Will Trump Defuse the Coming Debt Deflation Bomb?
Trillions in global debt could default, while the economic cleanup from COVID-19 could take much longer than anticipated.
The mounting wreckage in the global economy as a result of the COVID-19 pandemic that began in Wuhan, China, is quickly surpassing the damage seen after the 2008 financial crisis. The good news of sorts is that the banking and payments system is strong and in no immediate danger of the sort of liquidity problems that brought the global economy to its knees more than a decade ago.
The bad news is that just about every other major business is suffering from reduced sales volumes and activity levels. Many companies are being forced to lay off people and close operations. The cumulative impact of deflation on corporate and personal finances and credit profiles could be catastrophic and long-lasting. The fact that debt levels at many private companies and public agencies are high by historical standards could worsen the crisis of debt deflation that lies ahead.
The scope and speed of the economic change have been breathtaking. In China, for example, industrial output has fallen dramatically and unemployment in the cities is rising—this according to official statistics from the Chinese Communist Party. But around the world, government actions to reduce the rate of infection are also resulting in rising unemployment and falling production. New York City, for example, has essentially shut down all public schools and meeting places except for food stores and pharmacies. The financial and social cost to New York as a result of the loss of revenues from tourism and other activities is incalculable.
The Federal Reserve and global central banks have cut interest rates and added massive amounts of liquidity to the global markets, prudent actions that are still not having much impact on the anxiety felt by the public. Many Americans are now facing a two-week period of self-isolation in order to slow the rate of infection, an involuntary sojourn that will negatively impact the finances of just about every public and private organization. The world economy is, in a very real sense, under siege by COVID-19.
At the very least, the global economy faces a difficult period for years ahead. Think of it this way: just about every company in the U.S. has effectively received a credit downgrade as a result of the response to COVID-19. Markets, banks, and investors do not yet understand how to translate this economic reality into prices for stocks, bonds, and credit. Even as the Federal Reserve and other central banks act to blunt the impact of the crisis by providing liquidity, the markets remain weak because investors cannot describe much less quantify the degree of the changes and the risk to the private debt and equity markets.
Governments are moving next to provide relief to those severely impacted by the outbreak, but private employers such as airlines, hotels, restaurants, and other public facilities are still likely to feel a severe financial shock. Because of the scale of the crisis, there will be no bailouts for the shareholders or creditors of private companies caught in the vise of economic deflation. As a result, Americans should expect to see a dramatic increase in business closures and bankruptcies, and eventually in credit losses for U.S. banks and investors.
Part of the reason that the financial markets seem, so far, to be indifferent to the massive amount of liquidity injected by the Federal Reserve and other central banks is the huge degree of asset inflation that the Fed, the European Central Bank, and the Bank of Japan have created with their unconventional monetary policies. These policies include the purchase of securities and open market operations to depress interest rates. Stock prices in the U.S., for example, have been inflated to grotesque valuations by the Federal Open Market Committee, which now pretends to offer the solution to this very same problem as equity markets collapse.
The irony of the situation would be amusing were the consequences not so terrible. Since the 2008 financial crisis, the Fed and other central banks have used low or negative interest rates to stave off debt deflation and created vast asset bubbles in stocks and real estate in the process. Why? Because the world has far too much debt.
For years now, the Fed has fretted that inflation is too low. This is another way of saying that debt is too high. But now, thanks to the black swan event of COVID-19, the global economy faces a period of debt defaults and restructuring that will dash the hopes of central bankers. Until we begin to see markets address credit, corporate cash flows, and lending disruptions from an economic shock that is still expanding in scope and scale, the markets are likely to remain in turmoil.
As the great economist Irving Fisher wrote in his great essay on debt deflation in 1933, “if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself.” The big question is this: does the Trump administration and the Federal Reserve understand the wave of debt deflation that is approaching the global economy?
Because of the strength of the U.S. financial system and the huge reservoirs of financing capacity that the U.S. government commands, the resources exist to address the immediate economic impact of the crisis. The longer-term changes, however, to consumer behavior and consumption patterns, may prove more difficult to mitigate. That’s especially true if many providers of travel and leisure services, for example, disappear in the fires of debt deflation.
The amount of private debt around the world that could default in the next years totals into the trillions of dollars, suggesting that the cleanup from COVID-19 could take many years to accomplish. More than any economic or financial expedients, however, the biggest driver of the mounting economic catastrophe is a lack of information and the fear that arises from uncertainty. Governments in the U.S. and around the world need to do a better job of informing the public and helping to set expectations for the weeks and months ahead.
The Trump White House has gotten off to a slow start in crafting a narrative of recovery. This has changed in recent days, however, as the administration’s message has become more refined. The White House must set expectations about the economic effects of COVID-19. That means not just unemployment and other short-term dislocations but the prospect of the financial failure of many private employers and public organizations. Proposed fiscal action by Congress will be helpful in this way.
President Donald Trump needs to learn from the tragedy of Herbert Hoover in the 1930s, who knew there was a problem with the U.S. economy but didn’t act effectively to deal with the mounting crisis. The lack of purposeful action between the election of FDR in November 1932 and when Roosevelt took office in March 1933 allowed the banking crisis of 1933 to explode. A century later, the government needs to grasp the deflationary problem that faces us all and act to avoid a repeat of the Great Depression. Fortunately, the response is accelerating and this is indeed a reason for optimism.
Christopher Whalen is an investment banker and chairman of Whalen Global Advisors LLC. He is the author of three books, including Ford Men: From Inspiration to Enterprise (2017) and Inflated: How Money and Debt Built the American Dream (2010). He edits The Institutional Risk Analyst, and appears regularly on such media outlets as CNBC, Bloomberg, Fox News, and Business News Network. Follow him on Twitter @rcwhalen.