Sunday, May 31, 2009
Irving Fisher's Debt-Deflation Prescription Debunked: Too Big Not To Fail
We at TILB obviously fancy ourselves "smart enough" (why other than intelligence ego would we maintain a blog?) but certainly nobody will mistake our intelligence quotient for that of the eminent dead such as John Maynard Keynes, Karl Marx, or Irving Fisher. Each certainly possessed a mind with greater horsepower than we at TILB could ever hope to claim as our own.
These geniuses of persuasion and IQ still managed to err in a variety of ways, generally by failing to grasp the consequences of consequences; missing the derivative impact of their philosophies.
Despite that fundamental and underexplored shortcoming, each retains a great deal of credibility today. In fact, outcroppings of the most famous philosophies espoused by each are being implemented today in The U.S. with more gusto and philosophical fervor than at any time since the Carter administration or perhaps, more probably, since F.D. Roosevelt.
TILB doesn't have the intellectual capacity or, frankly, stamina to take on each of these titans point by point in one posting. However, we do intend to occasionally take liberty and rebut an idea here or there.
Irving Fisher's debt-deflation prescription Fisher wrote the magnum opus on debt-deflation cycles in his monumental 1932 Booms and Depressions and he summarized his key points in his essay The Debt-Deflation Theory of Great Depressions.
You should read the essay. It is brilliant in its core description of how a debt-deflation cycle coils then springs. Written in 1933, it was penned in the immediate aftermath of the most painful portion of The Great Depression and its perspective benefits (if that's possible) from Fisher's firsthand experience of The Great Depression.
Fisher's basic description of the cycle is that the unwind of a system wide, overly large volume of debt catalyzed by some period of cyclical downturn leads to an incipient deflationary pressure that becomes increasingly suffocating. This deflation actually makes the remaining debts bigger in real ("real" = inflation/deflation-adjusted) dollars. In essence, in this nasty cycle as debts are called or due, borrowers are forced to liquidate assets on a widespread basis. This broad based, rushed liquidation depresses asset values. Lenders, frightened by those declining asset values, are uncomfortable lending against this depreciating collateral and thus either hoard cash or lend on very expensive terms. This behavior both a) reduces the supply of money; and b) further pressures asset values leading to continued liquidations. This spiral ultimately consumes banks, corporations, and individuals in a seemingly unending wave of bankruptcy which leads to yet further liquidations. According to Fisher, ironically, even as these liquidations are happening, the resultant price and monetary deflation leads to a currency that continually strengthens at a speed that outpaces debts being paid off.
In essence, as long as the cycle persists, the real value of debts is growing even while the nominal value is shrinking, leading to persistent, ever widening circles of pain.
As great as Fisher's brilliance is in describing the damnable process of a debt-deflation cycle, he is as miscalculating in its prescription.
While we at TILB agree that his debt-deflation cycle can indeed occur, we suspect a) this cycle is less common and not as certain to occur as Fisher; and b) when it does occur, the cycle will happen faster and provide a sounder base for recovery to build from if allowed to happen naturally and without interference (unlike the 30s).
Fisher goes on to say that we need not even suffer the failure or spend time worrying about it. In his analysis, the problem is not a general over-production or over-capacity of something (such as housing and related materials, in modern times) but rather a shortage of money supply.
In essence, he believes the "deflation" portion of the "debt-deflation" is the dirty half of the process and if we could do something to arrest these deflationary pressures, we would be able to short-circuit the vicious cycle of liquidations begetting more liquidations begetting more liquidations.
His intellectual breakthrough (sarcasm dripping) indirectly birthed our wonderful Dr. Bernanke's moniker Helicopter Ben. Quite simply, Fisher prescribes that monetary authorities simply offset the deflationary forces of liquidations with the restorative powers of the reflationary printing press:
- A shortage of money supply has an obvious "solution": print money. Lots of it;
- Quite simply, reflate precisely enough to offset the deflation created by debt liquidations and lender hoarding.
