Understanding Great Recessions, Part 3 (The Debt-Deflation-Default Nexus)
April 19, 2020 by jackrasmus
In this part 3 in the series explaining the unique characteristics of Great (aka Epic) Recessions the focus turns to how excess Debt, when combined with Deflation, leads to Defaults (by banks, corporations, or both), which exacerbate and intensify the negative feedback effects of overlapping financial cycles and real business cycles. The contraction of both accelerate and deepen. Deflation spreads from financial asset securities to real goods and services to labor and other input prices (wages). Falling prices lead eventually to defaults–i.e. failure to pay principal and interest on prior debt loads. Deflation in fact raises the real cost of the prior debt. So debt continues to rise in real terms as the ability to ‘service’ that debt (pay principal and/or interest) declines as prices deflate and revenues and cash fall. The interaction of debt with deflating prices and defaults creates a mutual feedback effect among the three factors–debt, deflation, default–and hence creates what I call the ‘debt-deflation-default’ nexus.
Here’s Part 3 describing the processes, which create within the capitalist system a condition of ‘fragility’. That is, the increasing likelihood of a major financial instability event–i.e. stock or bond market crash, commodities futures crisis, derivative securities super-contagion and contraction, property values collapse (residential and/or commercial), and so on. (In the final Part 4 to follow, it will be explained how this process and multiple feedbacks, and ‘nexus’, occurs not just in the financial side of the economy, but may occur as well in the household consumption sector and the government sector. When all three sectors–financial, households, government–become ‘fragile’ as their separate ‘nexuses’ intensify, then the entire economic system may become ‘systemically fragile’.
Debt As Driver of Deflation
The prior debt levels created by excessive leveraging and the shift to speculative investing over the business cycle mean that, once prices of speculative assets begin to fall, the greater volume of debt previously accumulated over the cycle will result in a longer fall in the price of the assets. And the poorer the quality of that debt, the more rapid the fall. Thus the level and quality of the accumulated debt will determine the asset price deflation. Speculative investing works through the medium of accumulated debt in depressing asset price deflation, by creating excess debt as a result of creating ‘tiers’ of speculative instruments, ‘layered’ leveraging, and creating a false sense of reduced risk. Details of the debt-deflation process work something like this:
During the boom cycle, debt servicing payments are not considered a major factor to the investor. He intends to sell the asset after a price rise before the debt payments are due in any great volume. But this works only so long as the price of the asset continues to rise. When it doesn’t, if it declines, and sometimes even if it just slows in its rate of rise, then debt servicing payments come due and may become a burden. That debt servicing cost burden may prove significant if a large volume of debt was taken on in the original process of asset purchase and/or if the additional debt over time was of a poorer quality (i.e. shorter term and higher interest). Rising debt servicing costs may represent only one part of the growing cost pressure on the investor. Terms of borrowing for investors are often such that, should the value of the asset purchased fall below its original purchase price, the borrower is required to ‘make up the difference’. That is, put in more money assets or put up other assets as collateral. When that point is reached the investor typically tries to ‘dump’ the asset and sell it. But that may pose a problem as well, when most investors are trying to dump the asset and sell it at the same time. The more savvy investors quickly exited the market early in order to avoid the inevitable rising debt servicing cost and losses and write-downs that can quickly follow once prices start falling. Their exiting, however, accelerates further declining asset prices and rising debt servicing costs. Unable to sell the assets for which prices are deflating, the investor may turn to selling off ‘good assets’ (i.e. other classes of assets not losing value due to price declines) in order to make the rising debt servicing costs. In this manner asset price deflation may spread between classes of assets as well. A company as investor, for example, may have to sell its better assets in order to raise cash with which to service its rising debt costs. It can all become a self-fulfilling downward spiral; general asset price deflation can quickly set in.
Deflation Feedback Effects
It has been explained how, in the runup of a financial boom rising debt and excessive debt leveraging may result in excess demand for financial assets that drives asset price inflation to extraordinary levels. But speculative investing may also drive product price inflation in several ways. Speculation in food commodities and oil drives up futures options prices for these commodities which are passed on to what is called ‘core inflation’, energy and food prices, at the food and energy wholesale and consumer levels. Rising commodity prices for metals also causes a rise in product prices of crude, intermediate and finished producers goods, as metals and other raw materials prices are passed through producer goods prices. In turn, rising producers goods prices are eventually passed on in part to consumer products made from those producer goods. The consequence is a speculative investing-debt driven asset, as well as product, price inflation. Rising debt thus drives inflation. But the opposite may occur as well. That is, asset as well as product price deflation may actually result in a still further rise in debt levels and thus debt servicing stress.
