Deflation and Debt

Over the next few years over $2 trillion in adjustable-rate mortgages are due to be reset, and reset at substantially higher prices. Meanwhile, tens of thousands of new homes are still coming onto the market, and inventories of unsold homes and condos are rising to record highs almost everywhere.

In the big picture, the world depends on the insatiable willingness of Americans to spend -- even if it means going into debt. In turn, Americans depend on the rise in the value of their homes to facilitate their spending. If the price of housing in the US halts or (God forbid) actually declines on a year-to-year basis, Americans will cut back on their spending. This could easily set off a recession in the US.

With the incredibly high levels of debt in the US, anything even hinting of recession could trigger deflationary trends. Deflation would put tremendous pressure on debt, and this could lead to an all-out bust in the US economy. The Fed cannot tolerate deflation -- in the face of a deflationary recession, the Fed would force short rates almost to zero. This would favor T-notes and bonds along with the highest-grade debt.

In a deflationary recession, there would be a rush for liquidity, and that would mean selling assets for cash. Anything tradeable would be thrown on the market as a way of raising cash. Commodities would suffer, gold and silver would suffer, oil would probably suffer, home prices would suffer, stocks across-the-board would suffer, medium to lower-grade bonds would suffer. All activity would be aimed at raising cash.

The debt and mortgage monsters would hold sway over the land, and the main thrust would be to avoid possible bankruptcy. Debt would be the enemy. You pay off debt with cash. You avoid bankruptcy by being solvent -- the less debt you hold, the more solvent you are.

Only four things can happen to debt. Debt can be serviced, it can be renegotiated, it can be inflated away or it can be reneged on. In the future, I predict that all four options will be utilized.

But there's another factor about debt. Massive debt in itself is deflationary. Massive debt acts like a sponge in that it sops up cash, since it's cash that services debt. To offset this deflationary feature, it is necessary for a government to inflate. If a government does not inflate enough, then the pressure of debt exerts a deflationary force.

This may be happening today. What I mean is that the Fed may not be inflating enough. This "emergency" could get quickly out of control. Declining gold may be the signal that this is, indeed, what is happening.