Debt can be a tricky thing.
As everyone who ever held a margin account knows, when prices of shares in your portfolio go up, the ability to buy stocks on margin is a very good thing. It becomes leverage — a lever that helps you to lift your portfolio. But when the market turns against you, leverage is an albatross around your neck. It’s easy to lose your capital and end up owing interest on money you borrowed.
The same principle applies to the macro economy. When the economy is expanding, being able to borrow is a blessing. You can take advantage of a wider range of opportunities, offering in return not a share of your profits, as you would to an equity partner, but a set percentage. But when the economy stagnates or shrinks, debt becomes a killer — as the roughly one third of U.S. households owing more on their homes than they are worth can attest.
Incidentally, the fact that economies in Europe were stagnant throughout the Middle Ages may explain the prohibition on money lending by the Catholic Church.
The invention of money, and especially paper currency not backed by gold or other assets, added an “accelerator” to the Jekyll/Hyde dichotomy of debt. Paper money goes hand in hand with inflation, which reduces the value of funds in which borrowers repay their debts. Inflation occurs in periods of rapid economic growth, so that being leveraged becomes even more advantageous.
Not so when prices are falling — and money is appreciating. Deflation happens when growth stagnates or goes in reverse, adding an extra burden on debtors. Suddenly, it becomes a vicious cycle. Debtors want to pay down debt, because they see its real value going up. Moreover, what during an upturn looked like a bargain borrowing rate of, say, 6 percent, suddenly becomes 11 percent if deflation is running at a 5 percent annual clip. But paying down debt may be difficult if you lose your job or if your assets lose value.
A deflationary environment becomes a no-win situation for debtors, who may end up in bankruptcy. But deflation is horrible for creditors, too, because not only their default rates rise, but the value of the collateral they seize falls — as banks running today’s foreclosure sales have discovered.
In the United States, where private consumption accounts for 70 percent of GDP, deflation also delays economic recovery. That’s because when prices are falling, consumers start postponing their buying decisions on hopes that prices will decline further. This makes further price cuts a self-fulfilling prophesy.
There has been considerable optimism a year after the Lehman collapse. The IMF announced that the global recession ended in the second quarter, and the Federal Reserve, having patted itself on the back for saving the world by infusing trillions into the banking system, predicted that the U.S. economy is about to return to growth.
However, the economic environment continues to point to a deflation, as both producer and consumer prices fell over the past year. Job losses have been swift and severe, with around 7 million positions lost in a year and a half. Consumer credit outstanding declined in nine of the past 12 months. Savings rates rose after falling to zero late in the expansion, and consumer spending sagged, suggesting that households are indeed trying to pay down their debts.
Central bankers fear deflation even more than they fear inflation. When inflationary pressures accelerated in 2006-07, the Fed took its sweet time raising interest rates and certainly didn’t starve the economy of credit in order to stem price increases. But when a deflationary specter began to emerge in late 2008, rates were slashed to zero and the printing press was turned on full-speed.