The reverse scenario in which falling prices result in rising debt works something like the following: Once a financial bust and crisis has occurred, businesses don’t only sell assets that have started to collapse in price. First, the assets rapidly collapsing in price may prove difficult. The prices of the falling assets may have declined so far that their sale provides little revenue gains with which to make debt service payments. So the company may simply hold onto the asset that might be now virtually worthless instead of selling it. That is what, in effect, happened to many banks and shadow banks after 2007 that were caught holding collapsed securitized assets. The dollar value had fallen to as low as 10 cents on the dollar. In that situation, banks just held onto the collapsed and now nearly worthless assets. But they still had to make debt servicing payments, and perhaps as well make up for the lost value on those collapsed assets on their balance sheets. They therefore first sold other ‘good’ assets that had not yet fallen in price. That applies to non-finance companies that found themselves in a similar situation. For example, GMAC, the financing arm of General Motors, had speculated in securitized assets and lost billions. It played a major role in GM’s ultimate financial decline. GMAC had to sell off ‘good’ assets to compensate for the collapse in value of the ‘bad’ assets it couldn’t sell. Similarly, GM itself had to sell at ‘firesale’ prices real assets of several of its product divisions to cover the losses in assets at GMAC.
This, by the way, is also an example of a transmission mechanism illustrating how asset price declines can spread from asset class to asset class, eventually infecting good assets and setting off a general asset price decline. Cash flow must be raised in some manner in order to service debt payments coming due from debt accumulated during the boom phase. Selling ‘good’, as well as ‘bad’, assets is one response. But selling company assets, good or bad, is not the only way to raise cash with which to cover debt payments coming due. Reducing product prices to raise revenue and cash flow is another.
If the company is a non-financial institution, another alternative available is to sell more of the company’s inventory of real products in order to raise cash to make debt payments. But with a weakening real economy, selling more products requires lowering the prices of those products in order to increase sales revenue and raise the needed cash flow for debt servicing. This is an illustration of another transmission mechanism describing how asset price deflation can spread to product price deflation.
But lowering product prices in order to raise cash to service debt payments means the company’s real debt levels rise. Specifically, falling product prices results in rising real debt and thus a rise in the servicing costs of that real debt. The company’s original debt obligation and payments have not risen, but the company’s income and cash flow available with which to make the debt payments has fallen—i.e. the real debt load for the company has risen. Sometimes referred to as the ‘Fisher Effect’, this is an important process by which paying off debt by raising cash by lowering prices actually results in rising debt. It represents the process by which deflation can feed back and cause a rise in (real) debt, just as debt can result in deflation. If left unchecked, deflation results in a spiraling down of debt and deflation as they both feed upon and further exacerbate each other.
This debt to deflation and deflation to debt spiral is typical of Epic Recessions. If not checked early in the process, it may lead to a deepening and extending of Epic Recession. And if allowed to become particularly severe and protracted, it can play a central role in transforming an Epic Recession into depression.
Asset and product price deflation may also ‘spill over’ into wage deflation as well, further exacerbating the process. As product price deflation occurs and company revenues and cash flow eventually decline further, the natural management response is to cut operating costs as well. That is typically employment and wages for those left still employed after layoffs. In fact, it is not necessarily sequential. That is, asset firesales leading to product price deflation, then to wage deflation. A company facing particularly severe debt servicing stress may engage in all three forms of deflation at the same time more or less, selling assets, reducing product prices to raise more revenue, and cutting operating costs. However, cutting product prices will eventually lead to wage deflation. First as reductions in hours of work for a company’s labor force and in the form of layoffs. Both constitute forms of wage deflation for the general labor force at large. Total wage payments decline for workers as a group. For those still employed, wage deflation can assume more traditional forms of hourly wage rate reduction, suspension of bonuses, reductions in company contributions to benefit plans, etc. In Epic Recession, resort to non-traditional forms of wage cutting frequently occurs as well, such as ‘forced monthly furloughs’ (days off without pay), cuts in paid sick leave, vacation, and holiday pay, and other forms of supplemental compensation. The key point, however, is that product price deflation eventually spills over to wage deflation in a general way in Epic Recessions.
Wage deflation also has the effect of feeding back upon and exacerbating debt. In this case it is consumer debt levels that are affected. When workers’ experience reduced income from job loss and wage cutting, in effect their ‘cash flow’ also is reduced. Their real debt thus rises as well, as does their debt servicing stress. There is also a further feedback effect. Rising real debt for consumers means less consumption and therefore less demand for products. Product prices are in turn reduced further, causing additional rising real debt for business. In other words, rising real consumer debt results in a further rise in business real debt. Debt drives debt.
Finally, as business real debt rises and reducing product prices reaches its lower bound limits, businesses’ only option is to turn to selling more assets. Thus, deflation in wages and product prices drives a second round of asset price deflation. We now have a generalized process of the three types of prices—asset, product, and wage—each driving the other in a downward spiral through the medium of rising real debt for each. The more generalized and the more multiple feedbacks that occur, the more severe the condition of Epic Recession.
