
   More Distress Selling
   More Reduction in Velocity


5. More Distress Selling
   Contraction of Deposit Currency
   Further Dollar Enlargement (i.e. Deflation)


6. Reduction in Net Worth
   Increase in Bankruptcies
   More Pessimism and Distrust
   More Slowing in Velocity
   More Liquidation


7. Decrease in Profits
   Increase in Losses
   Increase in Pessimism
   Slower Velocity
   More Liquidation
   Reduction in Volume of Stock Trading


8. Decrease in Construction
   Reduction in Output
   Reduction in Trade
   Unemployment
   More Pessimism


9. Hoarding


10. Runs on Banks
    Banks Curtailing Loans for Self-Protection
    Banks Selling Investments
    Bank Failures
    Distrust Grows
    More Hoarding
    More Liquidation

Consequently, we are teetering on the edge of a debt-deflation death spiral of the kind detailed by Fisher.  The only reason we have not spiraled down into a new great depression already is because the governments around the world keep creating more credit to replace the credit that is destroyed when the private sector defaults on its debt.  This has been going on since 2008 when the crisis began.  Whenever the debt-deflation dynamics begin to gain momentum, the governments take some reflationary action that checks and temporarily reverses that momentum.  TARP, QE 1, QE 2, LTRO and trillions of dollars of government budget deficits around the world are all examples of such government action. 

I believe it is useful to think of the global economy as if it were a big rubber raft that has been inflated with credit instead of air.  Floating on top of the raft are all the stocks (equities), commodities (including gold) and the world’s seven billion people.  The raft is defective.  It’s full of holes on all sides and the credit keeps leaking out as it gets destroyed by defaults.  For years now the raft’s natural tendency has therefore been to sink – just as the global economy sank during the 1930s.  Every time it begins to go under, however, global policymakers have reflated it by injecting more new credit into it.

The events of the last three months or so once again clearly demonstrate this pattern.  The first quarter of 2012 was great for investors.  The European Central Bank had created roughly one trillion new Euros and injected them into the global raft by making loans to European banks at very low interest rates.  The stock markets and most commodities soared in response.  During the first quarter, the MSCI World (stock market) Index rose more than 20% from its fourth quarter lows, while oil (NYMEX Crude) rose from less than $80 per barrel to $110 and gold jumped from $1,550 per ounce to nearly $1,800. 

Then our raft began sinking again.  By June the MSCI World Index had lost 80% of its first quarter gains.  Oil fell back below $80 per barrel and gold fell back to $1,550 per ounce.  The weakness in the asset markets was mirrored by a marked deterioration in the real economy.  In the United States, the GDP grew by only 1.9% during the first quarter, unemployment began to rise again and consumer sentiment deteriorated.  Outside the US the story was the same.  Signs of a sharp economic slowdown were everywhere. The weakness in the BRIC economies (Brazil, Russia, India and China) was taken as a particularly worrying development since many economists had believed those countries would act as a driver of global growth regardless of what happened in the developed world.  In April, China’s imports were flat compared with one year earlier, meaning that China contributed nothing to the growth of the rest of the world that month. 

This deflation of the global economy gathered momentum as the second quarter advanced.  Then, on June 29th, government policymakers once again did what they had to do.  They agreed to pump more credit into the raft.  As reported by Bloomberg:  “Euro-area leaders agreed to ease repayment rules for emergency loans to Spanish banks and relax conditions on possible help for Italy as an outflanked German Chancellor Angela Merkel gave in on expanded steps to stem the debt crisis.”  In other words, it was decided that the European Union would provide new credit to the Spanish banks to replace the debt that the private sector could not repay.  A near-term Eurozone crisis was thus averted.  Global stocks and commodities jumped for joy and the second quarter of 2012 ended on a very happy note for the financial markets.

The lesson to be drawn from this latest government-directed bailout is clear.  Global policymakers understand that if a Debt-Deflation Spiral takes hold, the world will be plunged into a new great depression.  Therefore, they will do whatever they can for as long as they can to prevent that from happening.  It is uncertain how long Friday’s newly inflated market euphoria will last.  If it is not sustained and the global raft begins to sink again, there is no doubt that Ben Bernanke’s Fed will act to reflate it with a new round of Quantitative Easing.  If stocks, commodities and employment numbers fall between now and the Fed’s next FOMC meeting on August 1st, QE 3 may be announced that day.  When it comes, QE 3 will ignite a new wave of market euphoria. 

I discussed the likely outcome of the European Summit on CNBC on June 28th before the announcement was make.  Please find the link here: 

How Credit Expansion Led to the Global Crisis >>