An Analysis of Debt Deflation in the US

Here is a bit from an article by Yves Smith in Salon magazine explaining the mess the US finds itself in:

Despite the hysteria that the downgrade of US debt would lead to US funding costs rising and Treasuries crashing, instead we've had stocks crashing and Treasury prices rising sharply. That's completely rational. The policies being implemented as a result of this contrived budget crisis are deflationary. For non-economists, as much as inflation has been touted as a major financial problem over the last 30 years, deflation is widely acknowledged to be Economic Enemy Number One. And high quality bonds like Treasuries are the place to be in deflation.

Deflation occurs when you have a falling level of prices and wages. Even though it isn't included in the Consumer Price index, the most important price in an economy is that of labor. We've had stagnant real worker wages over the last 30+ years, and from 2007 to 2009, IRS data shows that incomes fell 15% in real terms. Most of that is due to unemployment, but remember another pattern of the last decade: when seasoned workers lose jobs, when they find work again, it is often at much lower pay. Stagnant real wages are pretty much stagnant actual wages in a low inflation economy.

As many economists have recognized far too late is that increasing consumer debt levels is what enabled the US to fuel economic growth even with no real wage increases. Rising consumer debt is not a plus over the longer term, since consumers don't make productive investments from debt (the one supposed exception, that of borrowing to fund education, is misleading, since the rising borrowing has led to increased costs of education as well as more people getting graduate degrees that have more to do with credentialing than actual value to economic productivity, such as MBAs).

Since wages in aggregate are not growing, consumers are now trying to or being forced to delever, and the other ways to keep growth going (business investment and government spending) are very much absent or in retreat, the slack in demand can lead to stagnant or falling prices (that doesn't mean particular prices, like milk, won't rise, but the general price level will be flat or lower). That took place in the Great Depression and in a less extreme form, in Japan in its bubble aftermath. Deflation turns an economic downturn into a self-reinforcing spiral. Outstanding debt, which is usually too large to begin with, becomes crushing. The interest payments were set assuming positive inflation, so that the future interest payments and the principal would be paid back in cheaper dollars.

But in deflation, the reverse happens. With prices falling, cash is worth more in the future. That discourages consumers from spending, and means that paying off existing debt becomes harder and harder as incomes fall. The fall in spending as consumers and businesses delay purchases slows economic growth further, which makes the price fall accelerate, which increases the real cost of the debt burden.

There is more. Go read the whole article.

The obvious fix is to let inflation roar at about 5 or 6% for 4 or 5 years. But nobody in the US government or in the Federal Reserve is looking to use this antidote. Why? The rich hate it. It devalues their bonds. And one thing that TARP and the other government programs demonstrate is that the US government sees job #1 to be protecting the rich. The idea that they should help the unemployed or those who lost houses or the students who have huge debts and no prospect of a job or those recently retired or about to retire in a few years with no enough savings... well, that isn't a concern of government. You are on your own!