Debt Deflation: The Future Of The EU and US
There is little doubt about the debt levels of the Western world. Both the EU and United States are embarking upon debt levels that are historic by any metric. It is something that also will continue since austerity is not in the vocabulary of any of today's power brokers.
We are at a point where many are questioning what the policy is and what the results will be. Fortunately, we have a recent situation that shows us precisely what is going to happen.
Actually, if we harken back to the Great Depression in the United States, we see how this appeared. Then, half a century later, we saw a similar situation show up on the other side of the world.
Back in the mid 1980s, Japan was the darling of the economic world. It was a high flying country that was threatening, according to many, to overtake the United States as the largest economy in the world. What ensued was one of the most spectacular falls in economic history.
During that time, the Bank of Japan took the approach of lowering interest rates. This set off a firestorm of economic activity as a cheap money environment ensued. As most can guess, the result was massive price appreciation.
One of the problems that Japan has is that they were a net exporter. Being in such a position meant their economy was not only dependent upon the rest of the world but also currency relationships. During the mid 1980s, the USD was very strong, making it great to be an exporter. However, after the major economies decided it was best to weaken the dollar, their currencies were strengthened.
This creates a problem for exporters. While it is great for those products imported, it makes those outgoing more costly. This really hit the Japanese economy as the cost of their goods to their biggest market, the United States, went up a great deal.
Of course, when this happens economic activity contracts. This leads to a host of problems including deflation. As economic conditions tighten, firms lay off workers which means people spend less. We get a reinforcing motion that only keeps growing. People get fearful of the future, thus looking to spend less.
This is enhanced by the debt load. Japan had an enormous amount of debt at every level. This set off a deflationary cycle that lasted most of the 1990s.
For more about deflationary debt cycle, which was theorized by Irving Fisher, click here.
The challenge with this situation is that when things tighten, people have to do the same to their budgets. We also see the problem with assets declining in value. When a lot of real estate is held, we see the situation of the asset being worth less then the note, meaning one literally has to pay to get rid of it. At the same time, declining economic conditions, usually with employment, means that people spend less to keep up with the payments.
Eventually, in Japan, this led to a banking crisis, which then helped to create inflation expectations that never showed and, finally, a demographic situation which only furthered their deflationary spiral.
Central Banks With Nowhere To Go
When the next economic crisis hits, the Central Banks in both the US and EU have little room to maneuver. They already zapped their interest rates so they cannot reasonably lower them anymore.
Also, their present course of action is only locking more money into the banking and financial sectors. This means they are creating a liquidity crisis for their currencies which will likely help to fuel the economic tightening. This will put people in a position of having to tighten on a personal level, something that further erodes economic activity.
Of course, this all will end up affecting companies at some point. Since individuals spend less, we see corporate bottom lines affected. They will turn around and start cutting which, under normal circumstances, would be effective. However, the balance sheet of many of these companies is not normal. They are drowning in debt, something that is going to keep them from investing in R&D, expansion, and entering new markets.
As we can see, it all feeds onto itself.
So how does a country get out of this cycle? Japan approached it by turning to Abenomics. This was an easing program on steroids. The Bank of Japan purchased 70% of the government debt, 15% of the corporate bonds, and now owns 7% of the stock market.
With all that printing, you would think they could get inflation. Nope.
They are still falling off a cliff. The entire situation keeps getting worse. It got to the point that even the "Abe" himself couldn't take it anymore, resigning last year due to health reasons.
A major problem I see with the approach the Japanese took is that it is similar to what the US and EU are doing. The money gets locked up in the banking and financial system. Buying stocks is not typically going to help the mainstream economy. This is especially true when companies use those proceeds to rewards shareholders, who then simply hoard the money by saving it in some way.
End Result: Recession
There is only one pathway that all this takes. As the Japanese found out, there is no sustained growing economy. Instead, the economic conditions keep tightening. Couple that with a demographic issue in that country and we see where things can get really bad. Simply put, older people do not have a great deal of discretionary income. Thus, their spending tends to be less than those of younger people with families.
Recent demographic data from around the world is telling us that many countries need to pay attention to this. While immigration can offset this, nations such as Germany, Spain, and Italy are presumed to be at the point of declining populations. This adds the same component as the Japanese had.
Both the ECB and Fed are bringing recessions to their economies. Of course, at this point, there is really little choice. Easing is the only approach they have left. They are well aware of the debt loads and that their approach does not work. However, do you let the whole thing collapse while doing nothing?
The slowing growth rates around the world tell us exactly what is taking place, especially in the Western economies. Even when things are "improving", the numbers are terrible. Now consider how this will look when we move into a slowing situation.
In the US, the Fed crossed into the liquidity trap in the late 1990s, so this is nothing that was created overnight. It is a slow bleed of the economy to the point where it is on life support. Many talk about the market is addicted to the stimulus, well the economy is dependent upon it.
Nobody wants to allow for the cleansing to take place. With economies, unfortunately, it can be delayed but not stopped. That means the burden of debt will eventually catch up to these institutions.
Many do not realize the devastating effect of deflation. The Central Banks, likely without their knowledge, have been battling for the last 15 years. It is why their policies are failing so miserably.
To see some of the impact, here is a chart of the N225 (Japanese market). It is still 10,000 points below its high from more than 30 years ago.
And we won't even talk about what the Japanese real estate market looks like.
It is not a pretty picture.
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