I keep hearing talk that defaults on debt are deflationary.

Is this really true?

Debt is what causes demand for dollars. Debt, denominated in dollars, demands dollars to service. If I punt my debt, I no longer need dollars to pay it back. Dollar demand goes down in that case, not up. That's inflationary. But the creditor also loses his revenue stream asset and that's deflationary.

The amount of dollar demand destroyed is exactly equal to the debt Therefore debt default is neutral, neither inflationary, nor deflationary.

Debt (created out of thin air) creates the SUPPLY of dollars (in account balances) ... so total money supply = total debt.

Payoff ALL debt ==> total money supply vanishes. (Uber deflationary)

Dollar demand falling is not inflationary.
Dollar supply rising IS inflationary. Why?

Inflation and deflation are measured with respect to the equilibrium amount of money and credit in the system.

If dollar demand falls, and if dollar supply falls with it, its deflationary. (Aggregate money supply declines.)

If dollar supply rises, but demand falls, you get pushing on a string. Its not deflationary. Its an inability to inflate further.

One other thing, if you punt on your debt, your demand for dollars falls (dollar liabilities drop), but so also does the supply of dollars since someone else (the creditor) now has fewer "assets." That's still deflationary, as monetary aggregates fall.

Money is destroyed at the inverse of the fractal accounting ratio it was created at- hence if a 500k home debt- created 4:5 miillion in new debt if money is being created debt that is with new debters each signing on the dotted line- once that debt is destroyed then it destroys all that leverage in reverse - at least that is what I am theorizing why the big fear of home defaults and why they trick people into staying in underwater homes with a bunch of so called home preservation loans

Supply of credit greatly exceeds dollars in circulation.

If debt defaults, a creditor is hurt and cannot loan as much money to others as well as the person who defaulted now has ruined credit and cannot borrow money.

Both things hurt supply/use of credit which is far more important than how many phyiscal FRN's there are to spend.

What Poer said.

Payoff ALL debt ==> total money supply vanishes. (Uber deflationary)

I disagree. If all debt is paid off, there is no more need for currency.

There may be demand, but is isn't need since you don't owe anyone anything. You aren't under the gun.

If I have a contract to repay a debt in dollars, I need dollars, nothing else will do.

If I clear my debts, my cash is available to spend elsewhere.

Lending is simply moving money from one entity to the other. It's a net zero transaction. The only "demand for currency" created is to pay the interest.

I think debt is a red herring.

Credit is money. But debt is not. And don't say they are two sides of the same coin because a default means one side of the coin ceases to exist. Credit cannot be renigged on. You can have credit without debt; it's simply printing money; printing money knowing you won't be repaid, i.e. student loans and knowingly lending to bad risks. You cannot have debt without credit.

You guys are fooling yourself thinking default decreases the money supply. When credit is funded out of thin air, a default leaves that money in the system: i.e. NO DEFLATION. In days of yore when money was actual hard currency like gold and silver, yes, but not now. The Federal Reserve is not impacted by your default. It doesn't in any way prevent it from lending money.

Think about it.

It's a lot more complicated than simply "defaults cause deflation".

The bank is on the hook for that money which is no longer there and so it is forced to sell assets or raise capital. Selling assets is deflationary for obvious reasons. Raising capital is too since they cannot extend credit while doing so. In fact, potential deflation is enormous especially when excess credit is so prevalent.

You are confusing the fact that new money that is created and now exists is in the system. It isn't. It is deposited into the bank once again. Look at the number of real dollars per capita. It is shockingly small.

P: Payoff ALL debt ==> total money supply vanishes. (Uber deflationary)

B: I disagree. If all debt is paid off, there is no more need for currency.


I hurried that post, Boz. Should have written total money supply NET OF CURRENCY vanishes. However, currency is a minuscule part of the money supply. [I've seen estimates of $4T currency to $60T in global M3. See last chart in http://news.goldseek.com/GoldSeek/123177....]

As to your point, if debts are paid off, money is still needed to conduct transactions and for people to save.

The bigger issue with a credit collapse is not how much credit based money is necessary to a functioning economy, imo. Any more than the hopelessly ignorant view that we haven't enough gold to support a growing global economy under a gold standard. We can make do with whatever quantity of either we choose. Prices will simply scale up or down.

The problem we face is that society's expectations are now built up around the massive and historically excessive amounts of leverage in the system. Any return to historical norms of debt to production will catch most of society wrong footed and insolvent. The adjustment will be a killer, literally. So it goes.

Debt PAID OFF is different than DEFAULT.

Paying off debt allows for the creditor to loan more money to others as well as the borrower to now borrow more money.

Both increase velocity of money, total credit and M1 money supply.

* assuming of course that money is continued to be borrowed. if All debt is paid off but no one chooses to borrow more.. then simply paying off all debt is deflationary.

otherwise paying off debt is likely inflationary over time.

DEFAULTING debt is deflationary, as the opposite of all of the above occurs.