Debt-Deflation As Driver of Default
These processes of deflation and debt ultimately lead to a condition of default. When a business can no longer reduce wages (beyond a point it results in an insufficient workforce to produce its product), can no longer reduce product prices (further reductions would mean producing products for a price consistently below the cost of producing those products), and has few or no remaining real assets to sell to raise cash flow to finance debt payments—then the only alternative for the business is to default. That default may be on its debt servicing payments. Or it may take the form of a more serious company level default, meaning a bankruptcy.
Default may be postponed, however, by various means. Lenders may allow the business to ‘roll over’ its debt due—in effect reducing its debt payment levels in exchange for a longer term debt obligation. The business may simply borrow additional debt in order to make the payments on the original debt. Or it may convince lenders to accept stock in exchange for debt. If it is fortunate enough, it may invoke prior ‘covenants’ that allow it to suspend or slow its debt payments. Or perhaps the company’s original lender (financial institution) is itself near insolvent so it chooses not to take the company into bankruptcy court in response to the debt default, since doing that would require the lender to register even greater losses on its own balance sheet which it may be loathe to do. There are a host of measures that are designed to ‘buy time’ for a company facing default as bankruptcy. Most measures take the form, however, of the company taking on additional levels of long term debt amortized over a longer period in order to pay for increasingly unaffordable short term debt. A favorite option in 2009, for example, was for companies having difficulty making debt payments to sell more junk bonds to cover immediate debt. But this represents a temporary solution only. It means raising long term debt levels in order to finance short term debt payments.
A similar process to that described above occurs for consumers and consumer default. Falling consumer income from job losses, wage cuts, and growing inaccessibility to credit (wage deflation) means a greater difficulty paying for debt incurred during the boom phase (real debt rise). However, unlike businesses there are fewer temporary solutions available to consumers facing default on their debt as debt servicing burdens rise dramatically. Their options are default via foreclosure, default via credit card nonpayment, default via auto repossession, or default on student loans resulting in wage garnishing by the lender.
Unlike non-financial businesses and consumers, the so-called ‘big 19’ U.S. banks and shadow banks avoided default by the U.S. Federal Reserve or Treasury giving them interest free loans to cover their debt payments (and then some). In fact, frequently the Federal Reserve ‘paid’ banks to take its loans, in effect offering negative subsidized interest loans to banks. This amounted to the U.S. government making the debt payments for the banks. This largesse did not extend, however, to the 8200 smaller regional and community banks, several hundred of which by the end of 2009 were allowed to default and were subsequently reorganized by the FDIC.
Notwithstanding possible short term or government subsidized solutions, the more protracted the period of deflation, and the greater the prior debt levels and poorer the debt quality, the more likely is default—either in its severe form of company asset liquidation or in the partial form of company restructuring involving selling off some assets and downsizing. Once again, the medium by which the rising debt is transmitted into default is deflation in either or all of its three price systems.
Default Feedback Effects
Defaults in turn provoke further price deflation. For example, bankruptcy means severe asset firesales. Bankruptcy in the form of a total liquidation of a company means all the remaining assets of the company are sold at auction at firesale prices. A good example is the late 2009 liquidation of the once hundred billion dollar valued communications equipment company, Nortel Inc. It sold its assets for less than $900 million in late 2009. Bankruptcy in the form of partial reorganization of a company, instead of total liquidation, also results in asset sales determined by the bankruptcy courts. The asset price deflation is not as severe but still quite significant. The very best assets are typically sold off at well below market prices.
Reorganizations also almost always result in a major downsizing of the company’s workforce and thus major layoffs of employees. The remaining workers are thereafter generally paid at reduced wages and extremely reduced benefits. Wage deflation thus occurs as job, hours of work, and earnings are reduced. As the restructured company re-enters the market, it typically must offer lower product prices in an effort to re-establish a new foothold once again in the market. Defaults therefore translates into more intensified deflationary pressures across all three price systems—asset, product, and wage.
While a restructured and reorganized company no longer has the burden of excessive debt and debt servicing payments, employees of that company—those laid off and those remaining—in contrast end up with less income. Their income is less but their prior incurred debt levels have not changed. In other words, their real debt has risen and their debt servicing difficulty has grown. All things equal, employees of the company must reduce their level of consumption. Lower consumption feeds back into lower product demand and further pressure to lower product prices and cut wages.
Non-bank defaults can provoke bank defaults, as well as vice-versa. When a non-financial business defaults, it means that the debt previously borrowed from its lender, a bank or other financial institution, becomes virtually worthless. The bank-lender must then write off the now ‘bad’ debt on which the non-bank defaulted. With a loss now on its own books, the bank needs to make up the loss by either adding more capital, selling more of its stock, borrowing from the government (i.e. Federal Reserve), or getting bailed out by the U.S. Treasury. Sufficiently widespread and numerous defaults by companies it lent to may result in the bank-financial institution itself defaulting. Until its losses can be offset by other measures, like asset sales, the bank or financial institution in question is generally reluctant to loan or issue credit to its business customers. Unable to obtain credit, the non-financial customers necessarily turn to asset, product and wage deflation solutions, thereby continuing the cycle. In short, debt drives deflation, which in turn drives defaults that subsequently feedback upon deflation.
