Charles Davì

The Anatomy of Deflation

In Not So Efficient Market Hypothesis, Slight Departure on December 11, 2008 at 1:38 am

Slight Departure

In this article, and others to follow under the category “Slight Departure,” I will take a slight departure from the narrow topics that dominate this blog. Instead, I will focus on broader economic issues and attempt to make sense of current macro economic conditions. Enjoy!

One Way Ticket

Yields on U.S. Treasuries have fallen quite a bit over the last 12 months across maturities. This was probably caused in part by what has been dubbed a “flight to safety.” That is, investors have sold off “risky” positions in exchange for safer ones. But why? My personal opinion is that while risk aversion is certainly playing a part in the quick movement into Treasuries, this risk aversion was itself spurred by a rush to meet short term obligations. Please note that this is my own version of what happened and what is to come. Anyone claiming to have a conclusive answer to such a broad question is either incorrect or correct as a matter of coincidence.

Collective Failure

Mortgage backed securities, CDOs comprised of mortgage backed securities, and the like (collectively refereed to as “Structured Products”) were widely held and widely believed to be fairly liquid and safe. But, for reasons that will likely be debated for decades if not longer, they became illiquid as the markets in which they were traded fell apart. If you were holding one of these, you were stuck with it, unless you were willing to sell it for pennies on the dollar. But before the failure of these markets, those holding Structured Products continued to accumulate short term obligations based on the assumption that Structured Products could be sold, if necessary, to meet these short term obligations. That is, they continued to operate under the reasonable and shared assumption that at any point, Structured Products could be exchanged for an amount of cash close to the par value of the product. When this assumption failed, it caused those holding Structured Products to sell other liquid assets and if necessary draw on existing lines of credit to meet these short term obligations. In my opinion, this bout of collective selling and exhaustion of credit began the first wave of downward pressure on prices.

Capital Requirements

Many of the entities holding Structured Products were banks or other institutions subject to capital requirements and regulations. When the Structured Products they were holding became illiquid, devalued, and subsequently downgraded by the various ratings agencies, various capital regulations forced them to either raise equity capital or shift their asset allocation towards high rated assets. In order to do this, many such entities simply sold riskier assets and purchased low risk assets or held the cash. This collective selling put enormous downward pressure on asset prices across asset classes, with the notable exception of Treasuries, where prices soared and yields plummeted. Moreover, the most dramatic drops along the Treasury yield curve were front loaded, in short term Treasuries. This is consistent with a rush out of other asset classes and into short term treasuries. Thus, it is arguable that those entities holding Structured Products simply liquidated other assets en masse in order to meet short term obligations and comply with capital requirements.

The Supply Of Credit

As mentioned in the previous paragraph, many of the entities holding Structured Products were banks. And for banks, like any other business, resource allocation is a zero sum game. That is, if banks allocate more cash to one endeavor, they must allocate less to at least one other. This simple observation suggests that as banks allocated more cash to Treasuries they could have cut back on lending. The dramatic escalation in short term LIBOR rates that took place over the last year (which has since subsided) suggests that there was indeed a severe shortage of credit, particularly short term interbank lending. As the cost of credit increases, the total cost of assets purchased using credit increases, which lowers the price at which these purchasers are willing to purchase assets. So those who purchase assets using credit will become less competitive during a credit shortage when compared to those who pay for assets with cash. Thus, the demand for assets in general should be expected to shrink given a large enough contraction in the supply of credit. This exerts further downward pressure on asset prices across asset classes.

Joe The Plumber

A decline in asset prices across asset classes decreases the balance sheet wealth of not only institutions, but individuals as well. This could lead to a decrease in consumer spending as the perceived wealth of individuals decreases, which would exert downward pressure on non-financial asset prices. This is consistent with the recent decline in the CPI.

And in addition to the individual’s role in the so called “real economy,” the individual also plays a role in the financial system. If individuals do not believe that the assets they have in the financial system (bank deposits, mutual funds, etc.) will maintain their value, they will have an incentive to sell these assets in exchange for cash. This not only exerts downward pressure on asset prices, but it exerts upward pressure on the cost of capital, particularly for banks, since this type of behavior erodes the deposit base.

Rinse, Lather, Repeat

A decline in asset prices across asset classes could cause the capital structure of a bank and therefore its ability and willingness to lend to deteriorate. As mentioned above, it could also cause its cost of capital to increase. As a result, the entire process outlined above could begin anew as a result of it having occurred once, compounding the downward pressure on asset prices.

