Saturday, May 23, 2009

Debt Deflation Depressions

As Irving Fisher noted, depressions are always associated with high indebtedness. Attempts to liquidate this debt then induce deflation which actually increase real indebtedness. The only ways out of this are repudiation of the debt through default, reduction of the debt through inflation, or repayment of the debt over time. Is it possible or even desirable to prevent the rise of indebtedness?

The source of indebtedness changes between depressions. The Panic of 1837 centered on real estate, the Long Depression of 1873 on railways, the Great Depression of 1929 on stocks. Not that these areas alone were affected. Debt spreads to whatever can absorb it, it is just that there are not that many areas of sufficient capital value at a given time to absorb large amounts of debt. Real estate is a common one, as are large scale infrastructure such as canals and railroads, utilities such as electricity and telecommunications, to stocks. Only the largest, most capital intensive, most geographically extensive, most economically productive, most impressive new industries qualify, but as these are at the center of the economy, all others are encompassed by them.

The amount of lending reaches a climax, optimism reducing risk perceptions. Conservative lending can prevent credit bubbles by focusing on retrospective rather than prospective views, and based on income as much as asset values, but whether conservative lending can be maintained amidst the temptation of quick easy gains is difficult. Easy lending then chases out hard lending as easy lending increases all asset prices, even those hard lending lends on. Once the price of an asset becomes detached from the value of the income to pay for it, once the price comes from the gain expected rather than the dividend generated, a bubble becomes inevitable.

Some approaches to preventing this have been to limiting the amount of debt raised through debt covenants, limiting the debt leverage involved which was done in the case of stocks, and limiting the types of loans allowable such as requiring income documentation and requiring qualification at market interest rates, and these can work, but only if maintained and required. It will probably take another generation for people to forget and for the temptation of easy lending to arise and it will likely occur in some different area as yet untouched by it. A vigilant market and a vigilant regulator may keep it at bay longer, but when our guard is down and we least expect it, it may come again.

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