posted on 13 December 2015
Written by Norman Carter
Spill-Over Effects and Contagion
In 1933, during the depths of the Great Depression, famed economist Irving Fisher wrote a work that became a classic of economics and is still widely read and cited today. The book was titled The Debt-Deflation Theory of Great Depressions.
Fisher was the most famous U.S. economist of the first half of the 20th century and made many intellectual contributions to economics, including work on monetary policy and equilibrium analysis that led to later contributions by contemporary economists including Milton Friedman and Ben Bernanke.
Yet Fisher's work on debt and deflation is his best-known and most important effort. Most applauded. His thesis was straightforward. Depressions are the inevitable aftermath of credit booms and extreme over-indebtedness.
During the expansion phase of a cycle, easy credit allows debtors to bid up asset prices. The higher asset prices then serve as collateral for further debt, which is used to invest in other assets, causing those prices to rise also. At some stage, valuations become stretched.
Creditors refuse to extend more credit and demand repayment or require more collateral from the debtors. At this point, the entire process goes rapidly into reverse. Now debtors have to sell assets to repay creditors. This forced selling causes asset prices to drop. The lower asset prices reduce the collateral values on other loans, which cause those loans to be called by the creditors also.
Now the forced liquidation of assets becomes widespread, businesses fail, layoffs increase, unemployed workers cannot afford to spend, more businesses fail as a result and so on until the entire economy is thrown into recession or, even worse, full depressions.
This process played out in the period 1929 - 1933, and again from 2007 - 2009. The latest episode is usually known as the Great Recession, but is more accurately called the New Depression. It is still with us in the form of below-trend growth, threats of deflation and low labor force participation. This new episode has led to a revival of interest in Fisher's theory.
The Perfect Storm 101
Investors today can see Fisher's thesis at work in the field of shale oil production. From 2009 - 2014, several trillion dollars of debt was issued to support shale oil exploration and drilling using a method called hydraulic fracturing, or "fracking."
Most of this debt was issued on the assumption that oil prices would remain above $70 per barrel. With oil now trading in a range of $50 - 60 dollars per barrel, much of this debt is un-payable, and defaults can be expected in early 2016 if oil prices do not recover. This has caused new exploration & new credit in the shale industry to dry up.
The next stage, exactly as Fisher predicted, will consist of the bankruptcy of the smaller producers and the forced liquidation of assets. This causes existing wells to be pumped even faster to generate what revenues they can to maintain cash flows in the face of falling prices. This pumping, a kind of asset liquidation, puts more downward pressure on prices, making the situation even worse.
Unfortunately, the process has far to run. Eventually, a new equilibrium of supply and demand will be achieved, but for now, the debt-deflation story has just started. There are many ways to "liquidate" in the oil patch. Including laying off workers, canceling new orders for pipe and drilling rigs and shutting in existing shale reserves until prices recover. This liquidation stage affects not only the drillers, but also oilfield suppliers, labor, landowners who lease their properties for drilling, equipment leasing companies and municipalities that will see declining tax revenues.
Fisher also pointed out that once deflation begins in one economic sector, it spreads rapidly to others. When debtors are in distress, they don't sell what they want - they sell what they can. A debtor involved in one sector of the economy who needs to raise cash will sell assets from an unrelated sector to meet his obligations.
Today, this behavior that Fisher identified in the 1930s is called a "spillover effect" or "contagion." Distress can rapidly spread from the oil patch to commercial real estate and beyond.
Some of this debt-deflation spiral has already shown up in the stock prices of affected companies. More stocks like them may be heading for a fall as the Fisher debt-deflation cycle runs its course.
The System is Now Even More Unstable
Our job is to figure out how unstable global financial system is/or how big an unstable snowpack is now. We knew something about the risks derivatives, bank balance sheets, sovereign debt & currency imbalances posed.
Now the oil price drop has revealed that snowpack even bigger than we thought ~ $5.4 trillion of oil debt suddenly seems to be in jeopardy. Will that be the snowflake that causes the financial avalanche?
At the risk of sounding like a broken record, I advise readers to focus on instability. Then how big is the snowpack? How much damage is it going to cause when the avalanche comes tumbling down? Those are the relevant questions. Now we have both at once - a bigger, more unstable mountainside and more snow falling harder from the sky. That means we have more snowflakes to take account of.
One Oil Snowflake to Watch
One snowflake that I've been looking at more closely is Algeria. As we've heard so much about the Islamic State in Libya & Syria, Iran, Iraq, Afghanistan and Turkey. Those are all important issues and none of them are going away. But keep an eye on Algeria.
Algeria is a major energy producer. It has a very powerful Al Qaeda type Islamic extremist movement that has recently declared allegiance to the Islamic State. They're the same bad guys but they've hitched their wagon to the leadership of the Islamic State. They're gaining strength and it may just be a matter of time before they topple the Algerian government.
At that point, the Islamic State would stretch from Iran almost to Morocco. It would begin to look more & more like the real caliphate. When I say the real one, I mean that the Islamic State has declared a caliphate & that they think what they have is a real caliphate.
If you go back in history & look at caliphates that have existed, the biggest ones went from Spain to Indonesia and everything in between. There were smaller ones in North Africa and the Middle East too.
What's interesting is that when Islamic State gets control of these oil fields, they don't shut them down. They keep pumping because they need the money. That's something that a lot of investors misunderstand. They see geopolitical turmoil in the oil patch and they think it's going to cut production & send the price of oil higher. Actually, history shows the opposite is true.
Islamic State will produce oil like crazy because they want the money, and they're not bound by OPEC casts. That's going to make OPEC's job a little more difficult. We saw this in 1986 during the Iran-Iraq war.
Iran and Iraq are two of the largest oil producers in the world. When they got into a war - when Saddam Hussein and Ayatollah Khomeini were still around, lots of people thought the price of oil was going to go to the moon because of supply disruptions. The opposite happened.
Both countries pumped like crazy and oil price went down to $12 a barrel. Just think, so far, we've been talking about distress at $60 per barrel. You could have a worst of both worlds if Islamic State takes over Algeria because there would be no oil production disruption. Then you may see embargoes and seizing of tankers. It could get very messy.
With these geopolitical and domestic energy trends, the biggest question is what the most powerful central bank will do in the 16 December 2015 meeting. The Federal Reserve has hinted, teased and implied that they're going to raise rates in 2015. The market believes that to be true, based on some strong data in the US economy recently.
If they do that, that could produce a massive emerging markets crisis and debt defaults for the reasons we mentioned. That could produce massive deflation. The U.S. may even go into a recession. That's what is at risk if the Fed stays the course.
If the FED blinks, which I think they will, and decides not to raise rates, people will realize the FED is doing more easing than expected. You can look at the dynamics, use complexity theory, observe the interactions between players and see problems before they happen. The one thing I think you can count on, though, is a lot of volatility and a lot of danger lies ahead.
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