A reader from Germany has questions regarding the role of credit in my deflation thesis. Josef writes:
Hello Mish
I am trying to understand your reasoning in the discussion about inflation vs. deflation.
One of the things I don't understand is the role of "credit". You write that "the market value of credit is collapsing at an amazing rate".
But isn't "credit" the same as "debt"?
When the market value of debt falls, then I wouldn't I need less "real estate" to get rid of my debt? Please, can you spend a minute to clarify this contradiction.
No Contradiction
Hello Josef
An accepted offer for credit is a loan, resulting in debt for the borrower, and an asset (the loan) on the balance sheet of the lender (typically a bank or finance company). So yes debt = credit extended (plus agreed upon interest).
When the value of assets (loans) drop significantly, banks become capital impaired and cannot lend. This is happening now even though banks are hiding losses by not marking assets to market prices.
We have heard absurd statements from the Central bank of France that there are no toxic assets on French bank balance sheets. The market price of Greek debt says otherwise.
Plunge in Mark-to-Market Prices of Bank Assets
We can infer marked-to market plunges in value of bank assets by the enormous drops in financial stocks this year. We know the value of debt on the balance sheets of banks has collapsed, even if banks deny it.
Inability to pay back debt also shows up in credit default swaps, sovereign debt ratings, and soaring bond yields of Greece, Portugal, Spain, and Italy vs. Germany.
These credit actions show a demand for safe hiding places such as US and German government bonds and cash. We can see that in record low US treasury yields and German government bond yields.
Debt Not Marked-to-Market
The second question is where your error is "wouldn't I need less real estate to get rid of my debt?"
The debt remains until it is written off. In the US, people still owe more on their houses than they can pay back. The money is owed but will not be paid back. The same applied to may types of loans including auto loans, credit card debt, home equity lines, etc.
Enormous Foreclosure Backlog
US Banks have the value of their assets (mortgage loans, commercial real estate loans, consumer credit loans), at prices that do not reflect likelihood of default and thus that debt is not marked-to-market.
Writedowns are deflation in action, and they are coming.
In many instances, people walk away from mortgage debt. In those cases banks eventually foreclose. The key word is "eventually" as the list of pending foreclosures is measured in decades at the current rate.
Please see First Time Foreclosure Starts Near 3-Year Lows, However Bad News Overwhelms; Foreclosure Pipeline in NY is 693 months and 621 Months in NJ for details.
US Writedowns Coming on REOs
When homeowners walk away or go bankrupt, generally they are relieved of debt. However the problem for banks does not go away.
After foreclosure, banks have a different asset on the books. It is no longer a loan, but rather REO (Real Estate Owned).
What do you think those houses on the balance sheets of banks are worth vs. the value banks hypothesize they are worth?
Once again, this capital impairment shows up in banks inability and unwillingness to lend. When banks don't lend, businesses don't expand, and when businesses don't expand unemployment stays high.
This deflationary cycle feeds on itself until home prices fall to the point where there is genuine demand for them and banks are recapitalized.
European Writedowns
The biggest debt problem in Europe is in regards to loans made by French and German banks to Greece, Spain, Portugal, and Italy.
The ECB, EU, and IMF compounded the problem by throwing more money at Greece, on terms and timelines Greece cannot possibly pay back.
Europe has other huge structural issues regarding productivity in Spain and Greece vs. Germany, and in currency union that cannot possibly work given the lack of a fiscal union.
Poor Policies by IMF, EU, ECB, Fed
EU, IMF, ECB, and Fed policies in the US and Europe were designed to hide losses on real estate loans, to hide losses on sovereign debt loans to Greece, Spain, Portugal etc, and to prevent losses to banks and bondholders.
Barry Ritholtz had an excellent column on that yesterday called Banking's Self Inflicted Wounds.
Policies of governments and central banks that bail out private banks are wrong because they place more burden on already over-extended and deep in debt taxpayers who are not equipped to take on more debt.
The deflationary backdrop will persist until debt is written off, consumer deleveraging peaks, home prices fall to affordable values, and global structural imbalances fixed. The situation is not encouraging because of five critical problems.
Five Critical Problems
- Keynesian clowns everywhere refuse to accept the fact that debt is the problem and one cannot possibly spend one's way out of debt crisis.
- Europe has structural problems related to the currency union, productivity, union work rules, pensions, retirement, and country-specific fiscal problems.
- The US has structural problems related to prevailing wages, collective bargaining of public unions, corporate tax policies, etc.
- Stimulus and bailouts are bad enough in and of themselves, but stimulus and bailouts without fixing structural problems is insanity.
- Politicians on both continents refuse to address structural issues
Process is Important, Not the Term
It's important to not get hung up on the term "deflation" but rather to understand the process I am describing, the implications of that process, and why the policy actions taken have not worked (and cannot possibly work), all called well in advance.
For more on the process of deflation (regardless of what one wants to call it), please see Bizarro World Inflation; About that 2011 Hyperinflation Call ...
Yes Virginia, U.S. Back in Deflation; Inflation Scare Ends; Hyperinflationists Wrong Twice Over
