How did the US economy get itself into deflation and why we are going through a deflationary crash.

By many measures we are in a deflationary crash, but it is being masked right now by all kinds of government asset prop-up initiatives and vast social safety net.  Housing prices are partially subsidized by the government at a tune of $8000 per buyer, but if one were to look at the marginal value of additional home sales generated by this tax credit scheme, the cost jumps to nearly $45000 per additional house sold (Calculate Risk blog). And if this program continues through 2010 then it will be more like $100000 (Calculated Risk blog). If this charade were to be cast aside we would easily see that we are following the footprints of Great Depression!

Case Shiller index suggests we are still 20% above long term averages. These long term average prices are the result of bank credit inflation that lasted for 50 years. It is a huge bubble that is deflating now. Whenever credit reaches multiples of GDP as we have it at 375% now, it implodes taking down the economy with deflation. As the money disappears due to deflation, we should expect substantially lower home prices going forward. You cannot rely on current rent prices. They will come down too. You cannot rely on your salary, it will come down too. When we borrow banking system creates money through credit out of thin air. This money stimulates the economy. People can earn more because there is simply more money to earn. But when we pay back, the money disappears in the banking system just like the way it was created. Robert Prechter predicted this bust years ago in his book “Conquer the Crash”.

The herd behavior of the population causes these boom and bust cycles. When things get better, people start borrowing. They look at each other and do more of the same. If each person acted individually in a vacuum, while one person was borrowing, the other would be paying back debt and it would be a smooth sailing. But when the entire population borrows and goes on a shopping spree, this creates a lending boom that translates into consumption boom. When debt levels reach such height that no one is able or willing to take on additional debt and service the existing obligations, then borrowing flattens and growth stops. And then the bill comes due. People have to pay back what they borrowed. However, almost all money in the economy is bank credit. It has principal + interest. And the principal exists, but the interest is not created yet. As people pay back debt and the money supply shrinks, it becomes harder and harder to earn enough money to pay principal + interest.

One important aspect of this mechanism that is seldom mentioned is that the modern debt inflation implies that debt is never payed back and that every year it increases by at least the amount of interest. That means that millions of borrowers simply borrow more to pay off previous principal + interest as dutiful debt slaves they are. That is why debt levels are roughly doubling every decade or so. But what happens when debt growth stops? It is not just that nobody is taking on more debt, the actual principal is being destroyed either via defaults or pay downs. That is, if level of debt is staying constant that means that the principal is actually shrinking by the rate of interest, roughly speaking. This is very deflationary in and of itself. And this is what the privately owned Federal Reserve statistics are showing with regards to most privately held debt in USA. More precisely the consumer and other private debt outstanding is actually shrinking since the beginning of 2009 according the reports that are regularly published by this privately owned Federal Reserve and can be verified on its own website.

Let’s put it in numbers. Monetary system has 60 trillion US dollars. Almost all of this is borrowed money. Let us assume, when people borrowed this, they promised to pay back 100 trillion. The assumption was that through non-stop borrowing, some day there would be 100 trillion in the economy, so that we could earn it and pay it back. However, now that the music stops and everybody stops borrowing, how will the additional 40 trillion be created? So bankruptcies soar, foreclosures happen. Not only that, as we pay back the debt, the deflation shrinks the money supply. Instead of having 60 trillion, we end up with 30 trillion of money supply. That creates an imbalance where prices, salaries were based on an expected 100 trillion, but now we have 30 trillion. You figure the rest. The stock market crash will be worse than Great Depression this time. We have not seen the bottom yet.

In a deflationary crash, even though FED makes credit easier, it is hard to turn the boat around due to the following reasons:
1. Lenders (banks) do not want to lend because they think they may not get their money back. This is because the money supply is shrinking rapidly. All prices around you were based on inflated bank credit. People borrowed and bought things and inflated prices along with salaries. It is very possible that all prices and salaries can be cut in half if the money supply shrinks 50%. Then it will be very hard to pay back a fixed rate loan.
2. Borrowers do not want to borrow because they think they may not be able to pay it back. This is normal because people see job cuts, companies cut costs, prices fall, so how can they be sure that they will make same salary in the future to pay back what they owe.
3. For inflation to happen, people must have alot of money to chase too few products. What we have now is the opposite. We have wage reduction. We have high debt levels. We have excess capacity producing too many products. The supply exceeds the demand. The prices will fall, not go up. All companies are selling less, good earnings results as being reported in the first half of 2009 are just a result of cost cutting. When one company does it, it is good. But when all companies do it, cost cutting is detrimental to the economy. Earnings will go lower.



  1. Posted February 16, 2010 at 9:36 pm | Permalink

    Do you have copy writer for so good articles? If so please give me contacts, because this really rocks! 🙂

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