Debt Deflation: Is It a Possibility?

There is still too much debt around. The fact that there is too much debt around is a result of fifty years of credit inflation and financial innovation that resulted from it.

The concern now as financial deleveraging takes place is whether or not we will go into a spiral of debt deflation.

The headlines currently are coming out of Europe. Austerity plans are forthcoming everywhere. Sovereign debt is the crowning issue…but there is growing concerns over corporate debt.

And, with the cutback in government spending, the cutback in business spending, and the cutback in personal spending people are getting gloomier and gloomier about a new, European recession. The clouds seem to be on the horizon.

But, a spillover of a European recession would be another American recession. The United States depends upon the exports that it sells to Europe. If Europe goes into a recession then the probability of the United States going into another recession increases.

The problem is that America still has lots of problems on its own. Just note some of the issues that have recently been floating around.

For one, corporate bankruptcies still are taking place on a regular basis. Just recently we have Solyndra going bankrupt which brought attention to the solar industry area as a source of more financial difficulties. Then we had Syms and its Filene’s Basement go into bankruptcy. And, then who could forget MF Global. And, there are many more still on the edge of considering such action…one of them possibly being Kodak.

And, what about the financially tenuous position of state and local governments? Just Wednesday, Jefferson County, Alabama filed for the largest municipal bankruptcy in United States history. And, Harrisburg, Pennsylvania was just taken over by the state of Pennsylvania because of its financial problems. Now we learn that Flint, Michigan is on the verge of insolvency where the state government will takeover there. And, what about Detroit, Michigan? Again, the state is about to take over this financially distressed city. And, there are many more still cities and states still on the edge of financial ruin with underfunded pension funds and so on.

Then we hear that mortgage problem is still not over and that banks are facing further write-downs of the mortgages on their books. The latest case is that of HSBC which has garnered all sorts of attention over the past few days. HSBC is still paying for its move into subprime loans earlier. But, it is also facing a relatively new thing…a customer taking a mortgage payment “holiday.” Given the political climate financial institutions are finding that people feel that they have very little to lose if they just stop payments on their mortgages. Banks are finding it very difficult to foreclose on delinquent properties these days and that people fear little retribution if they just quit on any kind of payment to the bank.

“Customers realized that if they stop paying, there’s very little we (HSBC) oar other banks can do. This is an emerging trend.” (link)

The commercial real estate market is not in very good shape either. Although commercial real estate is picking up in some areas of the country, a look at the commercial banking data indicates that loans on commercial real estate is the item that is declining the fastest on the balance sheets of commercial banks…especially those that are smaller than the largest 25 in the country.

Of course, these problems come through when we consider the condition of the banking system. The commercial banking industry is still not very healthy yet and the prospect of it getting much better through 2012 is not that great. Many small- and medium-sized banks are still really suffering. (link)

The Federal Reserve can’t really afford to tighten up at all because of the weakness that still exists within much of the banking system. (See my post, “QE2 Federal Reserve Watch: Part 3” of November 7) And, the FDIC still continues to close two banks per week and this does not include any banks that have been acquired and absorbed into other banks within the system.

The general desire within the economies of both Europe and the United States is to continue to shed debt…to de-leverage. But, if this de-leveraging takes place at the same time that the economies of Europe and the United States go into another recession, the situation can become a cumulative one. That is, de-leveraging can contribute to slower economic growth or even declining growth, which leads to more de-leveraging, which leads to even slower economic growth and so on.

This is a debt deflation.

We are not there yet, but, it seems as if we are edging closer to the precipice.

The problem seems to be that this situation cannot be undone by fiscal stimulus. If people want to de-leverage they will de-leverage. Adding more debt to the situation, even government debt created through more government spending, does not help the situation as the “fundamentalist” Keynesian would like to think. More debt implies more taxes in the future, which just adds that much more of a burden to the person trying to de-leverage. And, maybe, this just adds incentives to the equation leading the individual to take a debt payment “holiday”.

But, more debt write-downs can cause more debt write-downs. And, this is the problem of a debt deflation. It can become cumulative. And, this is something the Keynesian models cannot pick up.

And, writing down debt for some people just means that someone else has to “eat” the loss elsewhere…and then someone else has to take a loss…and so on and so forth. The consequences of debt do not just go away.

The dilemma: if fiscal spending is not an option and monetary policy is basically “spent”, what is there left to do? Not much? Is the problem of creating a situation where there is too much debt outstanding that you just have to wait until people work off the excess debt?

This is a conclusion that most people don’t like.

About John Mason 79 Articles

Professional history: Banking--President and CEO of two publically traded financial institutions; Executive Vice President and CFO of another. Academic--Professor at Penn State University and at the Finance Department, Wharton School, University of Pennsylvania. Government--Special Assistant to Secretary George Romney at Department of Housing and Urban Development; Senior Economist in Federal Reserve System. Entrepreneurial--work in venture capital and other private equity; work with young entrepreneurs in urban environment.

Visit: Mase: Economics and Finance

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