The Menace of Debt Deflation

It's not just the stock market that's vulnerable to bursting bubbles
By James H. Nolt, Senior Fellow, World Policy Institute
April 6, 2018 6:37 pm Last Updated: April 6, 2018 6:37 pm

Ten years after the 2008 financial crisis, the world economy has recovered but the world’s balance sheet has not. Gigantic debt bubbles in stocks, bonds, commodities, and real estate could burst as deflation causes debtors’ income to fall.

Throughout history, deflation in the context of high debt—around 300 percent of world GDP as of 2017—has always been a recipe for disaster, especially during the series of depressions that rocked the world economy during the last third of the 19th century and during the two major depressions of the 1920s.

First, we must understand deflation. Most economists consider only average inflation according to some measure such as the consumer price index. Averages are less important than extremes. An average of stable prices might conceal that some prices are rising fast and others are falling fast.

Furthermore, most measures of inflation or deflation used by economists ignore asset prices—the “Wall Street” economy as opposed to the “Main Street” economy. Thus, the dull gray averages economists obsess about often hide more than they reveal.

Oil Is Just an Example

It is even more important to consider price changes from the standpoint of the rich and powerful, including debtors and creditors, bears and bulls. For example, when oil prices were $100 a barrel, many oil interests around the world borrowed against their valuable oil properties, either to expand oil production, fund the spending plans of oil-rich states, bid up the prices of choice real estate, or indulge in lavish consumption.

If all spending was made from current revenue, the problem would be less catastrophic, but those owning valuable assets are often tempted to borrow against them for increased consumption, productive investment, or speculation.

However, when the oil price deflates to less than a third of the previous level—as it did from 2014 to 2016—debts incurred when oil was yielding triple the income now become hard to repay. To avoid bankruptcy, oil interests might panic-sell other assets, say stocks or real estate, to cover the debts no longer serviceable from oil revenues alone.

If enough unrelated assets are dumped, this leads to a contagion effect, dragging down other asset prices along with the fall of oil. Prices of luxury products may also tumble or sales fall dramatically.

But oil is not the only example. Most commodities have experienced similar trends, from agricultural products to a wide range of minerals, including such common products as wheat, copper, coal, and iron ore.

Real Estate Thrives on Debt

Another large component in this global debt deflation scenario is real estate. Wherever prices soften (and this is an uneven process), those who have borrowed to buy high-priced real estate often find themselves in a bind when prices fall. Even by selling the real estate, they might no longer get enough cash to cover the loan used to buy it. We just have to look back to 2008 for a reminder.

Bankruptcy, or a scramble to sell other assets to cover losses on leveraged real estate investments, results. This is a big problem in China, including Hong Kong, and other parts of Asia where prices have recovered but households have joined corporations in the borrowing binge.

Add to this that stock markets throughout much of the world have tumbled since the new year. Some speculators borrow money to buy stocks “on margin,” or the equivalent, using derivatives to leverage stock positions. Those investors may find themselves “underwater” and forced to dump assets to cover stock losses, or even worse, going bankrupt.

Additionally, bond prices have been booming since the early 1980s, the longest and strongest bull market in bonds in world history. Bond prices have reached record highs (which equals low or even negative yields), often now only sustained by heavy public or policy buying from the central banks.

The Biggest Bubble

When bond prices begin to tumble from these historic peaks, this adds deflation to another huge asset class. This is when a debt bubble actually bursts, as happened dramatically in Greece a few years back. If bond prices begin to crash, many investors who have leveraged positions in bonds (including using derivatives) will also join the rush of desperate bulls suddenly realizing the vulnerability of their leveraged positions.

The combination of debt and price deflation is dangerous—not on average, perhaps, but in specific asset categories where debt leverage is common and sometimes extreme.

There are no quick solutions to this problem. Monetary policy has clearly turned against the leveraged speculator as the Federal Reserve continues in its tightening cycle.

Before 2015 and even now in some parts of the world, central banks try to temporarily fight general deflation with so-called “quantitative easing,” or the loose provision of money and credit. But the effect of such profligacy is everywhere uneven, often only temporarily boosting prices of certain asset classes to artificially high and unsustainable levels.

This only exacerbates the problem because speculators incur new debts to leverage purchases of whatever asset is ballooning, while many other prices languish in deflationary doldrums.

Historically, periods of high debt have been solved either by a large crash and massive bankruptcies, or debt forgiveness. We will soon find out which solution it is going to be this time around.

James H. Nolt is a senior fellow at the World Policy Institute and author of “International Political Economy.” This article was originally published by the World Policy Institute.