Before Bernanke took the reigns, Fisher's directive was in fact what Dr. Greenspan obeyed when he gifted us his famed "Golden Era", even if his obedience was never explicitly credited to Fisher. The moral hazard laden slavish obedience to cutting off every economic downturn before it manifests as a debt-deflation cycle became known as The Greenspan Put (and now the Bernanke Put). Following Greenspan's lead, Helicopter Ben, armed with his lifelong study of The Great Depression, promised more of the same (much more, in fact).
All this is well and good and Greenspan/Bernanke did indeed seem to guide us through a Golden Era of prosperity and reduced economic cycle volatility. The problem, of course, is the consequence of this action.
Markets are crafty bastards.
The response to this stability and the value embedded in the Federal Reserve's gift of a monetary put option is to take advantage of it (as we've discussed before in this, one of our all time favorite postings).
The Fed's willingness to flood liquidity during any economic downturn and never charge a punitive rate of interest was effectively a thrown gauntlet. It is as if the Fed said, "you cannot create a problem big enough that reflationary, debtor friendly monetary policy can't fix it." The problem is that this is not a "fix", per se, it's a "deferral".
The standing policy of the Fed to continuously punish lenders through currency debasement for the benefit of creditors inevitably morphed into a de facto invitation to borrow. This constant deferral of borrower pain led market participants to reach down and seize the Fed's thrown gauntlet and mound leverage upon leverage. In particular, the financial and, to a lesser extent, residential sectors came to implicitly understand the Fed's wink and nod and sought more and more debt funding to serve their particular motives.
In essence, a generation of macroeconomic "bailouts" by the Fed led to a pile of debt so big that it is wholly plausible that even the Fed may not be able to handle it.
Too Big Not To Fail
This is the absolute inevitable consequence of the Fisher prescription to preventing an otherwise natural process. What else could happen? The nature of markets is to cycle. They will do whatever is required to fulfill their natural and necessary path. We cannot have a healthy economy that cuts off the left tail and simply performs at or above trend in perpetuity. The logical outcome of that would be for the slope of the trend to ever steepen such that it goes toward vertical or infinite prosperity (on a compounded basis, no less). Given the impossibility of that, particularly in a country as large as The U.S. with the demographics of The U.S., we can know that extending the slope of the old long-term trend into the future is all that can be aspired to. The longer we bounce at and above it, the more certain it is we must spend some time below it in order to create the trend. Constantly putting off the pain simply aggregates and concentrates it in the future.
So, the fundamental question is "have we reached a point where we spent so much time in lala land that the resultant debt load encouraged by the Golden Era is so large that the Fed cannot arrest its collapse; that the weight of our debt accumulated during our time spent over trend is such that the burden itself crushes us?"
Well, yes and no.
As long as our Treasury has the ability to issue debts payable in Bernanke Scrip, the Fed always will maintain the ability to monetize both Federal and private debts.
However, in this case the debt burden may be too big to do so without painful exigent consequences.
In past cycles, the immediate negative consequences of the monetization were largely unseen to the general public and thus, like good little mice, we were trained to eat and love the cheese. However, having picked up the gauntlet and consumed the cheese so many times now, we have been lulled into a false sense of security and have failed to notice that the current morsel is sitting inside a trap set spring forth and crush our spine.
The Fed's monetization process via: quantitative easing that's already happened; lending to private enterprise at non-punitive rates; and quantitative easing that everyone knows must happen in the future in order to fund the deficit this year and beyond (there literally are not enough real money buyers to absorb the incremental US Treasury and non-US sovereign issuances) have led market participants to the edge of dollar distrust.
While a bastion of relative strength in the past, the overwhelming issuance of freshly minted dollars required to offset the deflationary pressures of the natural debt-deflation cycle has begun to spook market participants and to contort behavior in somewhat predictable ways...