A rising level of consumer defaults—housing, auto, credit card, other loans—may lead to losses and write downs and subsequent defaults of financial institutions as well. But consumer defaults more often negatively impact secondary levels of the banking system—i.e. thrift institutions, credit card companies, smaller community and regional banks, auto finance companies (GMAC, Ford Credit), credit unions, small business and consumer installment credit, etc. The effects are thus not necessarily direct on the tier one banking and financial institutions. They also impact what are called secondary credit markets as well. In the U.S. these include the securitized markets for credit card, auto, student and other loans which after 2007 virtually shut down and, at the present, have still to revive.
Epic Recessions occur when the debt-deflation process results in an increase in defaults that are sufficient in scope and magnitude to feed back upon and exacerbate debt and deflation—and in turn cause a further deterioration in both financial and consumption fragility. An Epic Recession evolves and grows in momentum, bringing it closer to depression, when the scope and magnitude of defaults significantly exceed historic averages, and when business and consumer defaults feed back upon financially fragile banks and institutions and precipitate a second round of major financial instability. In contrast to Epic Recessions, depressions are characterized by a series of banking-financial crises that take place in the context of a further deteriorating financial and consumption fragility.
Debt-Deflation-Default Nexus and Financial Fragility
This dynamic interactions and feedback effects between debt-deflation and, as debt-deflation intensifies, between debt-deflation and default as well, result in a further deterioration of both financial and consumption fragility.
Recall that both forms of fragility are a function of levels of debt, of the quality (terms and cost) of that debt, and of cash flow (business) or disposable income flow (consumer)—all three factors ultimately combined in the ratio of debt servicing to available cash-income flow. As debt rises or deteriorates, financial fragility rises; as the latter (cash flow) slows or declines, financial fragility rises as well.
Asset deflation drives a company toward more debt accumulation, thereby raising financial fragility. When a company’s assets are declining in value, it is not able as a rule to raise liquidity through new stock issuance. Existing stock prices in such situations are normally stagnant or declining due to public negative perceptions of the company’s future economic performance potential. Thus that door to raising cash flow to make debt payments is largely closed. In addition, the company lacks by definition necessary internal funds in such conditions. If it had sufficient internal funds it wouldn’t have to sell off assets in the first place to make debt payments.
Without internal funding or stock equity funding available, the company is necessarily driven to debt financing. Declining asset prices thus mean the company must seek more debt financing in order to make debt servicing payments. New levels of debt are added to existing debt. And if company is already overloaded with debt in the first place, new debt is normally only obtained at greater cost than old debt, which means debt quality declines and fragility rises as well. The company becomes even more financially fragile over time from debt, as asset deflation eventually forces it to acquire more debt.
But product price deflation similarly results in more financial fragility. Price deflation works on financial fragility from the cash flow side. If a company chooses to reduce product prices instead of selling assets to raise necessary cash flow, it may grow revenue and improve cash flow in the short run in order to service debt payments, but it does so by weakening its revenue base and future cash flow in the longer run. Albeit not as rapidly as asset price deflation, product price deflation therefore also eventually results in reduced cash flow to finance debt and consequently a deterioration in financial fragility.
The company can buy some time from having to resort to asset or product deflation. It may avoid reducing product prices initially by reducing planned real investment or by cutting production and operating costs, especially labor costs. Yet all three—suspending planned investment, cutting labor costs, and cutting other costs of production—also translate sooner or later into reduced revenue and cash flow. Wage cutting and wage deflation may serve as a temporary substitute for price deflation and thus delay a further deterioration of financial fragility in the short run. But wage deflation will eventually result in less productivity and thus higher costs and less cash flow. Cutting back on new investment and production also reduces productivity, with the same effects on rising costs and less cash flow. Because wage deflation’s impact on cash flow is less immediate than product price deflation, that is why businesses typically pursue wage deflation first before product price cutting. And wage cost reduction via layoffs before other forms of wage cutting, since layoffs affect productivity of remaining employees less than wage cutting for those that remain.
To summarize, there are a combination of effects from the interaction of debt-deflation-default that result in a deterioration of financial fragility. Sell off assets is the quickest way to raise liquidity with which to make debt service payments. But asset sales and asset deflation eventually lead to the need to raise more debt, locking the company in a cycle of asset sales to offset rising debt. Reducing product prices are an alternative to raising cash to cover debt payments. But it takes longer than asset sales to raise the cash and is also more uncertain. It also means the company’s real debt servicing in effect rises. Paying debt by product deflation means raising real debt. Companies if possible therefore initially turn to shutting down planned real investment and cutting operating costs, especially labor costs—first by reducing hours of work, then layoffs, then other forms of wage cuts. However, all three of these measures may result in immediate cash to service debt but ultimately result in a reduction of cash flow. All forms of deflation therefore exacerbate debt and debt servicing problems. In the real world, companies with rising debt servicing stress and facing default undertake all measures in some combination, as well seek to raise more debt (even if more costly) and delay if possible making debt payments.
