Aig

Yetanotherstudent,

It's not really surprising that you don't know that much about deflationary environment. There hasn't been one for 70 years, it's not really taught in economics degrees except as a cursory aside, CT7, while not entirely useless, is clearly indequate for actuarial training. I suspect about 1 in 100 on the forum has any real idea about the effects of deflation, and probably only 1 in 50 qualified actuaries.

There are basically two types of deflation. The first is benign and caused by productivity increasing faster than the money supply. The second is malign and caused by paring down of debt by a liquidation process.

The USA in the 1920's was a very good example of the first benign type of deflation, where the money supply expanded (alarmingly at some points) but prices kept falling as productivity more than kept pace. The same would have happened over the last 10-15 years had Western Governments not deliberately set positive inflation targets and ramped up the broad money supply to achieve them. Essentially the deflation in far eastern imported goods was more than offset by service sector inflation.

The problem with era's of benign deflation is that central banks do not have to keep ramping up short term interest rates to control inflation when the money supply is expanding rapidly. The rapid increase in money supply leads to large increases in indebtedness and these are the conditions that lead to malign deflation. In the 1920's the sum of personal, corporate and government debt in the US went from about 100% to 300% of GDP. The same has broadly happened over the period 1982-2007 going from 100% to 275% in the 1980's and up to about 325% now. Clearly a debt liquidation is long overdue.

The problem with malign deflation is that everyone pares down there debt either by default or by paying it back. If default occurs then the bank's capital falls (does this sound familiar) and they need to withdraw a much larger amount of lending due to the money multiplier effect. Thus corporate lending falls and thus with less investment there are less jobs. When people pay back debt instead of buying consumables then employment in manufacturing falls, with consequent knock on effects elsewhere.

The effect of paying back debt or default of debt is to collapse the money supply and thus the general level of prices fall. The real value of debts also increases making them a larger burden on those holding them. This increases the level of defaults and the desire to pay them back. This is essentially a positive feedback process which is known as a deflationary spiral.

Deflation ends when debt levels reach a sustainable much lower level. The end is usually marked by what I call "what the heck prices". For instance if at the end of this I can buy a three bedroomed house in a reasonable part of London for say 65000, then I'm going to say "what the heck if I lose another 15000, I've still got a house" Also the level of leverage at the end of a debt liquidation is very much lower than at the top and so you get very few forced sellers and thus a large supply no longer hangs over the market.

 

Thanks for that Cardano!

If I may ask, what happened in Japan (leading to the negative real interest rates). I remember one or two articles commenting that what was happening in western markets was similar to what had happened in Japan, except that Japan was better placed to survive their turmoil? (As that crisis started when I was still at school, I didn't pay much attention at the time, and again the economics courses don't seem to focus on it much - I got a distinct 'that's never going to happen here' feeling....)

Now if the current western crisis is possibly going to go into deflation; why did the Japanese end up with negative real interest rates? Did they decide to rescue their institutions; leading to positive inflation, but are keeping their base bank rate low to... um, to what exactly?

Also, as an individual, what do you do in a negative real interest rate environment? Spend, spend, spend?


As a complete aside, if we do go into deflation, surely there is some possible arbitrage as there is still an implied inflation premium in the ILG vs gilt market? Or is that still there as the market doesn't think it'll be allowed to fail?


Hopefully I qualify this session and can then spend more time thinking of the wider issues (and so asking less dumb questions) rather than trying to recite guidance notes!

 

I know Japans interest nominal rates went to near zero, but as they suffered low rates of deflation 1-5% during the decade, the real rates were probably not unreasonable.

Japan is nation of savers, so you would expect real interest rates to be lower than a nation of borrowers like US,UK. This can be explained using a simple supply and demand argument - if you are going to save anyway the banks are not going to pay you that much extra to encourage you.

Japan is a good economy mainly. It has a massive trade surplus, highly skilled workforce and although it lacks raw materials and has an aging workforce, it's problems have not been that great. It avoided a massive deflationary collapse in the early 1990's by the government continually bailing out its banks (a mistake IMO). This meant that it turned a sharp deflationary depression into a long mildly deflationary stagnation and the banks still have large amounts of loans to write off. Its financial health allowed it to avoid an inflationary depression. The poor financial position of the US and UK make this much less likely for the North Atlantic powers. In fact I expect we will see both a run on the pound and the dollar. I'm still betting on inflation rather than deflation.

As regards your point on Gilt/inflation linked gilt, I'm not really sure. I expect the government to change the rules on its long term debt at some point to "stiff" its creditors. I wouldn't be surprised to see coupons reduced or terms extended. So I would probably recommend staying away from long term debt as it may become a political game

 

Negative real interest rates are typical in inflationary economies and inflationary crises. The conventional wisdom then is to buy real assets. I would stay away from property though as it is staggeringly overvalued. I also expect gold to be confiscated/banned if we have an inflationary crisis. Holding commodity futures is probably best, but it will be very volatile

 

Incidentally the scheme announced at the end of last week, has the potential to be massively inflationary.

Say for instance the real value of this crappy paper is 20c on the dollar, and the scheme offers 30c, then the difference has to be made up from taxes or printing. Since Paulson didn't mention increased taxes, you can bet the Fed will print it.

