By James H. Nolt
My friend and WPI colleague, Sherle Schwenniger, suggests 2016 may witness the “third leg” of the world financial crisis that started in 2007-2008 with the subprime crisis centered in the U.S.; continued in 2010 with the Greek bond crisis that soon threatened Spain, Italy, and other European countries; and now threatens to embroil China and other parts of Asia. I agree.
The cause of all three “legs” of the global financial crisis is similar and related to arguments I made in this blog two weeks ago. Successive debt bubbles are bursting as deflation causes debtors’ income to fall, leaving them less able to service high debts—a recipe for bankruptcy or default. Throughout history, deflation in the context of high debt has always been a recipe for disaster, especially during the series of depressions that rocked the world economy during the last third of the 19th century and during the two major depressions at the beginning and end of the 1920s.
First, we must understand deflation. Most economists consider only average inflation according to some measure such as the consumer price index (CPI). Averages are less important than extremes. An average of stable prices might conceal some prices that are rising fast and others that are falling fast. Furthermore, most measures of inflation/deflation used by economists ignore asset prices, i.e., the “Wall Street” economy as opposed to the “Main Street” economy. Thus the dull gray averages economists obsess about often hide more than they reveal.
It is even more important to consider price changes from the standpoint of the rich and powerful, including debtors and creditors, bears and bulls. For example, when oil prices were $100 a barrel, many oil interests around the world borrowed against their valuable oil properties, either to expand oil production, fund the spending plans of oil-rich states, bid up the prices of choice real estate, or indulge in lavish consumption. If all spending was made from current revenue, the problem would be less catastrophic, but those owning valuable assets are often tempted to borrow against them for increased consumption, productive investment, or speculation.
However when the oil price deflates to less than a third of the previous level, debts incurred when oil was yielding triple the income become hard to repay. To avoid bankruptcy, oil interests might panic-sell other assets, say stock or real estate, to cover the debts no longer serviceable from oil revenues alone. If enough unrelated assets are dumped, this becomes a contagion effect, dragging down other asset prices along with the fall of oil. Prices of luxury products may also tumble or sales fall dramatically.
But oil is not the only world product that has seen drastic price declines in recent years. Most commodities have experienced similar trends, from agricultural products to a wide range of minerals, including such common products as wheat, copper, coal, and iron ore. A large part of the reason is the slackening Chinese demand for these raw materials, but weak demand elsewhere contributes as well.
So not just oil producers are suffering from precipitous drops in income that threaten ability to service past debts. Other commodity producers are in the same boat, further contributing to a contagion effect, weakening the value of seemingly unrelated assets that must be liquidated to cover debt service costs no longer covered by income from selling primary products.
Another large component in this global asset deflation scenario is real estate. Wherever prices soften (and this is an uneven process), those who have borrowed to buy high-priced real estate often find themselves in a bind when prices fall. Even by selling the real estate they might no longer get enough cash to cover the loan used to buy it. Either bankruptcy results, or a scramble to sell other assets to cover losses on leveraged real estate investments. This is a big problem in China, including Hong Kong, and other parts of Asia today, including, for example, scandal-plagued Malaysia.
Add to this that stock markets throughout much of the world have tumbled since the new year. Some speculators borrow money to buy stocks “on margin,” or the equivalent, using derivatives to leverage stock positions. Those investors may find themselves “underwater” and forced to dump assets to cover stock losses or even worse, go bankrupt.
Additionally, bond prices have been booming since the early 1980s, the longest and strongest bull market in bonds in world history. Bond prices have reached record highs (which equals low or even negative yields), often now only sustained by heavy public or policy buying. When bond prices begin to tumble from these historic peaks, this adds deflation to another huge asset class. This is when a debt bubble actually bursts, as happened dramatically in Greece a few years back. If bond prices begin to crash, many investors who have leveraged positions in bonds (including using derivatives) will also join the crescendo of desperate bulls suddenly realizing the vulnerability of their leveraged positions, further adding to a contagion effect from liquidating sound assets to pay off debts on failing ones, i.e., “throwing good money after bad.”
Dangerous is the combination of debt and price deflation, not on average perhaps, but in specific asset categories where debt leverage is common and sometimes extreme.
There are no quick solutions to this problem. Many commentators have noted that monetary policy (what central banks do) has seemed to lose its efficacy. Monetary authorities try to temporarily fight general deflation with so-called “quantitative easing,” or the loose provision of money and credit. But the effect of such profligacy is everywhere uneven, often only temporarily boosting the prices of certain asset classes to artificially high and unsustainable levels. This only exacerbates the problem because speculators incur new debts to leverage purchases of whatever asset is ballooning, while many other prices languish in deflationary doldrums. It is not average prices that matter, but the extremes where leverage is the fuel and then the catastrophic vulnerability, bubbling and crashing one asset class after another.
The solution is not more markets or more tax breaks to the rich, who play this asset game most astutely. The solution is to reemphasize productive investment and broad consumer power, rather than concentrating wealth in the hands of those who invest in extremes of asset price volatility. More on the specifics of the China problem next time.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Iman Mosaad]