Here’s Part 3 describing the processes, which create within the capitalist system a condition of ‘fragility’. That is, the increasing likelihood of a major financial instability event–i.e. stock or bond market crash, commodities futures crisis, derivative securities super-contagion and contraction, property values collapse (residential and/or commercial), and so on. (In the final Part 4 to follow, it will be explained how this process and multiple feedbacks, and ‘nexus’, occurs not just in the financial side of the economy, but may occur as well in the household consumption sector and the government sector. When all three sectors–financial, households, government–become ‘fragile’ as their separate ‘nexuses’ intensify, then the entire economic system may become ‘systemically fragile’.
Debt As Driver of Deflation
The prior debt levels created by excessive leveraging and the shift to speculative investing over the business cycle mean that, once prices of speculative assets begin to fall, the greater volume of debt previously accumulated over the cycle will result in a longer fall in the price of the assets. And the poorer the quality of that debt, the more rapid the fall. Thus the level and quality of the accumulated debt will determine the asset price deflation. Speculative investing works through the medium of accumulated debt in depressing asset price deflation, by creating excess debt as a result of creating ‘tiers’ of speculative instruments, ‘layered’ leveraging, and creating a false sense of reduced risk. Details of the debt-deflation process work something like this:
During the boom cycle, debt servicing payments are not considered a major factor to the investor. He intends to sell the asset after a price rise before the debt payments are due in any great volume. But this works only so long as the price of the asset continues to rise. When it doesn’t, if it declines, and sometimes even if it just slows in its rate of rise, then debt servicing payments come due and may become a burden. That debt servicing cost burden may prove significant if a large volume of debt was taken on in the original process of asset purchase and/or if the additional debt over time was of a poorer quality (i.e. shorter term and higher interest). Rising debt servicing costs may represent only one part of the growing cost pressure on the investor. Terms of borrowing for investors are often such that, should the value of the asset purchased fall below its original purchase price, the borrower is required to ‘make up the difference’. That is, put in more money assets or put up other assets as collateral. When that point is reached the investor typically tries to ‘dump’ the asset and sell it. But that may pose a problem as well, when most investors are trying to dump the asset and sell it at the same time. The more savvy investors quickly exited the market early in order to avoid the inevitable rising debt servicing cost and losses and write-downs that can quickly follow once prices start falling. Their exiting, however, accelerates further declining asset prices and rising debt servicing costs. Unable to sell the assets for which prices are deflating, the investor may turn to selling off ‘good assets’ (i.e. other classes of assets not losing value due to price declines) in order to make the rising debt servicing costs. In this manner asset price deflation may spread between classes of assets as well. A company as investor, for example, may have to sell its better assets in order to raise cash with which to service its rising debt costs. It can all become a self-fulfilling downward spiral; general asset price deflation can quickly set in.
Deflation Feedback Effects
It has been explained how, in the runup of a financial boom rising debt and excessive debt leveraging may result in excess demand for financial assets that drives asset price inflation to extraordinary levels. But speculative investing may also drive product price inflation in several ways. Speculation in food commodities and oil drives up futures options prices for these commodities which are passed on to what is called ‘core inflation’, energy and food prices, at the food and energy wholesale and consumer levels. Rising commodity prices for metals also causes a rise in product prices of crude, intermediate and finished producers goods, as metals and other raw materials prices are passed through producer goods prices. In turn, rising producers goods prices are eventually passed on in part to consumer products made from those producer goods. The consequence is a speculative investing-debt driven asset, as well as product, price inflation. Rising debt thus drives inflation. But the opposite may occur as well. That is, asset as well as product price deflation may actually result in a still further rise in debt levels and thus debt servicing stress.
The reverse scenario in which falling prices result in rising debt works something like the following: Once a financial bust and crisis has occurred, businesses don’t only sell assets that have started to collapse in price. First, the assets rapidly collapsing in price may prove difficult. The prices of the falling assets may have declined so far that their sale provides little revenue gains with which to make debt service payments. So the company may simply hold onto the asset that might be now virtually worthless instead of selling it. That is what, in effect, happened to many banks and shadow banks after 2007 that were caught holding collapsed securitized assets. The dollar value had fallen to as low as 10 cents on the dollar. In that situation, banks just held onto the collapsed and now nearly worthless assets. But they still had to make debt servicing payments, and perhaps as well make up for the lost value on those collapsed assets on their balance sheets. They therefore first sold other ‘good’ assets that had not yet fallen in price. That applies to non-finance companies that found themselves in a similar situation. For example, GMAC, the financing arm of General Motors, had speculated in securitized assets and lost billions. It played a major role in GM’s ultimate financial decline. GMAC had to sell off ‘good’ assets to compensate for the collapse in value of the ‘bad’ assets it couldn’t sell. Similarly, GM itself had to sell at ‘firesale’ prices real assets of several of its product divisions to cover the losses in assets at GMAC.
