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June 13, 2006

DEBT DEFLATION

My friend and mentor, Kurt Richebacher, wrote a compelling argument for economic contraction. It may or may not happen at this juncture, but it’s important for you to appreciate the possibility. In the difficult environment he claims to be probable, you don’t hold assets for profit, you hold what you think will go down the least. Gold and silver seem to offer the best hope.

"In our view, the first ominous sign of coming change has been the dollar’s steady fall against all major currencies, which started many weeks ago. Considering all the different market reactions, there is but one single explanation that makes sense of them all, and that is the expectation of a distinctly slowing U.S. economy. We regard it as the first buds of this worry, to be followed by a very rude awakening after all.

"In the last letter, we tried to drive home the fact that the U.S. economy is in far worse shape today than in 2000. The U.S. current account deficit over the past five years has more than doubled, from $416 billion to $850 billion. Personal savings are down from $168.5 billion to negative $33.5 billion. Government finances have swung from a surplus of $239.4 billion to a deficit of $320 billion. Indebtedness by government, businesses and consumers has soared from $18,052 billion to $26,391 billion, or 46%. Financial institutions boosted their indebtedness from $8,104 billion to $12,496 billion, or 54%. And what is the basis of this borrowing mania? Inflated asset prices.

"Pondering the question whether the recent upheavals in the markets reflect a decisive break in global asset inflation or simply a hiccup from temporary profit-taking in a long bull run, we definitely opt for the former. The ultimate reason for this assumption lies in the U.S. economy, and therein the shrinking housing bubble. Considering the horrendous sums that this bubble has made available to the American consumer through "home equity extraction," we cannot imagine a gradual solution.

"Observing low inflation rates and floods of liquidity sloshing around, the consensus sees nothing that could cause a severe downturn of the U.S. economy and global asset markets. Recall what Melchior Palyi said about the 1920s in the United States: "It was, indeed, an illiquid overexpanded colossus of debts, rather than an excessive money supply, on which the price structure of the 1920s rested."

"That is precisely our opinion about the U.S. economy and its financial system today. For us, the source of liquidity is all important. True liquidity comes from a surplus of income over spending; that is, from savings. False liquidity comes from borrowing. In a country with zero savings, all liquidity is essentially from borrowing. Nor is it a secret that it generally comes about through borrowing against rising asset prices.

"Asset price inflation is self-financing because it creates the rising collateral for the borrowing that propels prices higher. With reckless bankers and borrowers, this can go to extremes. Yet there is an inexorable end. And this means overindebted borrowers have to sell their collateralized assets, driving down their prices.

"What is debt deflation? To quote Irving Fisher, who analyzed the debt deflation of the 1930s: "The very effort of individuals to lessen their burden of debt by selling assets increases it because of the mass effect of the stampede to liquidate in swelling each dollar owed." In other words, heavy asset selling drives down asset prices, which drives up indebtedness. To quote Mr. Fisher again:

-Then we have the great paradox which, I submit, is the chief secret of all great depressions: The more the debtors pay [by selling their assets], the more they owe.

-Thus, overinvestment and overspeculation are often important; but they would have far less serious results were they not conducted with borrowed money. The same is true of overconfidence. I fancy that overconfidence seldom does any great harm except when, as and if it beguiles its victims into debt.

"Mr. Fisher lost his total fortune in the stock market crash. He was America’s great apostle in the 1920s, who had preached that the stable price level in consumer and producer prices over the decade reflected and guaranteed a healthy economy and healthy markets. Belatedly, he discovered that insane borrowing had driven the stock market’s bull run. From this late recognition, he developed his debt-deflation theory."