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Minyan Mailbag - Deflation



Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.

Professor Succo,

What does the deflation theory as presented in the mailbag do to the dollar and interest rates? Typically, the dollar would rise and interest rates would fall in deflationary situations. Due to the debt structure today, is there a high probability that the opposite would occur? Keep up the good work!

Minyan Bob

Minyan Bob,

Japan's deflationary situation is more typical than that of the U.S. mainly because their debt is primarily owned domestically and they run a large current account surplus. As the credit/equity bubble in Japan unwound, economic growth slowed, income growth was curtailed, and Japanese consumers saved more and spent less (increasing their savings rate); they recognized that prices of a wide variety of goods and services were declining.

Moreover, the enormous amount of 'bad debt' created in the preceding asset bubble contributed to contracting credit and caused businesses to cut back in taking on additional loans and discouraged banks from extending loans.

All of this had the effect of raising real interest rates (inflation fell faster than nominal rates) and permitted the Ministry of Finance to issue debt with increasingly lower nominal rates (since real rates on this debt were relatively attractive). Furthermore, Japan's current account surplus continued to support a strengthening yen, despite many efforts to curtail that strength via intervention in the foreign exchange market.

The government of Japan issued tons of public debt to provide employment and use fiscal policy as a means of jumpstarting the economy, but frequent half-hearted efforts contributed to a long, drawn-out recessionary environment. In short, a very high domestic savings rate helped to keep nominal rates low and a continuous current account surplus helped to keep the yen relatively strong against foreign currencies.

The U.S. is in a much different position because most of our debt is not owned domestically: over 52% of our government debt is owned by foreign holders. We own $7 trillion of foreign assets while foreigners own around $9.5 trillion of ours. Moreover, our consumer savings rate is quite close to zero (it was negative before the government changed the way they calculate it a few years back), versus measures as high as 25% in Japan.

If deflation takes hold (right now we are more in the situation of stagflation in my opinion), the Fed is likely to address it by printing more and more dollars (as they always do) and dropping (or attempting to drop) the Fed Funds rate to zero. As deflation takes hold, there is likely to be an increasing move on the part of consumers and businesses to sell-off assets to increase liquidity and pay off maturing debt, as the real interest rate burden (inflation will drop faster than nominal rates) increases in a deflationary environment.

Given that total U.S. credit is in the neighborhood of $33 trillion, this is likely to create a large demand for outstanding U.S. dollars (i.e. to a degree U.S. debt is a synthetic short position on the dollar). However, given that foreigners own 52% of U.S. government debt, and have a net ownership of U.S. assets of about $2.5 trillion, the domestic demand for U.S. dollars is likely to be met by a supply of U.S. dollars from foreigners who recognize that the Fed is attempting to monetize the debt, and that they are likely to be paid off in the future with cheaper dollars. Furthermore, as the Treasury issues new debt to pay off existing maturing debt and provide capital for the government to meet ongoing expenses (as revenues are likely to be curtailed from traditional sources such as the income tax), the total amount of U.S. government debt outstanding is likely to increase at an accelerating rate.

As such, a scenario in which foreigners at least slow down the purchase of debt and perhaps diversify out of U.S. debt into debt of other European and Asian nations is likely. This is where it gets really different from Japan: upward pressure on real interest rates.

In a deflationary scenario, credit spreads widen and the disparity between good credits and bad credits increases. It is likely that foreign holders will penalize U.S. government rates in this way.

This would create a situation, unlike Japan, where our real interest rates can actually rise and the net demand for dollars fall, as the burden of the existing U.S. debt load (approximately 330% of GDP for all U.S. credit) increases: the rise in real rates rise will act as a vicious cycle, i.e. the viability of the U.S. financial system might come into question.

Domestic holders of debt who need to buy dollars would be more than offset by foreign holders of U.S. debt who would sell dollars.

Moreover, this scenario is likely to lead to widespread defaults, and the assumed demand for dollars may in fact turn out to be much less than anticipated, increasing the likelihood for a materially weaker U.S. dollar. This is supported by the huge trade deficit we continue to run, borrowing daily from foreigners sums of around $1 to 2 billion per day to finance our consumption.

Undoubtedly there will be periods of sharp dollar rallies (driven in part by the 'short squeeze' for dollars and the attraction of potentially high real rates), and material volatility in interest rates, but the larger trend, given the large U.S. cumulative current account deficit, budget deficit, and unfunded liability deficit, is likely a weaker dollar, and higher nominal interest rates.

This is not a pleasant scenario.

Prof. Succo

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