The forces of deflation are intensifying. Prices – and the collateral values – of goods are declining. The consequence is the credit that can be supported by collateral values shrinks alongside the declining prices.
Americans alive today have little experience with anything other than inflation and ‘growth’. Deflation takes some getting used to.
In an inflationary environment, finance creates – lends into existence – increasing amounts of liquidity, which is used to purchase assets, goods and services. The increase in the amount of liquidity presses asset prices higher; at the same time, the low ‘rental’ cost of liquidity allows the ‘real’ or relative cost of goods to remain low enough to expand business profits. Increasing asset values provide collateral to increase liquidity; the number of those with access to liquidity increases. In this ‘best of all worlds’, the incentive of higher real profits encourages the production of more goods and services, while the low cost of finance makes these same goods accessible to more and more ‘liquid’ customers. The entire process is a ‘virtuous cycle’, where assets generate liquidity which finances more goods and services … and more jobs and more customers with access to liquidity to buy even more goods.
In deflation, the virtuous cycle is short- circuited. Finance creates liquidity, but it isn’t used to purchase more goods and services. it is used to backstop the existing claims that the liquidity represents (or fund carry trades). Asset inflation cycles are consequently short- lived. Liquidity users increasingly lack the means to repay finance’s lending so less borrowing takes place. At the same time, the lenders themselves are constrained; the rental rate for liquidity becomes too high. The price of products falls relative to the cost to finance their purchase. The higher relative price of liquidity renders it scarce; there are many goods and services available, but liquidity to allow its purchase is not. Over time, the availability of the goods declines, as there are too few purchasers to keep production affordable. A new and more devastating cycle of decline emerges. Goods become relatively too expensive to produce or market and the industries that provide these goods and services eventually fail.
The question of whether the US and other countries are suffering from an asset or finance- driven deflation or and energy deflation is not answered by mainstream economists. One reason is because the ‘symptoms’ of deflation manifested themselves most fully and dramatically in finance. The ‘Lairds of Finance’ have the greatest claim on the public attention and on government. There was the noticeable decline of asset values, particularly in real estate along with the collapse of hedge funds investing in mortgage securities leading to the Lehman Brothers failure last year, followed by the failures of other finance legends and tycoons.
That the deflation is onrushing is impossible to deny; the credit multipliers have declined sharply:
This means less liquidity within the US economy is being created at the ‘money supply’ level. *
Less liquidity results in less purchases and the continuing decline in asset values. This decline is also self- reinforcing; spurned assets add to asset supply at the same time potential purchasers are removed from the marketplace.
I have received a couple of replies to Government and Lender Policies of Fear and Shame Help Keep Homeowners Debt Slaves that are worth sharing.
This one is from Michael Becker, a mortgage consultant in Maryland. Michael writes …
Hello Mish,
I wanted to let you know that I deeply appreciate your post on strategic defaults. I get people calling me all of the time looking to refinance and when I find out how underwater they are I tell them it might be wise to walk away from the property.
I also tell them the consequences of walking away. Like the article said, a foreclosure will stay on your credit report for 10 years. However, if you walk away it will only be 3 years before you can buy a home again. (It used to be 2 years but Fannie, Freddie, and the FHA made it longer to discourage people from walking away.)
I tell them if they choose to walk away they need to make sure they have a decent car, and at least one credit card. The reason for the car is that it may be hard to get a decent rate on a car loan for a while if they have a recent foreclosure, and the credit card is needed to help you re-establish your credit after the foreclosure. One of the biggest mistakes people make after a bankruptcy or foreclosure is not re-establishing their credit.
While finance difficulties are centered around banking/lending and credit creation and accompanying market disruptions, energy difficulties are focused on ground level production and wages. It is therefore unsurprising that little attention has been paid to the effects of energy price increases on the lower levels of the economy.
Noteworthy is the general decline in US wages over the past 20 years. This is considered an outgrowth of increased offshoring of domestic jobs, particularly in manufacturing, as well as the importation of millions of low- wage immigrants for jobs that cannot be easily transferred overseas. This consideration takes the ‘wrong end of the telescope’ view; there is a compelling competitive reason to ship jobs across US borders. The fact of the transfer is important but more so is the reason for it.
The outcome of offshoring has been the loss of domestic purchasing power. Good jobs lost are good customers also lost. Low- wage immigrants cannot afford to buy expensive products such as houses, regardless of financing – loans that cannot be repaid.
It is reasonable that the deflation began with the increase in energy prices beginning in 2003, while the energy dependence of the US on imports has been in the background of the domestic economy since 1970. Likewise, dependence upon imported energy has been in the background of the entire OECD since that time:
This is from the excellent Vox research site:
International trade, offshoring, and US Wages
Avraham Ebenstein Ann Harrison Margaret McMillan Shannon Phillips
31 August 2009
Over the last two decades, the US economy experienced a boom in offshoring and a doubling of imports of manufactured goods from low-wage countries. Over this same period, roughly 6 million jobs were lost in manufacturing and income inequality increased sharply.
These parallel developments led many critics of globalisation to conclude that “good” manufacturing jobs were being shipped overseas at the expense of the domestic labour force, putting downward pressure on wages of American workers. Concern over these developments led the US Congress to pass the American Jobs Creation Act of 2004. Yet whether these changes in the US labour market are a result of rising import competition or relocation by multinationals to other countries (known as “offshoring”) is not clear.
