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“In summary, we find that: (1) economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclical oscillations of innumerable kinds; (2) among the many occasional disturbances, are new opportunities to invest, especially because of new inventions; (3) these, with other causes, sometimes conspire to lead to a great volume of over-indebtedness; (4) this in turn, leads to attempts to liquidate; (5) these, in turn, lead (unless counteracted by reflation) to falling prices or a swelling dollar; (6) the dollar may swell faster than the number of dollars owed shrinks; (7) in that case, liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better, as indicated by all nine factors; (8) the ways out are either laissez faire (bankruptcy) or scientific medication (reflation), and reflation might just as well have been applied in the first place.” – Irving Fisher, The Debt Deflation Theory of Great Depressions (1933) “There is the possibility... that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control.” – John Maynard Keynes, The General Theory (1936)

Executive Summary
The essence of how our view differs from the consensus is that we believe the economies of the developed world are experiencing an extended deleveraging process rather than recovering from a “garden variety” recession. In this two-part Broyhill Letter, we will explore the mechanics of a Deleveraging Process, which is best described as a unique economic environment that severely distorts typical market functioning. Government actions to date have largely focused on measures intended to prevent this powerful deflationary force from spiraling out of control – Irving Fisher’s prescribed “reflation.” But government policies cannot halt this process. There are ceilings to debt growth and deleveraging must occur once the burden becomes too large for the credit bubble to continue. Government actions have been “successful” to date, resulting in a slower pace of deleveraging and Averting Armageddon. But a slower pace also means that it will take an extended period of time for households to rebuild balance sheets and until this process is complete, shrinking private sector debt levels will retard spending and slow growth. Reinhart and Rogoff demonstrated that severe financial crises typically produce an acute disruption of economic activity. In the decade prior to a crisis, domestic credit as a percent of GDP climbs about 38 percent and external indebtedness soars. Quite often, this leverage ratio continues to increase after the crisis as private sector debt is transferred onto public sector balance sheets, despite the fact that a credit crunch is underway (this should sound familiar). During the ensuing Deleveraging Process, credit declines by an amount comparable to the surge after the crisis. However, deleveraging is often delayed and is a lengthy process lasting a full decade or even longer. Typically, the greater the unwillingness to write down nonperforming debts, the longer the deleveraging process is delayed. The decade that preceded the onset of the 2007 crisis fits the historic pattern. If deleveraging of private debt follows the tracks of previous crises as well, credit restraint will damp employment and growth for some time to come. The unwinding of debt is far from complete

Balance Sheet Recession
In a “typical” economic cycle, growing demand eventually creates tightening capacity and causes inflationary pressures to build in the system. As central banks tighten monetary policy (i.e. raise rates), growth slows and recessions follow. Recessions relieve the system from building inflation, allowing the central banks to reduce rates and stimulate new lending and economic growth. That’s a “typical” cycle – ah, the good old days. Whereas a garden variety recession is caused by inflation and excess inventory, a Balance Sheet Recession ocurs in the wake of a debt-financed asset bubble that leaves private sector balance sheets overleveraged and unable to service the growing

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wall of debt with existing cash flow. Hyman Minsky referred to these swings in the financial system from stability to crisis as the Financial Instability Hypothesis. Minsky wrote, “...from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes, the economic system’s reactions to a movement of the economy amplify the movement – inflation feeds upon inflation and debt-deflation feeds upon debt deflation.” There is a very big difference between these two states. When everyone tries to save more and spend less, the whole economy is suffocated by a lack of spenders – the so called Paradox of Thrift. When everyone focuses on minimizing debt rather than maximizing profits, the net result is a saving surge that drives down income, price levels and interest rates. In most cases, the government becomes “the spender of last resort” as a consequence of the chronic lack of credit demand. Monetary policy works during a “typical” economic cycle, because lenders and borrowers respond to lower interest. But during a Balance Sheet Recession, reality runs counter to academic theory, which suggests that lower interest rates will generate an increase in borrowing. Conventional thinking lacks an understanding of debt dynamics. When a credit bubble financed by borrowed money bursts, liabilities remain despite the collapse in asset prices. The rationale response is for the private sector to pay down debt to a more manageable level – a level back in line with income and the ability to service that debt. If the private sector’s demand for funds with interest rates at zero is still declining, there is no reason to hope that monetary policy can generate a recovery. At the individual level, deleveraging occurs to repair balance sheets. But when most of the private sector deleverages at the same time, bad things happen. The economy falls into Irving Fisher’s classic Debt Deflation where the mechanics of a normal economy break down: “Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.”

