Bitter pill of deflationary adjustment to cure crisis

Interview with Mike Bechara, Managing Director at the Granite Consulting Group, talks about Standard & Poor’s downgrade of US credit.

S&P has downgraded the US credit rating from AAA down to AA+. How come the other rating agencies have remained silent?

We don’t know. I think the important thing to remember is that S&P weren’t telling anybody anything they didn’t already know. Even to the most casual observer it’s obvious that the country’s credit rating is not AAA. In a way, S&P was brave enough to do what the other rating agencies should have done long ago.

Do you think it was the whole debt ceiling ordeal that had brought S&P to take that move?

It’s a realization that there are no magic bullets from Washington in order to fix our economy. In fact, the debt ceiling debate and the S&P downgrade showed that they cannot even appear to be competent in handling the nation’s finances, let alone take some actual policy actions that would really do something to address the root causes of what’s wrong in our economy.

I believe the UK, Canada and France still hold a AAA rating with S&P. How is their economy qualitatively different from the US economy?

France is a full member of the European Union, the UK is a member of the European Union, but not part of the Monetary Union. So, there are some differences in the way they deal with monetary policy. I think all three of the economies that you mentioned – the US, France and the UK are all plagued with high amounts of debt, all plagued with slow growth and have serious underlying economic problems.

What would you say is the greatest problem in these countries?

In short, there’s a lot of money that was borrowed and that is not going to be paid back both by governments, by corporations and by individuals until a process of deleveraging occurs, whereby this debt is either paid back or written off. With the debt being written off being the more likely scenario, we are not likely to see a return to strong economic growth.

What would go into writing off US debt money?

If somebody borrows money and isn’t going to pay it back, the person they borrowed the money from has to admit the fact it’s not going to be paid back and incur a loss. And I think the fear is that if this amount of frankness and candidness were to occur it might result in a lot of financial institutions being insolvent. So, the game of extend and pretend is being played, where the institutions that gave these loans are prolonging the crisis, in essence, by refusing to admit that it won’t be paid back.

Would you say that writing-off the debt would be like a small-scale default?

There would be a default. The outcome would be a deflationary recession or depression, which would probably be very sharp and likely very short as well. At this point it’s very difficult to have economic growth when you have debt saturation. People and governments have borrowed as much money as they possibly can and they have no ability to borrow any more. So, until the debt is cleared from the system, we won’t have economic growth. Until assets are written down to a level where people can afford them again it will be very difficult for people to resume spending and investing. We have to go through a period of deflation. This is typically what happens in a recession. If governments don’t intervene to prevent a recession when a recession occurs, debt is written off, assets decline in value, assets are sold off at a lower value to those that are better able to manage them and real economic growth ensues, because it’s cheaper to buy the assets, prices calm down, and that’s a catalyst for investors and consumers to start spending and investing again. I think we have quite a bit of deleveraging to go through because we’ve delayed this process of deleveraging probably since 2000, we’ve prevented the deflationary recession from happening at least three separate times over the past decade. And each time you do it the longer and sharper the deflationary recession should be in order to clear the debt from the system.

What can the Fed and the Treasury do to influence the situation, if anything at all?

I think the best thing they could to is to let the nature take its course and let those who borrowed too much default on their debt and let those who lent imprudently write off and take the losses on the debt they issued.

As the process unfolds, what do you expect to happen to the value of the dollar?

The value of the dollar is likely to increase in a deflation area environment as dollars become scarcer because debt is being removed from the system. It’s very hard to tell what would happen to the dollar under various intervention scenarios, those being quantitative easing or money creation. This is a bit of the debate among economists as to whether the natural forces of the deflation or the forces of intervention, which are inflationary in nature would cancel each other out or one side or the other would “win”. The dollar has been weakened over the past couple of years due to the monetary easing. The monetary easing has ended, the Fed had a chance to do that today to continue its monetary easing and therefore to continue to weaken the dollar. They chose not to continue down that path today, although it’s very hard to tell whether they are going to continue it in the future or not.

What effect do you think the deflationary scenario would have on the average American?

I think we’re more likely to see falling asset prices, higher unemployment and reduced job prospects for a period of time until the markets equilibrate, and the debt is cleared out of the system, and asset prices have a chance to calm down.

Are there any fixes that you envision for the long-term side effects of the deflationary scenario?

No, I don’t think so. I think the medicine has to be taken and that is the one true way out of this crisis. Unfortunately, it’s a painful way out of the crisis. And that’s the big reason why nobody wants to take that path, most of all governments.