Global Credit Collapse Is Deflationary

NOTE TO READERS:  “Global Credit Collapse Is Deflationary” was originally published as an exclusive for TalkMarkets on October 29, 2024. I have not changed anything in the article, nor is there any reason to modify or alter what is written below because of U.S. election results.

Bond prices collapsed nearly 3% post-election and are down 12% since mid-September. Whatever that tells us did not change because of election results. The action in bonds is contradictory to the prevailing assumptions of a melt-up in asset prices because of expected lower interest rates, more cheap money and credit, and a collapse in the dollar. Speaking of the dollar, it was up almost 2% on foreign exchange markets since late Tuesday evening; and has gained 5% since early October. Finally, the price of gold fell sharply and is down $100 oz. since Tuesday’s close.

The action in bonds might not imply a credit collapse at this point, but it certainly doesn’t offer positive confirmation of higher stock prices, lower interest rates, and cheaper money and credit. The action in gold and the dollar is consistent with what is happening in the bond market. The price action in all three is contradictory to Fed attempts to lower interest rates. Keep your eye on the bond market and the U.S. dollar. – END OF POST-ELECTION COMMENTARY

GLOBAL CREDIT COLLAPSE 

As talk about impending collapse of the U.S. dollar increases, so too, does the talk about a collapse in the credit markets. The suppositions include collapses in the stock, bond, and real estate markets with corresponding lower prices for all. The supposed common denominator is a worthless dollar and never-ending, higher inflation.

The problem with most of the explanations is that there is usually one key point of a contradictory nature that is overlooked. The key point concerns the effects of deflation on the U.S. dollar.

INFLATION

Inflation is the debasement of money by governments and central banks. Expansion of the supply of money and credit IS inflation. All governments inflate and destroy their own currencies intentionally.

Inflation (expansion of the money/credit supply cheapens the value of all the money in circulation and leads to a loss of purchasing power. The loss of purchasing power in the currency (dollar, yen, euro, etc.) results in higher prices that are incorrectly referred to as inflation. The higher prices are the effects of inflation that was created by the Fed.

Since the origin of the Federal Reserve in 1913, the U.S. dollar has lost more than 99% of its purchasing power.  Theoretically, that loss of purchasing power can continue indefinitely, as long as the Fed continues to expand the supply of money and credit.

The world is awash in dollars and the entire global economy is dependent on credit. The situation is tenuous because a minimal amount of inflation is necessary to sustain and support the current level of economic activity.

GREAT RECESSION 2008 

The credit collapse leading to the Great Recession was triggered and characterized by sub-prime auto loans, real estate mortgage defaults, education loans, etc. Every facet of the credit markets was affected and the ripples took down banks, insurance companies, corporations, and individuals. The prices of all assets (stocks, bonds, real estate, etc.) dropped sharply.

Efforts by the Fed and the government seemed to stave off impending doom, but it took many years to restore an acceptable level of confidence in the financial markets and stability in the economy. Concerns about inflation and its effects were replaced by a lingering recession.

For years, the focus of the Fed was to restore inflation (the effects of) to a ‘necessary’ minimum. That minimum was targeted at 2%. (see The Fed’s 2% Inflation Target Is Pointless)

Now the Fed’s efforts are all focused on and intended to get back to the 2% target from the other direction. (see The Fed Is Chasing Its Own Tail)

CREDIT CONTRACTION 

Since the primary source of inflation is the expansion in the supply of credit (U.S. Treasury securities), any contraction at the source lessens or minimizes the potential effects of inflation. While the supply of credit was not curtailed in the Fed’s latest attempt to return interest rates to a higher, more normal level, the price of that credit was severely increased.

The effects of more expensive credit drove markets lower and spawned weakness in economic activity as individuals and businesses suffered the negative effects of sharply higher interest rates.

That prompted a renewal of concerns about a repeat of 2008. Could things get that bad again? A better question might be “Could the Fed stop another credit collapse and recession?”. Not likely.

CONDITIONS NOW ARE MUCH WORSE THAN 2008

Even though the Fed has officially targeted lower interest rates for the time being, the economy continues to weaken. The prices of most assets (stocks, real estate, gold, etc) have risen to levels that are beyond anything reasonable on a purely fundamental basis.

The credit markets remain at low levels that do not reflect the positive upside expectations on display in stocks and other markets. All markets seem quite vulnerable to a repeat of events that transpired in 2008.

This time it will be much more severe and the efforts of the Fed could be nullified by the sheer force of a financial tidal wave. It would not be unreasonable to see asset prices collapse by fifty percent or more.

THE KEY POINT 

A credit collapse and the subsequent implosion of asset prices is a destruction of money. The destruction of money is deflationary. Deflation is the opposite of inflation. Deflation results in a U.S. dollar which gains in value/purchasing power.

There would be fewer dollars available, but they would buy more – not less. This happened during the Great Depression of the 1930s which was caused by the Fed.

I expect something similar to happen again. (also see Default, Deflation, Depression)