Borrowing & Binging
Over the past decade, US consumers have learned a very important lesson – at least, we hope. Wealth created by inflated asset prices is not trustworthy. Income growth is required to service the excessive debt left behind by previous bubbles. Income growth is necessary because asset prices are prone to collapse, while debt bubbles stubbornly remain in place. Our work indicates that deleveraging is likely to continue until debts get back into alignment with income. Despite massive (ongoing) foreclosures and curtailed credit lines, household debt relative to income remains at a sky high 114% through early 2011. This ratio had never been

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above 100% until last decade. It peaked at 130% of disposable income in early 2008. The long term average is 75%. The US economy remains extremely over-indebted. The aggregate private debt to GDP ratio is now 267%, versus the peak level of 298% achieved back in February 2009. With debt levels as high as they are, the potential for further deleveraging still exceeds the worst that the US experienced during the Great Depression. The risk is that the Desire to Deleverage and the secular trend toward Pinching Pennies becomes so ingrained that consumers’ appetite for debt becomes permanently impaired even after balance sheets are repaired. This Debt Rejection Syndrome was what triggered the Great Depression and kept interest rates from normalizing for three decades. It is quite possible that we experience a similar dynamic today. Consider that Japan is still dealing with its aversion to borrowing after two decades. With long term interest rates still hovering around one percent, signs of normalization are few and far between. If the structural weaknesses at home are not addressed quickly, we suspect many households will share the same aversion for debt, and interest rates will remain remarkably low for a remarkably long time.

Enter Quantitative Queasing
Market forces are trying to correct the excesses created by a massive debt bubble blown over an entire generation. Government policies can and have slowed the process. But they cannot stop it. The Fed can boost the monetary base all it wants, but The Bernank cannot make overleveraged consumers borrow more. Reigniting animal spirits is easy when debt levels are low, but reigniting them when debt levels are astronomical is much more difficult, if at all possible. With Debt to GDP already at unprecedented levels, the chances of enticing the private sector to lever up are remote. Deleveraging must occur. Bernanke can publish Op-Eds singing the praises of Quantitative Easing all he wants, but he cannot force marginally capitalized banks to lend to borrowers of questionable quality. The spike in excess reserves indicates that banks aren’t lending. In other words, the money isn’t flowing into the economy. Something is broken. As the monetary base has increased, the private sector has rationally chosen to hold onto the extra cash. This is the hallmark of a classic Liquidity Trap. With interest rates effectively at zero, there is little incentive to invest sidelined cash for what equates to a minimal enhancement in yield. QE may or may not be “successful” in lowering interest rates. But the cost of money is not the issue here. Credit growth is no longer a function of interest rates. Interest rates are already low enough that a further decline toward zero is hardly

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likely to increase loan demand. Loan demand will increase when profitable opportunities arise. Not before. And not until debt burdens are reduced to more normal levels in relation to income. Until then, the private sector will continue to deleverage.