M1 money supply is what is important.. not MB (monetary base.. coins/bills)

Default may be deflationary, but not that deflationary. When a loan is created, the dollars created (liabilities) get spent into other's accounts. You don't borrow money to hold in your checking account, right?. Now the newly created dollars are dispersed elsewhere, and if the debtor defaults, then the only means of recovering dollars, is if the collateral is sold by the bank (thus drawing dollars out of the economy).

If the collateral is worth less than the loan, then the effect is inflationary, since there are more liabilities outstanding than can be recovered by collateral sale. The outstanding liabilites impact the banker's capital (which while denominated in the currency, is usually an asset, not the currency itself).

If the bank goes bust (i.e. runs out of captial to buffer default losses), and depositors lose their account balance, then that is deflationary. Liabilities (FRNs) or their demand deposit balance equivalent, are destroyed. If the defunct bank is bought by another, and the depositors account balances are made whole, the net effect is neutral.

Whether a default is inflationary or deflationary depends on whether the LTV ratio is greater or less than 1.

Of course, this is only the money supply component of inflation/deflation, and doesn't account for velocity effects.

Correct Eni, I have argued for some time now that velocity is beyond the control of the Fed and unpredictable in our current predicament, whether we have a large amount of deflation or inflation (or whether they print money or not). Therefore, I am interested in confidence (or rather loss of confidence) in the "system." As Rusmfeld would say, this is one of the known unknowns that can end the monetary system as we know it in a very short period of time. Human psychology cannot be modeled by the Fed or anyone else.

Interestingly, in the Argentina hyperinflation (not saying our situation is the same), there as a brief period of DEFLATION before the huge spike in the price level that was no doubt due to a velocity spike as the rats jump off the ship. I think a collapsing global bond market is exactly what will potentially trigger the velocity spike that ends in a total world monetary collapse. The dominoes are aligned, the stage is set, I await the trigger.

What you guys are saying is a default is not deflation if the government is willing to create money. Which is the case we are currently in.

In a normal scenario yep the money was already borrowed and spent into the economy. However the bank has to fix its balance sheet afterwards which means it must reduce lending. So someone else's loan will be called and they will pay it off or default. If default we continue along until the balance sheet is restored or the bank itself defaults.

In our case the government is willing to allow the Fed to simply create money and hand it to the banks so that they will never need to deleverage. Think of the extreme case - all of the bank's clients have defaulted. The bank itself is borrowing all that money from someone else (say depositors and bonds). The government will simply FDIC guarantee 100% of the deposits and the sheeple will leave the money in the bank and conduct business as normal. The bonds though will not be rolled as no one will lend a bankrupt bank money. So the Fed steps in and lends the money. Now we have a bank which has 0 loans outstanding because they all defaulted and it is still in existence. That is where we are now. The money supply is stable. The bank will make new loans (increasing the money supply) and continue to pay its employee's bonuses until those new loans default at which point we do it again.

I will throw one more thing into the mix.

Quote:

Debt (created out of thin air) creates the SUPPLY of dollars (in account balances) ... so total money supply = total debt.

This is not totally correct. It is correct the instant the first Debt is created but after that it is not correct. The mistake is that interest on the debt is not considered.

Consider the situation one year later:

Debt PLUS one year's Interest (which is more debt) > money supply.

That's right, there is not enough money to pay off all of the debt thanks to interest. That leads to two things we have all witnessed. One, you need people to constantly keep borrowing more and more to keep the system 'solvent' because new debt can then be used to pay the interest on the old debt.

It also leads to point two, when the flow of debt stops increasing (it does not have to decrease i.e. deleveraging) the system will sieze up becuase suddenly there is not enough money to make the debt payments. So, that is why the FED has been pumping in 'liquidity', they have become the source of new debt of last resort. The 'liquidity' phrase they have been using is misleading, they are in fact taking on new debt to keep the system solvent and prevent collapse.

Flap

Correct, Flap.

AND the total money supply also includes currency and coin, that doesn't come into existence via the creation of a loan.

Nevertheless, at the level of first order approximation that I was getting at, the basic point I was making stands.

My concern with that point is that if we ever do get a sweeping tide of debt repudiation or a default cascade, and so all perceived assets on the other side of those liabilities suddenly get marked down to near zero, what assets other than productive assets that throw off real returns will have ANY nominal value?

Piet I am right there with you. A financial product (stock, bond, cd whatever) really represents a loan to someone (or corporation) with the hope that they will perform some work to give the financial product value. Debt repudiation would be the wholesale destruction of bonds and CD type instruments. I guess stocks would still have value if the debt destruction did not BK the company you owned stock in.

This is what I keep telling everyone, if your savings/retirement is in financial products, all that you own is someone else's promise to pay. That is why I am going at 100 MPH to try and get all of my savings/retirement out of financial products and into tangible assets. Also, please remember that all you own is someone else's promise to pay in an environment where there is not enough money for everyone to pay.

Flap

I don't know why people get hung up about 'debt being created out of thin air'. Credit is almost always thin air. You don't go into debt for the sake of holding currency. You go into debt to buy some asset or to procure some services or whatever. It's all thin air.

