The following is an excerpt from the February issue of The Sentinel Financial Report.
It’s difficult to get away from our theme of debt and deflation. Our premise has been, and continues to be, that the crushing debt burdens in the public and private sector will usher in a period of deflation in the U.S. and world economy. To review, deflation is a reduction in the amount of money and credit. Most of us think of “money” as the green pieces of paper in our wallets and purses. Many of us view credit as something that comes from a plastic card in our wallet or something that originates in the banking system. Most of our “money” or what we use to buy things is credit. Credit experienced a historical bull market that in many respects began in the early 1980s. That bull market in credit fueled price growth in several areas of the economy. The ease of credit creation led many to over-consume and boundless investment speculation. In order to continue to grow the consumption and speculation, more credit was needed. At some point, the economy says “Uncle” and wants no more credit. The first sign of “Uncle” is the inability of borrowers to pay their creditors. Prices collapse. This whole process is detailed in Escaping Oz in the chapter on speculative bubbles.
Much time has been spent on assigning “blame” for the economic crisis - it was greedy bankers, it was Wall Street, it was government spending, or the U.S. consumer. Certainly all of these participants had a hand in the crisis. It could be no other way. Economic Law #4 says:
- Markets allow people to satisfy themselves by satisfying others
Each one of these players has a selfish desire. Until we get to a point where the economy is 100% controlled by government (and we are not close to this point), Economic Law #4 is in play. Regardless of who you want to blame, markets respond to bubble collapses. Consumers have taken a small step. Many had no financial factor of safety built in to their spending habits. With this in mind, consumers trimmed debt more quickly than many economists thought was possible. Figure I illustrates how consumer spending habits have changed since 2007. Consumer credit continued to increase during the “official” recessionary period but has fallen sharply since. Total household debt declined for the first time since the end of World War II.
U.S. consumers are spending less of their disposable income to satisfy debt payment. The typical household’s debt relative to take-home pay was 138% in 2007. The ratio now is closer to 122%. Historically this ratio has been well below 100%. This tells us a couple of things. First, consumers will have to pare debt much further to simply reach historical averages. Perhaps most importantly, consumers will likely go below the average as is often the case in the aftermath of a speculative bubble.
Part of the process of paring debt is default. Consumers are walking away from mortgages, car loans, and credit card balances. This wipes out the debt but it also means little or no credit in that consumer’s future. This is deflationary.
Banks are making credit tougher as well. Credit card interest rates have increased despite mortgage rate decreases over the last couple of years. So while a mortgage loan might fetch a historically low interest rate (in part due to the Federal Government), credit cards are not so accommodating. This restriction of credit is causing people to switch to cash or debit cards. Demand for cash and credit are inversely related – when one goes up the other goes down. In our case, lessened supply and demand for credit coupled with increased demand for cash is deflationary.
Despite what you might hear about inflation concerns, the specter of deflation continues to hang around.
Jim Mosquera is the author of Escaping Oz: Protecting your wealth during the financial crisis and is the editor of The Sentinel Financial Report.
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