Tuesday, April 29, 2008

Debt Deflation

Cole and Ohanian (1999) document that U.S. per capita GNP fell 38% below its long-run trend path (of 2% per annum growth) from 1929 to 1933. Real per capita nondurables consumption fell nearly 30%, durables consumption fell over 55%, and business investment fell nearly 80%. On the input side, total employment fell 24% and total factor productivity (TFP) fell 14%. On the nominal and ¯financial side, the GNP deflator fell 24%; per capita M1 (currency plus deposits) fell 30%; M1 velocity fell 32%; the per capita monetary base rose 9%; the currency/deposit ratio rose over 160% (Friedman and Schwartz (1963, Table B3)); the loan/deposit ratio fell 30% (Bernanke (1983, Table 1)); and ex-post real commercial paper rates rose from 6% in 1929 to a peak of 13.8% in 1932.


Bernanke (1983) argued that the reduction in borrower net worth increased the cost of obtaining external finance, while bank failures and tightened credit standards hampered the efficient allocation of capital


Today, in the US


Banks have watched the value of the assets they hold, especially those that are mortgage related, decline. At the same time, their liabilities do not change. That means erosion in their capital, or assets minus liabilities. When bank capital falls below regulatory minimums relative to assets, financial institutions have to sell assets, which set in motion the kind of downward spiral the Fed was looking to prevent.

The UK…


Net lending to individuals in the U.K. came in at £8.2 billion in March, compared to £9.6 billion in February. We had expected a decline in net lending to £9.0 billion. Although the Bank of England cut its interest rate three times since November 2007, from 5.75% to 5% in April, lenders are unwilling to pass forward the base rate cuts. Declining house prices and stiff money markets are restraining mortgage demand as well.



The period from 2000-2007 is an interesting period in that global markets should have rolled over because of the collapse in the stock markets.  That stock market were so overvalued that dividend yields on the Wilshire 5000 fell below 3%, actually 1.65%.  The second part that was different is that for some reason in a secular decline in interest rates, a final rise back to 6% ended all previous historical financial bubbles.  That did not happen this time, what we witnessed back in the 2000-2003 time was a concerted effort to reinflate the global economy.  What was most important is that Real Estate did not roll over as we all know that it went on to its own historical overvaluation that has no historical precedent.


The key in the global big picture is that all that liquidity (debt), and that leverage is either 7:1 with banks and with some hedge funds 32:1, so every dollar of contraction or destruction involves selling of seven dollars or assets, or more which then starts the vicious cycle of more ratchet down of assets.  The whole game is to keep growth or more leverage, which is impossible, the complete western world have values overinflated of over 50%. 


As the destruction of assets, spread around the world will really see how that no place will be immune to the destruction of assets, what I mean is that there is a decoupling theory that many believe Asia can pick up the baton, Asia exports are much more important that they were back in 2000, the Chinese current account surplus as a percentage of GDP has gone from 2% to 8%, so the US consumer is extremely important to Asia.


Most of the whole world’s production, (especially in Asia) is built on current consumption that is artificial; we will witness the collapse in demand that came from asset inflation the so called liquidity (debt)?


All bubbles correct to their starting points, meaning as this follows typical patterns, no place in the world will be immune. 


 What we will have massive deflation because the purchasing power of the public will not increase fast enough to offset the losses in values, they will be forced to sell assets to cover credit demand, consumption will collapse and corporations will be forced to slash prices as Wal-Mart has.



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