Deflation, Debt & the Monetary Reset

Series: Peak debt

A confluence of driving forces nudges the global monetary system toward a reset, with deflation leading the charge.

Part 1 of the peak debt outlines the logic for this phenomenon and examines one of the debt components – household debt starting with mortgage debt.

Part 2 of the peak debt series digs into the auto and student loans component of household debts.

Part 3 of the peak debt series examines the state of corporate debt, how it is used and where it is heading.

If anyone is looking for that proverbial fly in search of a windshield, Japan should take away this honor unabashedly thanks to its ingenious central bank and wonders of Abenomics which have yet to fail to pull rabbits out of their hats of ‘unconventional’ monetary policy tricks.

Undeterred by the abysmal results thus far from the likes of near-zero interest rates for decades, buying up ALL of the new issuance of government debt and then some, to the purchase of Japanese equities in order to stimulate growth and generate inflation, the BoJ pulled out its latest trick with its decision to cut interest rates to negative.

As stunning as the move was, the BoJ is by no means the ‘thought leader’ in the ‘whatever it takes’ department – it is merely a follower when it comes to negative interest rate policy (NIRP) which has already been implemented in the ECB, Switzerland, Denmark and Sweden.

With the BoJ becoming the latest central bank going deeper down the rabbit hole of monetary twilight zone by introducing NIRP, there is now $5.5 trillion in government bonds having negative yields, covering 23% of global GDP, according to the Financial Times.

Long considered only possible in theoretical economics in the sheltered cocoons of academia, this theoretical excursion into monetary la-la land has since escaped the lab and permeates the minds of the world’s central bankers and Keynesian priests.

As the current global monetary system drifts farther and farther away from common sense, sane people are wondering what other insane ideas are going to be rolled out by governments and central bankers in their futile attempts to save the status quo. Rest assured, desperate people make desperate moves.

As savers of the world ponder the assault being launched against them by their very own government, there will invariably come a time when the increasingly unstable monetary system becomes unglued. When that happens, the system will have been so damaged beyond repair that it will be easier to bulldoze it and start from scratch.

The latest NIRP move by the BoJ is yet another significant step along the path of destruction leading eventually to a monetary reset.

A monetary reset would result in a reboot of all facets of the monetary system the way we know it. It would cause a magnitude 9 earthquake to the fundamental building blocks of the system, including the fiat currency regime, the global capital markets, credit creation and flow, monetary and fiscal policies and both private and public monetary institutions.

A monetary reset will likely be an evolving process inundated with hair-raising trigger events in between, and is a complex topic involving many moving and interlocking parts which will be dissected in this space in the near future.

By for today, we will start this off by exploring perhaps the most critical driving factor of the coming monetary reset. That is the word all mortal central bankers, and governments, are utterly scared of – deflation.

Deflation: who’s afraid of the big bad wolf?

Let’s first listen to what we are told why deflation is a bad thing. According to mainstream economists and the government, deflation would put a damper on the economy as the expectation of price deflation would cause consumers to defer their purchase decisions in anticipation of lower prices later.

Is that really true?

Look around in real life. Ask yourself these questions:

Would you stop seeing a doctor because the medical cost will be lower a year from now?

Would you stop purchasing essential clothing or other necessities because it will be cheaper next year?

Would you defer going to a restaurant because it will be cheaper in six months?

The cost of digital communications (long distance phone calls, cost of sending files between computers) has plummeted thanks to technology innovations. Not only did people not defer their purchases in anticipation of even lower prices, usage has exploded and the age of internet was born.

Computer prices have been going down year after year (ok, maybe the price has bottomed, but the functionality continued to improve for the same price). Have you deferred purchasing one because it will be cheaper or better two years down the road? How about smart phones or digital cameras?

So it is pretty clear consumers do not mind deflation.

Why then is the government so desperate to stimulate growth and engaged in a seemingly mortal fight against deflation?

In one word: debt

Good Debt vs Bad Debt and Leverage

In a healthy economy, businesses borrow to invest in additional productive capacity, and credit expands as a result. Modest credit expansion accompanying economic expansion is normal and healthy. Leveraging by borrowing makes sense when one’s economic prospects are growing.

For an individual, becoming a first time home owner or taking on a bigger but affordable mortgage in order to trade up makes sense when the household income is getting higher. For a business, taking on additional debt to increase capacity to meet growing demand also makes economic sense, as the resulting increase in revenue more than offsets the additional debt burden. In both cases, leverage works in one’s favor.

Take for example, if you have a one million loan and your current revenue is $400,000 your debt to revenue is 2.5 times. If your revenue expands to $600,000 as a result of the expansion of your productive capacity thanks to the loan, then your debt to revenue ratio decreases to 1.6. The lower ratio reflects the fact that it is much easier for you to service the loan.

The rationale for raising debt also holds true under an inflationary environment. The reason is that the dollar you borrow today is worth much more than the dollar you will use to pay back the lender tomorrow due to inflation.

So when you borrow wisely to expand your business and get to pay back the same dollar in an inflationary environment years later, you get the double barrel effect. Life is good.

If you are a business and you made a wrong bet, however, and your revenue stops expanding, or worse yet, starts contracting, it makes servicing of its debt more difficult. Using the same example above, if your revenue shrinks from $400,000 to $300,000, the debt/revenue ratio jumps up to 3.3, meaning that it takes much more effort to service your debt.

Worse still is if such debt is raised for non-productive (share buybacks, M&As at the peak of an economic cycle, etc.) or counter-productive activities (for example, expanding production to the point of overproduction, as in the case of tight oil and shale gas and many industrial commodities).

The same mechanism which impairs a business’ ability to service debt works much the same way in a deflationary environment. In such an environment, not only is your ability to grow revenue challenged, the dollar you borrowed before is now worth more than a dollar while your loan amount remains the same.

In a deflationary environment, your debt becomes much more difficult to service.

So when you borrow and the growth fails to materialize and you are stuck in a deflationary environment, the leverage which works like a double barrel turns into a double whammy.

Peak Debt

Debt-and-GDP-II-1-15-2016Debt has significantly outgrown growth since the 1970s

When one’s debt outgrows one’s revenue growth, over time one is going to run into trouble. When your debt is growing at 10% while your income is growing at 3% or, gasp, 0%, eventually you will be in trouble. At that point, you do not have a liquidity problem; you have a solvency problem. This holds true at the individual, corporate or public (federal, state or municipal) level sooner or later. It is sooner for individuals and can be much later for governments.

As debt outpaces growth perpetually and the amount of debt reaches a point where further accumulation is no longer possible, peak debt has arrived.

There is no theory involved here. It is just simple math, folks.

Check out the other chapters in this series as we dissect debt into its components:

 

 

Peak debt

This article is part of the Peak debt in-depth topic. Get a crash course and read the latest developments on this topic.

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