Sunday, September 20, 2009

Phase change

Imagine you're driving on a crowded highway. In theory, speed doesn't matter as long as everyone drives at the same speed. But at some point, a car will slow down because of a road bump, or a moment of distraction. The car behind it will need to react. At 10MPH, this is not a problem. At 100MPH, on a crowded highway, the result is disaster: reaction times are too slow, drivers overreact, and suddenly the fast flowing traffic crashes to a halt.

What is true of traffic is also true of the economy: like speeding on a crowded highway, too much consumer and corporate debt is unsustainable. If A owes B money who owes C money who owes D (and so on), in theory it all cancels out. But if B can't pay, C now needs to find some money to pay D; if the level if debt is too high, a damaging chain reaction occurs. Irving Fisher, who in 1929 declared that "stock prices have reached what looks like a permanently high plateau," later recognized that the plateau was really the edge of a cliff of debt:

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:

1. Debt liquidation leads to distress selling and to
2. Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3. A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
4. A still greater fall in the net worths of business, precipitating bankruptcies and
5. A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
6. A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
7. pessimism and loss of confidence, which in turn lead to
8. Hoarding and slowing down still more the velocity of circulation.

The above eight changes cause

9. Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

The need to repay debt causes distress selling of assets and less spending by indebted consumers and companies, which reduce prices, and therefore profits, leading to unemployment... and to even more fire sales and even less consumption in order to pay off debt. The more effort is put into paying off debt, the worse the economy does, and the harder it is to pay off debt. Noticed falling house prices recently?

Consider the following graph, US total debt to GDP ratio (keeping in mind that data before 1950 or so is less accurate). Notice where were in 1929, and where we are now:

If we really are in a debt deflation, then things are not going to get better anytime soon.