Specter of debt deflation looms over economy
yomiuri.co.jp
Jesper Koll Special to The Daily Yomiuri
All over the world there is an ever growing number of analysts and economists who are trying to forecast what will happen to financial markets on the basis of predictions about what will happen to economies.
Unfortunately, much of this may be a waste of time. More often than not it is what is happening to financial markets that explains the future course of economies.
Given the dramatic decline on global stock markets and the relentless drop in interest rates during 2002, this should make forecasting economic growth in 2003 easy: The world economy may be headed toward a deflationary decompression.
The good news is, of course, that markets may be wrong. An optimist could argue that 2002 brought a one-off combination of events that, though unfortunate, will not be permanent.
The result was a surge in general uncertainty. And if there is one thing that financial markets do not like it is uncertainty. Specifically, the global war on terrorism has raised the risk of unpredictable confidence swings across the globe, as well as an increasing U.S. public deficit and energy price uncertainty.
Moreover, the attack on corporate greed and management fraud raises profit outlook uncertainty. And finally, the wealth destruction in stock markets exposes economies to negative wealth effects that have unpredictable consequences. An optimist would argue these are only temporary "shocks" that will soon pass, that 2002 was an "outlier," and that markets are wrong to view 2002 as the start of a new trend.
Unfortunately, closer observation of the U.S. economic and political dynamics suggests that the optimist view is likely to be wrong, that 2002 probably marked a fundamental paradigm shift--the United States and the world economy is falling into deflation. The most important question is whether the accelerating fall in prices of goods and services during 2002 will start to trigger a full-blown debt deflation meltdown.
Deflationary realities are all over the U.S. economy. By mid-2002, goods prices for consumers were falling at an unprecedented rate of almost 2 percent. Service prices were still rising, but this is mostly due to the imputed rent calculations as well as high measurement error for services.
For example, the true cost of services offered is falling much faster than measured because service providers are offering extended "free" service periods. The only true price that did not fall is the oil price, but oil is a "Terror War Premium," not the start of a new secular inflation trend.
Of course, deflation of prices of goods and service is not necessarily bad news. Throughout economic history there were several periods of prolonged deflation during which the U.S. and global economy did just fine. The problem is that deflation combined with too much fixed rate debt can be an economy killer. Whether a debt deflation meltdown can be avoided is key to the 2003 U.S. outlook.
Debt deflation is triggered when companies and individuals--who lack pricing power in their price strategies and wage negotiations--become unable to make interest payments on loans that were contracted on the assumption of increasing corporate sales or rising incomes. A debt deflation meltdown happens when the market value of assets falls below the par vale of the debt that was taken on to acquire the assets. This then provokes lenders to "call the loan," demanding that debts be paid back rather than rolled over.
Debt deflation is about lenders demanding that borrowers liquidate themselves. In falling asset markets, that is very difficult for individual borrowers, and impossible for the entire community of borrowers. It is a fact that not all borrowers can liquidate all their debts by selling all their assets--you have got to have somebody to sell to, and when everybody is selling, nobody will buy.
Bankers know all about this little truth, which actually serves to accelerate the lender's demand on individual borrowers to liquidate as quickly as possible. To get their money back, creditors will force borrowers to monetize assets before prices fall even further.
This individually rational, but collectively irrational behavior is the engine of bank runs and true financial system crises.
The Bank of Japan's zero interest rate policy has cushioned against this risk. It allows banks to fund themselves at zero cost, thus keeping banks infinitely liquid and infinitely wealthy. Moreover, the government's deposit guarantee has kept deposit financing stable.
In the United States, such absolute emergency measures have not had to be implemented yet, primarily because corporations and individuals have able to refinance their existing debt obligations at lower interest rates. Because of the United States' aggressive "flexible rate refinancing" culture, the interest payment cost for housing and corporations actually came down in 2002.
For next year, however, the end of this one-off boost is in sight. This is because nominal revenues and nominal incomes are set to fall, pulled lower by relentless price deflation, the beginning of decline in household incomes and rise in unemployment.
Moreover, the boost from lower rates is coming to an end because interest rates cannot fall much further. For example, even if the U.S. Federal Reserve were to cut interest rates to zero, private mortgage rates would only come down another half a percent at most, because of the extension risk and convexity risk to the buyer.
There will never be a much-less-than-5 percent Ginnie Mae (General Government Mortgage Association), Freddie Mac (Federal Loan Mortgage Corporation), or Fannie Mae (Federal National Mortgage Association) mortgage issued, no matter how much the Fed cuts short rates.
All said, despite price deflation accelerating throughout the year 2002, the threat of debt deflation was averted by aggressive refinancing into lower rates. For 2003, this safety valve will be closed. This raises the risk that borrowers will fail to make interest payments and lenders will start to force loan liquidation.
The only savior out if this downward spiral scenario would be the start of a new, self-sustaining investment cycle, starting before the refinancing benefits come to an end. We will know the answer by the middle of next year, but chances are high that companies will not start to reinvest, but rather do the opposite--cut excess capacity, sell noncore businesses, reduce employment, and work as hard as possible to pay back excess debt to their bankers.
With the private sector dynamic likely to be dictated by deepening deflation and rising risk of a debt deflation meltdown, the policy response will become increasingly important. With standard monetary policy close to its absolute limit already, we are bound to see U.S. policymakers starting to think about unorthodox policies, like inflation targeting or quantitative ease.
Unlike Japan over the past decade, the rising threat of a debt deflation meltdown will spur U.S. policymakers to use all available tools to reflate--including a unilateral depreciation of the dollar.
Also, given its status as the world's largest debtor nation, the risk of the United States thus exporting asset deflation to its creditors is very large indeed. European or Japanese holders of U.S. Treasuries will have to swallow the loss of the dollar collapse. For Group of Seven major industrialized nations' policymakers, preventing this export of asset deflation will be the key task in 2003.
Koll is chief economist at Merrill Lynch Japan Securities Co. |