Table 1 shows that some occupations experienced enormous increases in exposure to international trade during the sample period. These included shoe machine operators, for whom occupation-specific import penetration increased from 37% in 1983 to 77% in 2002. Table 2 shows those occupations where export activity increased the most. However, many individuals were in occupations where there was no exposure at all. These occupations included teachers, therapists, sales workers, judges, dancers, and many others.
Table 1. Exposure to international trade across selected occupations
Patternmakers, lay-out workers, and cutters
Miscellaneous textile machine operators
Miscellaneous precision woodworkers
Lathe and turning machine set-up operators
Knitting, looping, taping, and weaving machine operators
Numerical control machine operators
Electrical and electronic equipment assemblers
Table 2. Sectors with large increases in export shares
Miscellaneous textile machine operators
Winding and twisting machine operators
Patternmakers and model makers, metal
Lathe and turning machine set-up operators
Drilling and boring machine operators
Tool programmers, numerical control
Lathe and turning machine operators
Mechanical engineering technicians
Milling and planing machine operators
Knitting, looping, taping, and weaving machine operators
Numerical control machine operators
Electrical and electronic equipment assemblers
What we find is that a one percentage point increase in occupation-specific import competition is associated with a 0.25 percentage point decline in real wages. (Emphasis mine) While some occupations have experienced no increase in import competition (such as teachers), import competition in some occupations (such as shoe manufacturing) have increased by as much as 40 percentage points. The contrasting experiences of workers in textiles and apparel-related sectors compared to many service sector employees such as teachers helps to explain why some parts of the US economy have been deeply affected by globalisation while others have not.
Jobs that have seen the greatest exposure to overseas competition are also heavily energy- intensive. The list of jobs charted by Ebenstein, Harrison Et Al are the tasks of industry: Tool and die makers, patternmakers, lay-out workers, and cutters, textile machine operators, precision woodworkers and lathe and turning machine set-up operators, among others. The rising cost of petroleum has had the effect of making energy- intensive operations more expensive in real terms. In a broad view, product sales can support high wages and cheap fuel inputs but cannot support high wages and expensive fuel – something has to give! This is where other business inputs remain at stable levels.
The energy costs to business have driven jobs overseas. Only the demand destruction accompanying last summer’s $145 oil temporarily suspended the shift.
Real energy costs tend to fall in low wage countries relative to high- wage countries; there is small relative ‘leisure’ demand for fuel along with less energy- intensive transport and manufacturing in these countries. The result is less price competition for fuel. China aims to lock in lower prices by purchasing production at the wellhead. Lower wages constraining demand against increased relative supply depresses real energy costs further.
Removing well- head production from world markets adds to oil price pressure in the US and elsewhere. Higher wage countries have higher and increasing real energy costs; US inflation and ‘growth’ is now counterproductive. Regardless of wage cuts and unemployment, real US wages are still higher than in low- wage countries and the difference propels real energy costs upward.
Since the structural advantage of low wages remains, there is an accelerating wage race to the bottom. The advantage remains until trade vanishes, at which point any benefits of trade are lost and deflation intensifies further.
Businesses exported manufacturing jobs beginning in the early 1980’s to preserve brand or nameplate profits. The ‘value added’ of retail was intended to supersede the value added in the manufacturing processes. The dependence of industry falls upon cheap energy and labor. The dependence on retail is upon financing and credit. From a manufacturing economy that celebrated high manufacturing wages and low real energy costs, the US descended into a middleman economy with relentlessly increasing real energy costs amplified by finance driven over- consumption.
It is the transition from manufacturing to service in the US that identifies the source of deflation rather than failures in finance. By this metric, the ground for the current deflation was prepared in the early 1980’s during the energy crisis of that period.
Energy costs are the propellant of the current deflation. With cheap energy – $30 or less per barrel – there would still be credit expansion. There would still be sufficient domestic demand – from high real wage income to pay for goods. Cheap energy allowing the high wages would support sales. At the same time, the burden upon finance would be small as customers would pay the low rent on liquidity out of wages … rather than ‘rolling over’ or financing service costs. Finance would thence remain solvent, liquidity would be sufficient at low real cost to finance both business investments as well as additional purchases which would drive further lending in the virtuous cycle.
Escape from this conundrum by conventional means requires competition with low real- wage and energy consuming countries. Most of the high- technology industries in the US use proportionately much larger amounts of energy for units of output than do to low- wage countries. Even the removal of wasteful leisure consumption of energy leaves high- wage countries consuming too much where it counts the most.
The implications of this are severe and sobering. US energy costs make wage labor uncompetitive at just about any wage level, even against at what is posted as ‘Chinese minimum wages’. This reduction is self- limiting: wage levels eventually fall too low to support the industries themselves. This is already the case in low- wage countries, which is why these countries rely on exports rather than internal consumption. US over- consumption has left the country with unsupportable wages on one hand and unsupportable industry on the other.
The US would have to somehow reduce energy consumption … to press world consumption and prices – not simply US (OECD) consumption – lower. The effect of energy price ‘spikes’ is noticeable; there is a consequent plummet as demand is destroyed. It is clear that high and increasing energy prices are strongly deflationary.
Depletion does not give long- term relief to low wage countries. These will face greater difficulties supporting their increasingly higher real- cost industries as oil – and coal – depletion intensifies and real energy prices continue their relentless rise.
* The expansion of derivatives – currency, interest rate and other swaps – does generate liquidity but is not part of domestic money supply.