Tis Good To Be King

So what should we do to stop this financial recursion? I have a few ideas. Again, these are my ideas, and you should keep that in mind. These problems are maddeningly complex and gigantic in scale and so you may not agree with my ideas for any number of reasons. That said, something must be done. And despite deep reservations, I think that U.S. government spending during this crisis is the thing to do.

Right now, the U.S. Government is able to borrow at almost 0% interest at a time that the U.S. dollar is at its strongest in years against certain currencies. This is a truly odd combination, but could be explained if we accept that people are leaving capital markets all over the world and running for the hills, i.e., U.S. Treasuries and therefore U.S. dollar denominated assets. This market dynamic will change in the long run, hopefully. So, my plan to exploit this aberration would be as follows:

Flood the market with short term and medium term U.S. Treasuries and thereby borrow to the hilt. Spend this money on fixing the U.S. financial system (creating more repo facilities, buying toxic assets, etc.) and U.S. infrastructure projects (to create jobs and demand for non-financial assets). The net effect of this is to allow the private entities in the U.S. economy to borrow at near 0% interest, giving the U.S. a tremendous near term advantage over the rest of the world.

At some point, this borrowing will push the interest rates on Treasuries up and will push the dollar down. When interest rates on treasuries reach non-bargain basement levels of borrowing, the U.S. should stop borrowing. But what about the green back? As a bonus, because the U.S. dollar will eventually fall from its current heights, the U.S. debt issued until that point will depreciate in value.

Thus, the U.S. could borrow for almost no interest, pump that money into its own economy, and then get a free principle reduction at the end. As for the rest of the world, yes, my solution rests your fate on the shoulders of the U.S. economy. I’m sorry, but I just don’t have enough time to think of a way out of your mess as well.

  1. I have believed for some time that a dose of above-optimal inflation would help by countering the drop in housing prices which seems to be at the root of all other problems. A lot, not all, of mortgages could soon be right side up. The real value of the mortgage debt would drop.

    This seems consistent with your final two paragraphs, albeit on another balance sheet.

  2. I agree with issuing paper until they can’t take any more. I also think that the US should suspend or greatly reduce capital requirements, if you don’t have to have capital, you don’t have to de-lever, and you can loan and reflate the economy.

  3. The flaw in your thesis is that 0% is a nominal rate and the real cost is much higher. Money is a standardized unit of productivity to lubricate exchange and debt is borrowing against assumed future productivity. Taking out a debt has a cost, interest, so the asset/activity the debt was created for must yield more than the cost of the debt. The problem is debt backed by future productivity that isn’t going to manifest in the next 2 decades. Bad debts are cleaned out naturally in recessions, but Greenspan and Bernanke’s mission to engineer away recessions via government deficit spending flooded the financial engine with fuel (unsupportable debts). The solution all along has been a recession. Putting these off for a couple decades and piling on the government debt has guaranteed a depression.

    It’s all about productivity. Prices are falling and will continue to fall. The money the government is borrowing today to support the status quo are tomorrow’s catastrophic problem. There is one choice to be made between two options: deflationary depression or hyperinflationary depression. Tweaking with credit and leverage are what got us into this mess. I have full confidence in the greed of the few to ensure we see deflation. I’m not the only one who understands what is going on and why deflation is the chosen path.

  4. i need to talk to Charles Davi. I work with Nouriel Roubini at RGE and am responsible for the blogs. Please email me at

  5. Daniel,

    Even at real levels treasuries still offer historically low rates of borrowing for the U.S.

    Repo facilities can have preset, finite durations. Therefore the timing of repayment of the treasuries can be matched to that of whatever repo facilities the borrowed money is used to finance.

    Infrastructure projects present a real risk of repayment. The risk in that case will come down to which projects we choose to finance with borrowed money.

    Deflation may or may not be desirable. What is certainly not desirable is a severe shortage of liquidity in the banking system. If we can borrow money at almost no interest and finance repo facilities to alleviate this problem, I think that’s worth the risk of running into inflationary pressure. In fact, such facilities would allow the Fed to take focus away from interest rate policy and address the liquidity issues directly.

  6. Erdo,

    We are living in historic times, so I keep an open mind as it relates to <100 years of data mining material. My favorite quote from your response is:

    “Even at real levels treasuries still offer historically low rates of borrowing for the U.S.”

