This is a brief follow-on to the last post on whether we should be optimistic, in particular now that the US housing market is improving. If you think about it, the problem now is that all debtors – public and private – are taking the deflationary route to reducing debt in attempting to increase net savings. This is the hallmark of global deflationary crises – deflationary crisis responses are locked in, guaranteed. That’s what I meant by constrained policy responses.
- What we know is that, just as in many other downturns before, private sector debtors have suffered from lost income, jobs, and revenue as a business cycle turned down. The natural response to this loss of income, when one has debt to pay off, is to pull in one’s horns and reduce new debt and work off old debt – to save more.
- The reason a recession happens at all is because enough people find themselves in this situation to overwhelm the long-term upward trajectory of the economy. So a recession is borne out of too many people reducing their debt level and saving in order to repair their balance sheets. Inventory purges happen to be the principal way this gets felt first cyclically. Businesses cut inventory to get their balance sheet right-sized after miscalculating end private demand. People get furloughed or cut loose as the production is recalibrated. If that’s not enough, then companies reduce capital investment, cut expenditures and more people get laid off. A cycle of lower spending and lower income takes hold.
- Government steps in and reduces debt burdens by lowering interest rates or adds income by adding spending to stop this cycle. Government can do this because it has the largest balance sheet, buoyed by a unique ability to tax in order to meet its revenue requirements. In the case of central governments which tax and spend in their own currency, government can just create currency. So their is no real limitation to the government’s ability to deficit spend.
- This is automatic. Remember for every increase in net savings in one sector there must be an increase in net deficits in all the others. So when the private sector increases its net savings domestically and abroad, government increases net deficits by the same amount.
- But there is always an uneasiness about this. How long is the government going to spend so much more than it takes in? When can we go back to normal? Shouldn’t we cut government spending now that this has gone on for so long? The deeper the private sector hole, the greater is the time and magnitude of the shift to government deficits. And this necessarily invites a deflationary policy response.
That’s where we are now. As I said three years ago when I predicted this: deficit spending on this scale is politically unacceptable. And so it will be cut. Here’s the thing though: the public and private sector cannot both increase net savings simultaneously. By definition, the net savings of one sector equals the net dissaving of the other. And so this attempt by government to net save, to reduce spending or increase taxes, is really an attempt to decrease the private sector’s net savings. The question is how this tension gets resolved in a period of high private sector debt. Look at Spain for your answer. People are thrown out of work, they default, they stop spending, more people are thrown out of work and so on. In the process, debt levels are usually reduced via bankruptcy, debt writedowns and debt forgiveness. This is a classic debt deflation.
The goal of government then is to attenuate the severity of this process. Ray Dalio talks of a “beautiful deleveraging” as consisting of enough parts of monetary and fiscal stimulus to counteract the contractionary effects of deleveraging which lead to social unrest, riot and potentially revolution. Unfortunately, a lot of policy makers haven’t figured out how this works yet. They are stuck in a paradigm of fiscal probity and household budgeting without understanding how the whole fits together. In Europe, they have taken this to an extreme, tying government’s hands as much as possible, inducing an “ugly deleveraging”. That certainly doesn’t make me optimistic.
I’d like to be optimistic. I have been cautiously optimistic for more than three years now. And I am when I see policy makers moving begrudgingly in the direction of economic support. But there is still a fundamental misunderstanding of why we are in this mess and how to get out of it. Until you hear more people talking in terms of affording government enough policy space to effect a private sector deleveraging without bloating the public balance sheet, it will pay to be vigilant. Until we see policy decisions framed in that light, given how much time has passed, we should expect deflationary crisis responses to increasingly become the norm. And that means the risk of a recessionary relapse is increasing. Right now, we are still in a US-centered reflationary period. When the US finally succumbs to the move toward deflationary responses, that’s when the next global downturn will begin. Invest accordingly.
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