The last time deflation struck in a big way, my father was just 20 years old.
Now, as deflation hits hard again, I’m 69.
That just goes to show you how rare deflation really is.
And that’s also why virtually no one alive today has first-hand personal experience with it.
I don’t either.
I vicariously relived my father’s experiences with deflation through the many colorful stories he told. But that’s not the same.
I frequently visited Japan during its two deflation-ridden decades. But that was also different.
Despite all this, though, there is one thing that history teaches us with relative clarity: The collision of deflation and debt leads to disaster.
Put yourself in the shoes of the average consumer, and you’ll see exactly what I mean.
If you’re mostly debt-free, you can probably get by even in deflationary times. Sure, you may suffer a decline in income. But if prices are being discounted on virtually everything you buy — gas, food, airfares, even rents — then the enhanced purchasing power of the money you do earn can help offset the pain quite a bit.
The big killer is debt. If you think your bank is going to give you a discount on your monthly payments for mortgages, car loans, student loans and credit card balances, forget it. With rare exceptions, your debts are fixed and immutable.
So unless you have a lot of savings, the exit door is through a bankruptcy court, and it’s not exactly a pleasant experience.
You know what I’m talking about. You saw it yourself right here in the U.S. starting in 2007 — the year American households had piled up a record $10.6 trillion in home mortgages.
And you also know what happened next: As soon as real estate deflation knocked on our doors, mortgage defaults and personal bankruptcies spread more rapidly than the Zika virus.
You’d think most of America’s smartest CEOs would have learned a lesson or two from these torn pages of insane financial history.
But the shocking reality is they haven’t learned a thing. Quite to the contrary, since the 2008 debt crisis, they’ve plunged headlong into debt with the same pathological lust for cheap credit as we saw in the housing boom.
And the parallel, equally shocking truth is that some of the nation’s brightest investment pros have financed the madness with vast sums of stock and junk bond purchases.
Look. Before the housing boom peaked, U.S. nonfinancial corporations had a total of $5.7 trillion in debts.
Now, as of the last reckoning (Sept. 30, 2015), they’ve got over $8 trillion.
Now, here’s the key (again): As long as the companies can command a decent price for their products and services, it’s not a big problem. But as soon as prices start falling, sales and profits follow. And suddenly, meeting debt payments looms as a huge hurdle each and every quarter.
I’m not the only one worried about this …
OFR Warns of Threats
The U.S. Government’s Office of Financial Research (OFR) says the recent surge in corporate debts in America is a threat to financial stability. And in their 2015 report to Congress, OFR economists were quite explicit about it:
“The ratio of the debt of nonfinancial businesses in the United States to gross domestic product is historically high and companies’ leverage (the ratio of debt to earnings) continues to rise. The hunt for yield and current historically low default rates are promoting easy credit and heavy borrowing.
“Today’s low default rates seem unlikely to persist. Stress in energy and commodity industries from declining prices could spread as investors reassess their risks.”
The OFR economists are even more worried about the collision of deflation and debts overseas. Their own words:
“In many emerging markets, such as markets in China, Russia, Latin American nations, and parts of Asia and Eastern Europe, debt levels in the private sector have reached historic highs after years of heavy borrowing. …
“A shock that erodes perceptions about credit quality in U.S. corporations or emerging markets could pose a threat to financial stability.”
The analysts at Fitch Ratings agree.
They decry the rapid rise of corporate debt in emerging markets.
They show how, in seven of the world’s largest emerging markets —Brazil, India, Indonesia, Mexico, Russia, South Africa and Turkey — private sector debt has now surged to a whopping 77% of GDP.
And they’ve responded by putting more emerging-market countries on their “Negative Outlook” than at any time since 2009.
But OFR and Fitch may still be underestimating the explosions that are likely when deflation collides with debt.
Emerging-Market Debts About to Blow Up
Last fall, I was in Russia, including their deep south.
I just returned from Brazil a few weeks ago.
I’ve also spent a good amount of time in China recently.
And, in each case, I’ve seen vividly the collision course they’re on:
In Russia, private sector debt has surged to almost 75% of GDP, including both corporations and households. While I was there, I met few people that had been laid off. But nearly everyone I know is suffering directly or indirectly from salary cuts. One good friend, an emergency-room doctor in Samara for over 40 years, says her meager salary has already been slashed twice. Another, who works in the federal court of St. Petersburg, has suffered a similar fate. Giant oil companies are on the brink. Big banks are next.
In Brazil, private sector debt recently hit a new high of 95% of GDP. As long as incomes continued to grow, no one batted an eyelash. But right now, incomes are sinking fast. The malls we’ve visited have been deserted. Christmas traffic was abysmal. Consumer confidence has fallen to the lowest I’ve seen in my lifetime. Industrial production has plunged. And the entire economy is contracting at the fastest pace in over a decade. Petrobras, one of the world’s largest oil companies with $24 billion in debt, could be among the first giants to fail.
China tops both Russia and Brazil, with private debts now up to a red-hot default-prone level of 185% of GDP. In other words, for every dollar of goods and services produced in all of China, the country’s corporations and households have $1.85 in debts outstanding.
What about China’s economy? If you look strictly at government-polished stats, the economy seems to be less troubled than Brazil’s or Russia’s. But when I talk privately to average citizens and business people, I sense growing despair and fear. They don’t believe the government’s numbers. Why should we?
Plus, all three countries have one huge additional problem: The value of their currencies is falling — even crashing. This means that any debt payments they have to make in U.S. dollars (or euros) are taking an even bigger chunk out of their shrinking incomes.
Will Governments Come to the Rescue?
Don’t count on it for three reasons.
First, most emerging markets and advanced countries have already exhausted all the monetary and fiscal weapons in their arsenal — and then some.
They’ve already cut interest rates — often to zero. They’ve already printed money up the wazoo. And they’ve already run down big chunks of their foreign currency reserves.
When it comes to fighting deflation, they’ve been there, done that. And it obviously didn’t do diddly-squat to help them achieve their inflation targets — let alone prevent the rampant commodity price declines that are now sweeping global markets.
Second, the governments of the world’s largest economies have done absolutely nothing to reduce their own government debt:
At the latest reckoning the debt load of the U.S. government, even excluding all the uncounted extras, was 105% of GDP.
Belgium’s was 107%; Portugal’s, 128%; Italy’s, 133%; and Greece’s, 197%.
Worst of all, Japan, the world’s granddaddy of government debt, was up to a death-defying 246%, or more than double the levels of notoriously debt-buried countries like Ireland, Spain, Cyprus and Ukraine.
Third, the central governments of many highly indebted countries have also thrust their fingers deep into the debt pile of private corporations. They own the indebted companies, run the indebted companies and are often the first to get stuck with the company’s debt before or after a default.
Here’s the key — the point I made at the outset and the same point I’m going to make again right now:
As long as inflation continues, virtually all of these debt problems get swept under the rug. Borrowers earn more income, making it easy to pay off their debts. Plus, the real, inflation-adjusted cost of the debt payments goes down, making it even easier.
But with deflation, the opposite happens. Debts suddenly loom larger. Borrowers default. Companies declare bankruptcy. And they set into motion a chain reaction of corporate failures and market collapses that topple entire economies.
Whether or not things will get this bad in the U.S. remains to be seen. But in many emerging markets, the combination of deflation and debt is already leading to disaster.
We’re watching those countries carefully — especially China, Russia and Brazil. Unless global deflation ends very soon, I fear they could be the precursors of a future debt crisis that makes 2008 look small by comparison.
Good luck and God bless!
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