Lessons from Japan
Few historical periods are relevant to today’s economic landscape, as deleveraging processes are a “once in a lifetime” occurrence. The two last credit bubbles in the US were followed by The Panic of 1873 and the Great Depression in 1933. Japan’s Lost Decade(s) provides the most relevant experience outside of America. In each case, debt alone is not the culprit. Rather, the problem is the credit-induced asset bubbles that predictably follow rapid increases in debt levels (China bulls should re-read this last sentence). The story always ends the same. Obscenely elevated asset values ultimately collapse, leaving behind all of the debt used to finance asset purchases. Multiple parallels exist between how Japan and the US responded to their respective crises. The duration and magnitude of both the rise and the fall of house prices in these two countries are almost identical. Deleveraging in Japan lasted for decades. Why anyone expects quantitative easing in the US to be any more successful than it was in Japan, is beyond us. Despite zero interest rates, any demand for credit has been dwarfed by debt repayments. Falling demand for credit translates into falling aggregate demand until private sector balance sheets are repaired and the private sector is borrowing again. An expansion of the monetary base does little to prevent this powerful force, contrary to what economists read in text books today. We do not question the Fed’s ability to increase the supply of money in the economy or its desire to reduce the level of interest rates. But neither of these factors represents a constraint on economic growth today, so there is no benefit to accomplishing them. Economists like to describe this behavior as Pushing on a String. We think it’s fitting. The chart to the right from Dr. John Hussman, plots the velocity of the US monetary base against interest rates since 1947. Dr. Hussman explains that:

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“Few theoretical relationships in economics hold quite this well. Recall that a Keynesian liquidity trap occurs at the point when interest rates become so low that cash balances are passively held regardless of their size. The relationship between interest rates and velocity therefore goes flat at low interest rates, since increases in the money stock simply produce a proportional decline in velocity, without requiring any further decline in yields. Notice the cluster of observations where interest rates are zero? Those are the most recent data points.” Clearly monetary base expansions have little effect on GDP. When the quantity of base money is increased, velocity falls in nearly direct proportion. The charts below compare the same historical information for the US and Japan over the past two decades. The cluster of points at the bottom right reflects the most recent domestic data.

Bottom Line
We believe that monetary policy and credit creation can have a profound effect on asset prices, often distorting economic reality. Financial asset prices can diverge from the real economy in the near-term, and often for longer than one would expect, but cannot remain permanently divorced from economic fundamentals. That said, the current cycle in developed economies has proved to be far different from “post-war” economic cycles. This time around, the deepest post-war recession was followed by one of the weakest post-war recoveries (chart below). Moreover, that lackluster rebound came despite unprecedented policy support. This suggests to us that the “vanilla” cycles of the post-war era may not be a very useful guide for what lies ahead. Comparable periods in history are rare, but if you look hard enough, you can find them. Japan continues to offer some important lessons in our view. During its lost decade(s), fiscal policy was the most effective tool in generating recovery. Unfortunately, temporary recoveries (and stock market rallies) typically ended as fiscal support was removed (left chart). Governments like inflation because it leads the sheep into believing that things are better than they are. It is easy to mistake rising prices with increasing growth. It also helps the largest debtors (i.e. the government) pay down debt with freshly printed dollars. But unfortunately for the Fed, the trajectory of inflation across the developed world has stubbornly followed the precedents of other periods characterized by long lasting slack .

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For the most part, big deficits and government debt have yielded low inflation, as growth proves to be sub-par and the slack is absorbed only slowly. Recent readings of core inflation suggest that we are just one cyclical downturn, or financial accident, away from outright deflation. One of the key lessons investors should have learned from Japan’s lost decade(s) was that, however low bond yields seemed to be, they always fell lower alongside the business cycle (see chart to the right). Quantitative easing is coming to an end, which implies tighter monetary policy. In 2012, developed world economies will face the first significant removal of policy stimulus – like Japan so many times before (see chart to the right). Based on IMF estimates, the fiscal tightening will be the most severe since 1981. That tightening contributed to the subsequent recession. In 1937, it took only the end of quantitative easing and the tightening of fiscal policy to create a hard landing for the post-depression recovery and a 50% decline in stock prices. It’s too early to call for a contraction in economic growth at this point but the odds are beginning to mount to the downside. And given the probability of continued economic pressures driving demand for “risk free” assets, the likelihood of sustained upward pressure on bond yields is limited . . . at least for now. We’ll explore the implications for investing during deleveraging processes in the second portion of this quarter’s Broyhill Letter.

- Christopher R. Pavese, CFA

The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The author’s opinions are subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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