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Massive Debt Deflation in Store?

February 14, 2009

Resource Investor quotes Elliot Wave analyst Steve Hochberg

“The systemic build up of total market credit is so large, currently about $52 trillion, that its implosion will swamp the Fed’s attempts to inflate. And as Conquer the Crash discusses, the remaining dollars that are not extinguished through bankruptcy, restructuring and write-offs, will increase in value. The thirst for cash will be insatiable relative to all other assets.

“Initially, the Fed’s attempt to inflate was akin to using a garden hose to refill Lake Mead after the Hoover Dam collapsed. Over the past five months the chart shows that the Fed has graduated to a fire hose. But creating just over $2 trillion in the face of a contracting pool of $52 trillion in total credit market debt is just not going to get the job done, and the only thing getting hosed right now is us.”

“Eventually credit will contract to the point whereby the income generated from economic production will be able to sustain it and at that point, yes, the U.S. dollar should indeed collapse of the weight of all the Fed’s machinations and gold should soar. But before the market arrives at that point, deflation must run its course. In our opinion, there is still a long way to go.”

But how far? A lot depends on the composition of that $52 trillion in credit. It can’t all just vanish can it? But how much of it is securitised by relatively stable assets? And how much of it could potentially melt away under the intense heat of deflation?

This quote in my opinion overstates the case for deflation.

Suppose that on an isolated island the total money supply consisted for 1000 oz of gold and there are no fractional reserve banks. Now suppose that people lend either other various sums of money. Total debt could expand if the same money were lent and re-lent by the borrower more than once (which happens with a lot of securitized financial instruments). Suppose that total nominal debt reached 2000oz of gold, twice the money supply. Now if all of this debt defaulted (not realistic but for the sake of discussion), would there be any general deflation? No, because the money supply remained the same.

The only way that debt default is deflationary is if the debt that is defaulting was created out of nothing by a fractional reserve bank. The default of that sort of debt is deflationary. Because the price system is an integrated single market, all debt competes against all other debt, and all money supply changes affect all prices. So in a system like ours where some debt is created by banks as bank deposits, while other debut, such as bonds only transfers existing money, default of non-bank debt will eventually work its way through the price system and have some effect on bank debt.

The total amount of money created out of debt puts an uppler limit on the magnitude of deflation that can occur. A quick trip over to the St. Louis Fed shows that the currency component of M1 is about 800 billion, and the currency component plus demand deposits is about 1.2 trillion. Demand deposits are therefore about about $400 billion. (The remainder of M1 is time deposits, which are transfers of existing funds, not money creation).

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