This, by the way, is also an example of a transmission mechanism illustrating how asset price declines can spread from asset class to asset class, eventually infecting good assets and setting off a general asset price decline. Cash flow must be raised in some manner in order to service debt payments coming due from debt accumulated during the boom phase. Selling ‘good’, as well as ‘bad’, assets is one response. But selling company assets, good or bad, is not the only way to raise cash with which to cover debt payments coming due. Reducing product prices to raise revenue and cash flow is another.
If the company is a non-financial institution, another alternative available is to sell more of the company’s inventory of real products in order to raise cash to make debt payments. But with a weakening real economy, selling more products requires lowering the prices of those products in order to increase sales revenue and raise the needed cash flow for debt servicing. This is an illustration of another transmission mechanism describing how asset price deflation can spread to product price deflation.
But lowering product prices in order to raise cash to service debt payments means the company’s real debt levels rise. Specifically, falling product prices results in rising real debt and thus a rise in the servicing costs of that real debt. The company’s original debt obligation and payments have not risen, but the company’s income and cash flow available with which to make the debt payments has fallen—i.e. the real debt load for the company has risen. Sometimes referred to as the ‘Fisher Effect’, this is an important process by which paying off debt by raising cash by lowering prices actually results in rising debt. It represents the process by which deflation can feed back and cause a rise in (real) debt, just as debt can result in deflation. If left unchecked, deflation results in a spiraling down of debt and deflation as they both feed upon and further exacerbate each other.
This debt to deflation and deflation to debt spiral is typical of Epic Recessions. If not checked early in the process, it may lead to a deepening and extending of Epic Recession. And if allowed to become particularly severe and protracted, it can play a central role in transforming an Epic Recession into depression.
Asset and product price deflation may also ‘spill over’ into wage deflation as well, further exacerbating the process. As product price deflation occurs and company revenues and cash flow eventually decline further, the natural management response is to cut operating costs as well. That is typically employment and wages for those left still employed after layoffs. In fact, it is not necessarily sequential. That is, asset firesales leading to product price deflation, then to wage deflation. A company facing particularly severe debt servicing stress may engage in all three forms of deflation at the same time more or less, selling assets, reducing product prices to raise more revenue, and cutting operating costs. However, cutting product prices will eventually lead to wage deflation. First as reductions in hours of work for a company’s labor force and in the form of layoffs. Both constitute forms of wage deflation for the general labor force at large. Total wage payments decline for workers as a group. For those still employed, wage deflation can assume more traditional forms of hourly wage rate reduction, suspension of bonuses, reductions in company contributions to benefit plans, etc. In Epic Recession, resort to non-traditional forms of wage cutting frequently occurs as well, such as ‘forced monthly furloughs’ (days off without pay), cuts in paid sick leave, vacation, and holiday pay, and other forms of supplemental compensation. The key point, however, is that product price deflation eventually spills over to wage deflation in a general way in Epic Recessions.
Wage deflation also has the effect of feeding back upon and exacerbating debt. In this case it is consumer debt levels that are affected. When workers’ experience reduced income from job loss and wage cutting, in effect their ‘cash flow’ also is reduced. Their real debt thus rises as well, as does their debt servicing stress. There is also a further feedback effect. Rising real debt for consumers means less consumption and therefore less demand for products. Product prices are in turn reduced further, causing additional rising real debt for business. In other words, rising real consumer debt results in a further rise in business real debt. Debt drives debt.
Finally, as business real debt rises and reducing product prices reaches its lower bound limits, businesses’ only option is to turn to selling more assets. Thus, deflation in wages and product prices drives a second round of asset price deflation. We now have a generalized process of the three types of prices—asset, product, and wage—each driving the other in a downward spiral through the medium of rising real debt for each. The more generalized and the more multiple feedbacks that occur, the more severe the condition of Epic Recession.
Debt-Deflation As Driver of Default
These processes of deflation and debt ultimately lead to a condition of default. When a business can no longer reduce wages (beyond a point it results in an insufficient workforce to produce its product), can no longer reduce product prices (further reductions would mean producing products for a price consistently below the cost of producing those products), and has few or no remaining real assets to sell to raise cash flow to finance debt payments—then the only alternative for the business is to default. That default may be on its debt servicing payments. Or it may take the form of a more serious company level default, meaning a bankruptcy.
Default may be postponed, however, by various means. Lenders may allow the business to ‘roll over’ its debt due—in effect reducing its debt payment levels in exchange for a longer term debt obligation. The business may simply borrow additional debt in order to make the payments on the original debt. Or it may convince lenders to accept stock in exchange for debt. If it is fortunate enough, it may invoke prior ‘covenants’ that allow it to suspend or slow its debt payments. Or perhaps the company’s original lender (financial institution) is itself near insolvent so it chooses not to take the company into bankruptcy court in response to the debt default, since doing that would require the lender to register even greater losses on its own balance sheet which it may be loathe to do. There are a host of measures that are designed to ‘buy time’ for a company facing default as bankruptcy. Most measures take the form, however, of the company taking on additional levels of long term debt amortized over a longer period in order to pay for increasingly unaffordable short term debt. A favorite option in 2009, for example, was for companies having difficulty making debt payments to sell more junk bonds to cover immediate debt. But this represents a temporary solution only. It means raising long term debt levels in order to finance short term debt payments.
A similar process to that described above occurs for consumers and consumer default. Falling consumer income from job losses, wage cuts, and growing inaccessibility to credit (wage deflation) means a greater difficulty paying for debt incurred during the boom phase (real debt rise). However, unlike businesses there are fewer temporary solutions available to consumers facing default on their debt as debt servicing burdens rise dramatically. Their options are default via foreclosure, default via credit card nonpayment, default via auto repossession, or default on student loans resulting in wage garnishing by the lender.
Unlike non-financial businesses and consumers, the so-called ‘big 19’ U.S. banks and shadow banks avoided default by the U.S. Federal Reserve or Treasury giving them interest free loans to cover their debt payments (and then some). In fact, frequently the Federal Reserve ‘paid’ banks to take its loans, in effect offering negative subsidized interest loans to banks. This amounted to the U.S. government making the debt payments for the banks. This largesse did not extend, however, to the 8200 smaller regional and community banks, several hundred of which by the end of 2009 were allowed to default and were subsequently reorganized by the FDIC.
Notwithstanding possible short term or government subsidized solutions, the more protracted the period of deflation, and the greater the prior debt levels and poorer the debt quality, the more likely is default—either in its severe form of company asset liquidation or in the partial form of company restructuring involving selling off some assets and downsizing. Once again, the medium by which the rising debt is transmitted into default is deflation in either or all of its three price systems.
Default Feedback Effects
Defaults in turn provoke further price deflation. For example, bankruptcy means severe asset firesales. Bankruptcy in the form of a total liquidation of a company means all the remaining assets of the company are sold at auction at firesale prices. A good example is the late 2009 liquidation of the once hundred billion dollar valued communications equipment company, Nortel Inc. It sold its assets for less than $900 million in late 2009. Bankruptcy in the form of partial reorganization of a company, instead of total liquidation, also results in asset sales determined by the bankruptcy courts. The asset price deflation is not as severe but still quite significant. The very best assets are typically sold off at well below market prices.
Reorganizations also almost always result in a major downsizing of the company’s workforce and thus major layoffs of employees. The remaining workers are thereafter generally paid at reduced wages and extremely reduced benefits. Wage deflation thus occurs as job, hours of work, and earnings are reduced. As the restructured company re-enters the market, it typically must offer lower product prices in an effort to re-establish a new foothold once again in the market. Defaults therefore translates into more intensified deflationary pressures across all three price systems—asset, product, and wage.
While a restructured and reorganized company no longer has the burden of excessive debt and debt servicing payments, employees of that company—those laid off and those remaining—in contrast end up with less income. Their income is less but their prior incurred debt levels have not changed. In other words, their real debt has risen and their debt servicing difficulty has grown. All things equal, employees of the company must reduce their level of consumption. Lower consumption feeds back into lower product demand and further pressure to lower product prices and cut wages.
Non-bank defaults can provoke bank defaults, as well as vice-versa. When a non-financial business defaults, it means that the debt previously borrowed from its lender, a bank or other financial institution, becomes virtually worthless. The bank-lender must then write off the now ‘bad’ debt on which the non-bank defaulted. With a loss now on its own books, the bank needs to make up the loss by either adding more capital, selling more of its stock, borrowing from the government (i.e. Federal Reserve), or getting bailed out by the U.S. Treasury. Sufficiently widespread and numerous defaults by companies it lent to may result in the bank-financial institution itself defaulting. Until its losses can be offset by other measures, like asset sales, the bank or financial institution in question is generally reluctant to loan or issue credit to its business customers. Unable to obtain credit, the non-financial customers necessarily turn to asset, product and wage deflation solutions, thereby continuing the cycle. In short, debt drives deflation, which in turn drives defaults that subsequently feedback upon deflation.