Even credit advanced by ordinary, non-banking businesses (i.e. payment terms) is credit formed out of thin air. Nobody complains about that.

Not really. If there's an asset behind the loan, then it's more like a "sell and buy back" transaction, you just buy back the collateral over time. No thin air needed.

I believe Karl uses the term "self-liquidating business credit" for part of this. It too is credit and yes it to can cause defaults/problems but, they tend to be minor in size and are usually backed with a purchased item that can be recovered.

Our financialized economy has credit sprayed all over the place and much of it is backed by an inability to pay. So, the extend and pretend games keep rolling.

Flap

Quote:

Even credit advanced by ordinary, non-banking businesses (i.e. payment terms) is credit formed out of thin air. Nobody complains about that.

If I allow you not to pay me until later we didn't create any new money. Only a bank is allowed ( by the government ) to create money and hand it out based on a promise to pay it back.

Now what happens if we limit banks to 10x leverage instead of the 30-50 we currently have? The banks acquire deposits and then create 10x that amount in money. Does this fix the money supply problem? No it does not - all that created money can be deposited back in the bank and 10x'd again. The balance comes from the demand for money - the willingness to borrow and the speed at which you can turn around loans into deposits.

I don't think you need me to figure out how home prices were able to rise faster than incomes.. But given that has occurred - companies are worth a crazy multiple of cash flow, houses are worth an insane multiple of income etc what happens when the defaults occur?

What happens to the demand for money after the total value of housing stock has fallen 50% and everyone is out of a job as leveraged business owners go under?

Yep - the money supply falls.

Think about the Facebook dude paying a billion for some website. Does he really have a billion dollars? Yes he does technically, but when we default all the leverage out of the system that same deal would have went for 100 million (if at all!). Do you really think that billion dollars didn't come from someone borrowing money to purchase Facebook?

Eni,

When debt is defaulted, you are ignoring the fact that there is a creditor who loaned that money. That money is now gone.. reducing that creditors reserve ratio and thus reducing the amount of money they can loan going forward.

That's essentially what happened on a very large scale with the fallout from the home bubble bursting.

That's why the government chose to divert 1.5 trillion dollars to the banks. To avoid a complete deflationary meltdown from banks going under and drastically reducing both M1 and velocity.

The government avoided what would have been a deflationary break down that would have resulted in a minor depression. But it would have been over by now.

In it's place we have a buliding government bond bubble and government spending bubble on a global basis that has the potential of causing a major global deflationary breakdown caused by surging worldwide interest rates and creating a major depression that is much worse and lasts much longer.

Cjworkman wrote..

When debt is defaulted, you are ignoring the fact that there is a creditor who loaned that money. That money is now gone..

No. The money isn't gone. It wasn't there to begin with. What existed was a loan agreement. The creditor has an asset (the loan), which is a promise of future cashflows from the borrower. On default, the creditor is entitled to liquidate the collateral, if it has any value to be redeemed. Thus, if the loan is underwater, the creditor is poorer by the difference between the loan value and the liquidated collateral value. The creditor is the banker (i.e. bank shareholder).

What is gone is wealth, not money. The only deflation is the amount raised and extinguished through sale of the collateral - except this frees up reserves to be re-lent. The net loss to the banker represents outstanding liabilities ('money') balanced against a depreciated set of assets (i.e. "the same money chasing fewer goods").

Hence the call for recapitalizing the banks.

The Fed can provide liquidity (reserves) up the wazoo, but banker's capital is more difficult to come by.

In his Ticker, Karl wrote..

The credit money that these banks "created out of thin air", if it is removed from the system (and removing the excessive leverage must inevitably mean removing that credit money) immediately reverses the monetary inflation that has powered higher prices in stocks, education, and (believe it or not, still) housing. This credit money has been and is nothing other than legalized counterfeiting of the currency.

Which is strictly wrong. The fixed exchange with gold was changed in 1933 and floated in the '70s. Since the markets sets the price for convertability, there is no such thing as counterfeiting credit. Credit is just that - confidence in the reliability of future cash flows. Aside from perhaps fraudulent procurement of credit, it cannot be counterfeited. Even fraudulently obtained credit is not really counterfeiting, since it is the asset side of the deal that becomes impaired.

Thus it is the economic and political conditions and market forces that decide on the value of a currency.

Remember to pay your hut tax.

Eni,

The money was there on paper, because the Bank must have the correct reserves in order to balance it's books and maintain its reserve ratio.

If the debt is defaulted, the money to cover the loan must come from it's reserves, therefore affecting its reserve ratio on its total loan balance.

Therefore, it can be put into a position where it cannot make more loans until it raises more captial.

If the banks cannot loan money, the velocity of money will plummet and the monetary base including credit will contract. Thus deflation.

If 1 person defaults on a home loan.. won't cause much issue.

But when 100k people default on home loans, it creates a problem.

most debt at the sovereign level is never paid off.. its just rolled over.. just as most corporate debt is also just refinanced.