    What other money is there my friend? Deflation is by no means desirable, but it is the path until the system is cleansed of bad debts and we are left with a mountain of treasuries. When we hit <90s-late 80s pricing on the indexes I will become concerned about inflation.

    RE: Liquidity

    The banks have and had liqudity. What the banks didn’t have was liquidity for their “assets” at prices they liked. While the assets were largely performing at the onset of the crisis recognition, the market correctly priced that they wouldn’t perform like the market is supposed to function…ahead of the fact. The short end of the yield curve and the 5 year tip-spread is pricing in AHEAD of the storm…again, like it is supposed to.

    Libor/EFF have collapsed merely because “we the people” were fleeced of $350 billion in outright cash and billions and trillions in the form of FDIC, GSE, and bank holding company bond guarantees. This was a recapitalization of the major institutions who will swallow the smaller players when they suffocate from being unable to compete with the economies of scale that the money centers have. Libor/EFF is the cost for a bank to balance its reserves overnight, not to fund loans held on the books. If banks are originating much credit interbank lending rates won’t move up because there is no demand for your “liquidity.” The bulk of credit originated today is treasury, GSE, secured w/FDIC blessing and distributed. Profitable banking requires fees (volume) and profitable credit origination, otherwise it is a really bad business (review pre-70s non-growth bank era).

    Furthermore, there is asset-liquidity at prices the banks are unwilling to accept. I know, because I talk to the people making offers. Fear not though, as the government purchases the bad debts outright, or defacto, the big banks will sit back and watch this fold in on itself. The concessions (18-20%) banks are making on mortgages now for capable borrowers is paid for on the back of the tax-payer and transfers the risk to the GSEs via refinance. There is no refi or risk transfer mechanism for unsecured revolving credit, stay-tuned in 2009.

    HSBC FIN 620/640
    GECC 475/490
    MS 430/445
    AXP 385/400
    COF FIN 333/348
    GS 330/340

  7. I copied the wrong sentence. 🙂

    “The risk in that case will come down to which projects we choose to finance with borrowed money.”

    I agree that there is a future risk of repayment, but that’s if we decide to maintain the entitlements as they exist today. Significant revision or repeal and I believe the costs will be manageable…for now. The alternative is there will be no material new deal two. I believe the attempt will be somewhere in the middle…operative word being attempt. BOb signed up for the wrong job. JMHO though.

  8. I thought that what is proposed in the original post was what we are doing, though that is not our specific intent. We’re trying to drive down long rates. The money pumped in will, we believe, eventually inflate the system and that will then devalue the dollar, etc.

    As for deflation, I enjoyed the piece but you left out, I think, the basic issue of aggregate demand. The credit bubble as financial spurred tremendous change around the world – and we should admit that bubbles are good if they don’t crush you when they pop because those are periods of great economic progress. Look at Eastern Europe, India, China, etc. A major issue for deflation is simply whether we’ll be able to maintain sufficient demand without the same credit mechanisms, availability, etc. It’s scary in the US but imagine India or China where population growth means they absolutely need a growth rate above our normal good rate just to stay even. It appears both aggregate demand and aggregate supply might be dramatically affected and that could lead to a vicious circle.

    I enjoy your writing.

  9. This is a remarkable breakdown of our current situation; laid out so elegantly and not with one word too many. I thank you for it.



  10. Interesting. Just a small caveat to mention: the dollar decline will not facilitate repayement, as the debt is dollar denominated. The only potential impact could be that purchaser of USD debt will be reluctant to buy it as the current strong rate, and demand some depreciation of the dollar to buy Treasuries on more advantageous terms (lower dollar, higher rates). This may be a crash scenario for the USD once the current USD-supporting funding squeeze is over…

  11. Alex,

    Thank you for your comment. In your argument, you say that foreign buyers will be reluctant to purchase because of impending depreciation in the dollar. For this same reason, the Treasury should be eager to lend since it holds foreign currency which will appreciate over the life of the notes the Treasury issues, which can be used to pay off those notes, thereby indirectly reducing the principle owed on the notes.

  12. Great column, enjoyed. Borrowing, advantageously, may be forgotten before returning. The dollar lost value for years, and I wonder if it has just begun an uptrend; people seem to want to qualify the “relative” strengh of the U.S. currency. I figure that “relative” still has a winner’s circle and notice the dollar within. The same coincidences make me wonder whether Treasuries are not overbought. Could they now be the “money market”?

    Anyway, I don’t know anything.

  13. With credit tight here foreigners are flocking from China and other nations to buy up the devalued homes in the US.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: