So, how does a deflationary depression resolve itself?
By Bill Tilles and Len Hyman:
When Ray Dalio, founder of the world’s largest hedge fund, Bridgewater Associates, referred to a possible economic depression as he was being interviewed at the World Economic Forum at Davos, it does not mean what most people think it means.
Most of us think about recessions and depressions in a linear way. That is, a depression is a really, really bad recession featuring even higher levels of unemployment and lower overall levels of economic activity.
But for Mr. Dalio, recessions are kind of normal, business-cycle related economic events that regularly occur every 5-10 years or so. The economy begins to overheat, the Fed raises rates in response (the removal of the “punch bowl”), business activity slows perhaps a bit too much in response, and voila! A recession results.
Depressions on the other hand are secular or long term, occurring much less frequently. That’s because according to Mr. Dalio, it takes a long time (perhaps decades) to accumulate the excess levels of corporate and government debt that end up triggering this type of economic event. A depression is a condition where more debt cannot be added to the system and instead it must be reduced, or as we say, deleveraging must occur. A depression always threatens systemic solvency.
There are several hallmarks of a systemic deleveraging or depression if you will:
- Various asset classes begin to be sold (like oil and gas wells today for example)
- As a result of these widespread asset sales, prices decline
- Equity levels decline as a result
- This triggers more selling of assets
- Since there is less worthwhile collateral available credit levels contract
- Overall economic activity declines. In short, there isn’t enough cash flow being generated to service all the accumulated debt. As a result assets have to be sold, bankruptcies become more common.
What makes this such a pernicious process is that it is a self-reinforcing cycle of economic negativity.
There are two “interesting” features of a depression.
First, with interest rates already at the “zero bound,” monetary policy ceases to be effective. There is no “punch bowl” to remove so to speak. In his interview on CNBC, Mr. Dalio explicitly stated we should forget about expecting future rate increases from the Fed and get ready for QE4, more asset purchases. In other words, the much maligned tightening cycle will end up as “one and done.”
Second, depressions also bring economic deflation. The credit impact of deflation is to raise the real rate of interest. The “real” rate is simply the stated rate minus the rate of inflation. When inflation is negative, the result is additive (subtracting a negative means you’re adding). This makes things even worse for heavily indebted borrowers at every levels: individual, corporate or government.
So if Mr. Dalio believes the Fed should resort to more QE, what does this mean? Quantitative easing has pushed up asset prices. But in doing so, it also lowers the value of expected future returns. As a result the economic risks have become, as he said, “asymmetric on the downside.”
In other words, too much risk for too little return. Almost as an afterthought he stated that if assets remain correlated and things continue to move in the “wrong” direction, ‘”there’ll be a depression.”
Sorkin and Quick, the CNBC interviewers, asked him what individual investors should do to protect themselves. His discomfort with the question was all but palpable. Diversification among broad asset classes was mentioned. But things really got weird when he cited self-help guru Tony Robbins, who has recently discovered finance, as having things to say. Ray Dalio citing Tony Robbins is like Albert Einstein suggesting that we consult Minnie Mouse for an explication of what he meant by the impact of gravitational forces on the time space continuum.
So, how does a deflationary depression resolve itself? Mr. Dalio was rather circumspect the other day. But in his words I thought I heard echoes of the late economist, Hyman Minsky. (I don’t think I’m alone here either.)
Dr. Minsky’s focus was long-term debt cycles and how prosperous economic times could lead almost inevitably to a financial crisis through the over accumulation of leverage. In good times, too much corporate debt is a minor hindrance. In bad times it leads straight to bankruptcy when contracting revenues prevent the timely payment of principal and interest.
He articulated almost presciently the financial excesses that led to the subprime lending crisis although he never lived to see it. Add to this the notion of banks further tightening lending standards at financially inopportune moments, and the self-reinforcing nature of the problem becomes evident.
For Minsky, who was a devotee of Keynes, booms and busts were an inevitable part of the free-market capitalist system. In part he saw it as hard wired into our nature. As inherent herd followers, we are inclined to act like momentum investors not value investors. This also means that by our natures, we exacerbate economic extremes both high and low. As a result he saw an important role for the Fed as a counter-cyclical agent and was staunchly opposed to financial deregulation.
What now? My guess is that Mr. Dalio, perhaps leaning on Dr. Minsky, sees the Fed as having a big problem. They can’t lower interest rates much because they’re already at historic lows. So that tool is gone. And even if they did encourage more corporate borrowing to stimulate the economy, they’d be adding more debt to already stretched balance sheets, thus furthering financial instability. Rock, meet hard place.
If the economy continues to wind down and the Fed, out of ammo, does nothing, they risk the prospect of sitting idly by, watching a self-reinforcing deflationary contraction — their worst nightmare.
The alternative to this unpleasant scenario is for the Fed to attempt to “reflate” the economy. In Dr. Minsky’s time, he probably would have advocated letting the Fed “run the printing presses” in the hopes of generating inflation. The idea is straightforward. If there is too much nominal debt, reduce the real economic burden by raising the inflation rate and hope the economy eventually grows out of it. The drastic way to accomplish the same thing is a currency devaluation followed by government guarantees of key financial intermediaries.
If we enter into a severe deflationary spiral, as suggested by Mr. Dalio’s comments, will our economic policymakers over-compensate with a hefty dose of inflation? No one ever said being an investor was easy. By Bill Tilles and Len Hyman.
But nothing goes to heck in a straight line. Read… After $7.8 Trillion Got Wiped Out in three Weeks, “Global Stocks Surge Most since 2012”