...and so we stand at the precipice. We are about to find out if we have reached that Too Big Not To Fail point. Symptoms of the failure will include:
- The Fed losing control of long bond yields
- Inability to arrest asset price deflation in traditionally levered asset classes (especially housing and CRE)
- Continued lack of demand for credit
- Continued lack of supply of credit other than from the Fed/Treasury
- Continued cycle of liquidations via bankruptcy, especially of banks and large corporations
- Continued rise in unemployment straight through the measured 10%
- A sudden weakness in the dollar relative to hard "currencies" such as gold, oil, or consumer products.
To date, nearly all of those symptoms have manifested in one way or another, but we believe the most damning symptom could be the first: if the Fed does indeed lose control of long bond yields, watch out.
The yield curve on any term longer than a few years has backed up a huge amount in the last few weeks. In fact, with the Fed's ZIRP still firmly in place, the 2s/10s spread has widened out to record width, surpassing Greenspan's early 90s gift to banks (please always keep in mind that is a taxpayer subsidy). From the Fed's perspective, the danger of long bond yields rising is that it has the potential to unwind a great deal of their efforts to improve credit conditions for term borrowers, especially home buyers/refi'ers.
Further, the back-up in rates will make it increasingly expensive for the Treasury to term out We The People's debt. For example, the party-agnostic CBO uses an average 3.0% Ten Year Treasury Note Rate for 2009 and 3.2% for 2010 for budgeting purposes (see PDF page 52 here - note they also are far too optimistic on tax receipts due to their delusional GDP and unemployment assumptions, which we've already blown past). With the 10 Year having backed up 100bps in the past two weeks to 3.61%, we are already in the process of blowing the CBO's budget (the 30 Year has similarly moved to 4.49%). It's worth noting that the 2s/10s spread is wide today not because of absolutely high 10s but because of artificially low 2s (due to the Fed's ZIRP). [data as of 5/27/09 close]
So that is the precipice. If longer rates continue to move up on the back of the enormous supply ($2 trillion deficit likely this year, as we predicted back in January when most people thought $1 trillion was likely), then the government will have three choices:
1) continue to issue the already planned volume of longer bonds at higher rates and blow through budget projections resulting in yet more debt needing to be issued and enduring a further credibility hit;
2) monetize the debt by having the Fed step in as a buyer of unlimited volume at a pre-determined level (say 3.5% on the 10s) and risk rapid debasement of the dollar; or
3) move down the curve toward the short end where rates are cheaper but take on roll risk of epic proportions.
My guess is some combination of All of The Above with a lean toward #1 and/or #2.
This is either Custer's last stand and we are about to be ambushed or it's a beautifully executed rear guard gambit by our Fed and Treasury, maintaining a strong-enough dollar while financing the deficit and arresting a credit crisis all at once.
My suspicion is the former.
If I am correct, there is a serious potential for all hell to break loose in the next year as the dollar gets obliterated from a purchasing power standpoint putting the Fed in one hell of a bind. They either deal with the dollar's weakness by tightening - which may precipitate a financial panic and prove Bernanke a liar for his apology to Milton Friedman - or they actively debase, calling into question the dollar's reserve currency status, punishing savers to help borrowers, and setting loose the inflation to end all inflations...which of course will ultimately force them to tighten.
In essence, under either scenario the Fed will have to tighten against their preferred policy. It is simply a question of when they do it and what type of pain we are interested in taking between now and then. Admittedly, this is not an attractive set of choices. I do not begrudge Bernanke his roll in history.
So this brings us back to Fisher's prescription.
The obvious flaw is that it actually encourages the "debt" half of the "debt-deflation" equation to grow. It encourages debt to grow and grow until it is too big. The side effects of trying to print our way out of the problem have the potential to be drastically worse than the damage from just taking the pain in manageable, natural increments along the way.
Fisher's prescription of never allowing a cyclical debt reduction process prevents the size of system wide debt from ever moderating and instead moves us inexorably down the path toward Too Big Not To Fail.
Let us know what you think!