Saturday 6 August 2011

AAA ratings - 10 little indians...and debt deflation (why Irving Fisher is right).

The title of this post is a refence to the wonderful book by Lady Agatha Christie written in 1965, as there are only 15 countries left in the world with AAA rating at Standard and Poor's, and four from the G7, Germany, France, United Kingdom and Canada.

In my previous post, "AAA, the most endangered rating, regulating the rating agencies and Basel III", In June 2010, I was expecting more downgrade to come. I am not going to go through the analysis made in relation to the much needed regulations of the rating agencies as I did it in the post mentioned above. In relation to my well founded critics of the rating agencies, I also discussed how the rating agencies behaved in 2008 and 2007 in the following post: Markets and Macro Update - Dude where is my Risk?

The downgrade of the mighty USA by S&P to AA+ is a significant event because it can have significant consequences if S&P follows up with Germany, France and Italy. It could in effect, destabilise completely the EFSF funding vehicle and render it powerless if Germany, France and Italy gets dowgraded.
So, have we crossed the Rubicon?

As a reminder from my post "Europe, The end of the Halcyon days", this is the amount owned to Germany:

European debt map:

European countries cross border exposure:

In November 2010 in "The European Vortex" post, I went through the analysis of the EFSF. I stated at the time:
"There is 440 Billions Euros available (probably less given its similar resemblance to a CDO structure). Clearly not enough to bail out everyone. If the EFSF wants a AAA to issue bonds to fund the oncoming bailouts, it will need to overcollateralize to 120% and maintain a cash buffer. It cannot lend against backing of troubled nations. The more countries in trouble, the smaller the pot available for bailing out countries in trouble, simple as that. Given Austria is witholding already its funding for Greece, the entire unity of the European Union is being tested."

Therefore, it S&P follow up on the downgrade of the USA and start downgrading the core members of the EFSF structure, such as Germany, France and Italy, the whole structure is in trouble.

The EFSF mechanism:

The reserves held by the EFSF needs to be invested in AAA paper.

I previously argued that "a way of reducing the burden of debt for peripheral countries, would be to create a European Compensation house and to do some debt compression. They would need to allow creditors to swap the debt of peripheral countries into more solid Euro-bonds issued at the ECB level, provided there is a haircut on the existing peripheral debt". The latest proposed plan for Greece involves small haircuts, bond buy backs, reduced coupon and maturity extension as well as debt swaps, but so far no mention of Euro Bonds. Time is running out and we need decisive action from European politicians.

The economic picture for the US is already bleak, and the downgrade of the US, will indeed raise the cost of funding, not only for the US as a country, but for the banks and agencies, as you can expect, some rating actions following this decision by S&P.

In past crisis when Velocity dropped significantly, recession occurred, as I posted in "Nightmare on Main Street - The impact of the rise of energy and food prices on US Households".
Graph of Velocity of M1 Money Stock
And velocity is dropping, confirming we are heading for a double dip in the US. In the monetarist theory deflation is associated with a fall in the velocity of money. We are in a credit deflationary environment, comparative to the Great Depression and Japan.

Irving Fisher's theory has been largely ignored by our keynesians friends at the FED. It is of no surprise given that Ben Bernanke largely ignores its influence and wrote in 1995:
"Fisher's idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects."
Ben Bernanke is wrong.
"Bernanke's dismissal of debt deflation is criticized as improperly applying the theory of general equilibrium – in equilibrium, marginal redistribution of income produces no macroeconomic effects, but financial crises are characterized by not being in equilibrium and markets failing to clear – debt ceasing to grow and instead falling, debtors defaulting, rising unemployment – and thus, it is argued, equilibrium analysis is inapplicable and misleading."
Ben Bernanke also added in 1995 about Fisher:
"Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors, forcing them into distress sales of assets, which in turn led to further price declines and financial difficulties."
For Keynesians, the fall in aggregate demand caused by falling private debt can be compensated by growth in public debt, a government credit bubble. It isn't working.
Here comes Irving Fisher solution for the debt deflation situation - Forward Tax Receipts.

Forward Year Tax Receipts

"Recognizing that the federal government issues liabilites (debt) in its own currency and thus can never go bankrupt, another solution is for the federal government to become more like the corporate capital markets with debt issuance at high real interest rates and equity like issuance at even higher real rates of appreciation. The likely candidate for equity like issuance by the federal government is forward year tax receipts. A forward year tax receipt is a receipt for taxes paid in advance that are due some time in the future. Like government debt issuance, forward year tax receipts have a rate of appreciation and a duration. Unlike, government debt, the rate of return is not guaranteed. The realized rate of return is totally dependent on the owner's future income and subsequent tax liability. And so savers are rewarded with a positive real rate of return and debtors can realize an after tax cost of credit that is significantly less. For instance if the federal government sells 30 year debt with a 3% real rate of return and sells forward year tax receipts with a potential 7% real rate of return, then a debtor can realize a -4% cost of credit. At that point inflation is not required nor should it be desired."

For those interested in the subject, I encourage you to review the post "The inflation debate or why you can have inflation in a deflationary environment" on the subject of the Austrian Business Cycle theory and Fisher's contribution to the debate.
"Debt deflation has been referred to alliteratively as the "D-process" by Ray Dalio of Bridgewater Associates, who suggests it as the template for understanding the financial crisis of 2007–2010."

In the post "Low rates environment and the risk of evergreening à la Japanese", I described the following:
Companies "are hoarding and in fact not hiring. The paradox of thrift versus the paradox of debt. Companies hoarding cash and households paying down their debt, typical of a deflationary environment and the fear of uncertainty. Households are busy rebuilding their balance sheets and companies have been busy defending their balance sheet."

I can see a solution for the US deflation thanks to Irving Fisher equation of exchange.

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