A rising level of consumer defaults—housing, auto, credit card, other loans—may lead to losses and write downs and subsequent defaults of financial institutions as well. But consumer defaults more often negatively impact secondary levels of the banking system—i.e. thrift institutions, credit card companies, smaller community and regional banks, auto finance companies (GMAC, Ford Credit), credit unions, small business and consumer installment credit, etc. The effects are thus not necessarily direct on the tier one banking and financial institutions. They also impact what are called secondary credit markets as well. In the U.S. these include the securitized markets for credit card, auto, student and other loans which after 2007 virtually shut down and, at the present, have still to revive.
Epic Recessions occur when the debt-deflation process results in an increase in defaults that are sufficient in scope and magnitude to feed back upon and exacerbate debt and deflation—and in turn cause a further deterioration in both financial and consumption fragility. An Epic Recession evolves and grows in momentum, bringing it closer to depression, when the scope and magnitude of defaults significantly exceed historic averages, and when business and consumer defaults feed back upon financially fragile banks and institutions and precipitate a second round of major financial instability. In contrast to Epic Recessions, depressions are characterized by a series of banking-financial crises that take place in the context of a further deteriorating financial and consumption fragility.
Debt-Deflation-Default Nexus and Financial Fragility
This dynamic interactions and feedback effects between debt-deflation and, as debt-deflation intensifies, between debt-deflation and default as well, result in a further deterioration of both financial and consumption fragility.
Recall that both forms of fragility are a function of levels of debt, of the quality (terms and cost) of that debt, and of cash flow (business) or disposable income flow (consumer)—all three factors ultimately combined in the ratio of debt servicing to available cash-income flow. As debt rises or deteriorates, financial fragility rises; as the latter (cash flow) slows or declines, financial fragility rises as well.
Asset deflation drives a company toward more debt accumulation, thereby raising financial fragility. When a company’s assets are declining in value, it is not able as a rule to raise liquidity through new stock issuance. Existing stock prices in such situations are normally stagnant or declining due to public negative perceptions of the company’s future economic performance potential. Thus that door to raising cash flow to make debt payments is largely closed. In addition, the company lacks by definition necessary internal funds in such conditions. If it had sufficient internal funds it wouldn’t have to sell off assets in the first place to make debt payments.
Without internal funding or stock equity funding available, the company is necessarily driven to debt financing. Declining asset prices thus mean the company must seek more debt financing in order to make debt servicing payments. New levels of debt are added to existing debt. And if company is already overloaded with debt in the first place, new debt is normally only obtained at greater cost than old debt, which means debt quality declines and fragility rises as well. The company becomes even more financially fragile over time from debt, as asset deflation eventually forces it to acquire more debt.
But product price deflation similarly results in more financial fragility. Price deflation works on financial fragility from the cash flow side. If a company chooses to reduce product prices instead of selling assets to raise necessary cash flow, it may grow revenue and improve cash flow in the short run in order to service debt payments, but it does so by weakening its revenue base and future cash flow in the longer run. Albeit not as rapidly as asset price deflation, product price deflation therefore also eventually results in reduced cash flow to finance debt and consequently a deterioration in financial fragility.
The company can buy some time from having to resort to asset or product deflation. It may avoid reducing product prices initially by reducing planned real investment or by cutting production and operating costs, especially labor costs. Yet all three—suspending planned investment, cutting labor costs, and cutting other costs of production—also translate sooner or later into reduced revenue and cash flow. Wage cutting and wage deflation may serve as a temporary substitute for price deflation and thus delay a further deterioration of financial fragility in the short run. But wage deflation will eventually result in less productivity and thus higher costs and less cash flow. Cutting back on new investment and production also reduces productivity, with the same effects on rising costs and less cash flow. Because wage deflation’s impact on cash flow is less immediate than product price deflation, that is why businesses typically pursue wage deflation first before product price cutting. And wage cost reduction via layoffs before other forms of wage cutting, since layoffs affect productivity of remaining employees less than wage cutting for those that remain.
To summarize, there are a combination of effects from the interaction of debt-deflation-default that result in a deterioration of financial fragility. Sell off assets is the quickest way to raise liquidity with which to make debt service payments. But asset sales and asset deflation eventually lead to the need to raise more debt, locking the company in a cycle of asset sales to offset rising debt. Reducing product prices are an alternative to raising cash to cover debt payments. But it takes longer than asset sales to raise the cash and is also more uncertain. It also means the company’s real debt servicing in effect rises. Paying debt by product deflation means raising real debt. Companies if possible therefore initially turn to shutting down planned real investment and cutting operating costs, especially labor costs—first by reducing hours of work, then layoffs, then other forms of wage cuts. However, all three of these measures may result in immediate cash to service debt but ultimately result in a reduction of cash flow. All forms of deflation therefore exacerbate debt and debt servicing problems. In the real world, companies with rising debt servicing stress and facing default undertake all measures in some combination, as well seek to raise more debt (even if more costly) and delay if possible making debt payments.
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