Also say it is on the banks books at 70c on the dollar, the immediate effect will be more write offs for the banks to the tune of 40c per dollar. (The value of 70c will have come from some idiotic quant's model). Thus the banks will have to withdraw more money from lending due to the multiplier effect. Thus real estate prices will fall further as lending becomes scarcer. Ofcourse the banks could raise more capital, but I think they have exhausted the supply of "innocent" money over the last year or so.

 

Bernanke recognises the savages of deflation, he wrote a paper on it, basically he said he would never let it happen, even if it means deploying "helicopter drops" of cash to stop it from happening.

 

Thanks for all the informative posts, Cardno.

While trying to understand your explanation of debt deflation, I've realise there are some basic economic concepts that I don't understand.

Why would the money supply be expanding? Was the government causing this on purpose, or was it because banks were lending more?

Can the government control the money supply directly, as an alternative to increasing interest rates? I feel like I ought to know this, but how does the government control interest rates anyway? I kind of imagined that it would lower short-term interest rates by buying short-term government securities, increasing their prices, and lowering their yields, and in the process, it would increase money supply.

Does this tie in correctly with those supply and demand curves for money on CT7, where interest rates would be lowered by an increase in the supply of money (the supply curve being vertical and shifting to the right)? edit: I think I get this now. MV=PT rearranged to M=PT/V. M is the money supply and PT/V can be interpressted as demand for money.

Is it clearer to think about the increase in money supply causing the indebtedness, than to think of low short-term interest rates as the cause?

Sorry if these are really basic questions.

I think I get the basic idea that during periods where productivity is expanding rapidly (eg. due to new technology), then there will be low inflation and also low interest rates because the government is not concerned with controlling inflation. Low interest rates mean that people will borrow more and so on . . . towards debt-deflation.

Thanks,



Sam

 

Since the US was running a large trade surplus in the 1920's I suspect they were importing a lot of gold and as the gold standard was running at the time this allowed the money supply to expand. Reserve requirements were also changed more often by the fed to control money supply and I suspect lowering of reserve requirements played its part. Increasing the money supply automatically increases indebtedness as banks lend out the high powered money M0 many times - the money multiplier. The important point is really the level of debt relative to income (or GDP taking a wider view) and this rose rapidly in the 1920's as well as in the period 1982-2007.

In 1929, there had not been a significant banking crisis since 1907 and so a whole generation of bankers had retired and those in charge only had youthful memories of that period. Bankers are not generally intellectuals and do not in general study the cyclic nature of banking and so they always make exactly the same mistakes as the previous generation
In the 1920's the money supply expanded much faster than the cpi, which was contracting mildly and so the large amount of available credit was going into bidding up the price of shares and real estate (and bonds too to some extent). Since interest rates were very low people who got away with borrowing money, buying something and selling it at a profit became complacent and started borrowing more and more. The banker's also became blase about lending money as the borrowers generally paid it back and central banks did not ramp up short term rates or increase reserve requirements as cpi inflation was not a problem. Lax lending was order of the day and a positive feedback cycle started where the more people were prepared to borrow the more the banks were prepared to accomodate them and the 1920's ended with an overindebted population without the means to repay. There was no commodity price boom in the 1920's, unlike today but interest rates rose from 1928 onwards as people started defaulting on their loans. The Federal Reserve also handled the monetary situation appallingly and made the liquidation much worse than it should have been.

The parallels between the 1920's and recent years are just striking, except it has been so much worse this time around. There were a lot of banking crises in the period 1973-1984, which is now almost a generation away and we now have a banking system run by complete incompetents who were youngish in the 1970's and so history looks like its going to repeat itself. The twist is that this time the liquidation will be inflationary (probably) and will impoverish many of the more responsible classes in society while bailing out many of the least responsible (Wall Street bankers for one).

 

Thanks Cardano,

I'm remembering there was a list on CT7 about ways that the government or central bank can influence the money supply. Earlier on in this thread you mentioned that CT7 is clearly not an adequate economics course for actuarial training. And here's one example of it - if you reduce an interesting subject to list after list, students will just forget 'em.

The amount of actuaries you speak to who will say that they don't understand the material in courses that they have passed is really shocking (I'm obviously including myself in that number).

Have you seen the recent edition of "The Actuary"? There's some stuff in there that seems to imply that actuaries could help prevent another financial crisis like the current on, if they are able to have more input into financial risk management. With the current actuarial education system, that's just delusional, is it not (not to mention unprofessional - see the lists on CA1)? Obviously, I'm not denying that some actuaries have the skills to do that, but I don't see how they could have learned those skills from the courses I've been doing.

Anyways, rant over . . .



Sam

 

It really does appear that AIG is a monster

Would any industry insiders care to comment on its current state (Parnell perhaps?)?

http://www.marketwatch.com/news/sto...x?guid={92C4EF08-68EA-4E4B-908E-36DDE1BD2E55}

AIG reportedly in talks over new bailout

By MarketWatch
Last update: 10:49 a.m. EST Nov. 8, 2008Comments: 439SAN FRANCISCO (MarketWatch) -- American International Group Inc. reportedly is seeking a new bailout from the U.S. government less than two months after the Federal Reserve came to the insurance giant's rescue with an $85 billion loan, according to a published report.
The Financial Times reported on its Web site late Friday, citing people close to the situation, that AIG (AIG:American International Group, Inc
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Last: 2.10+0.23+12.30%

3:59pm 11/07/2008

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AIG 2.10, +0.23, +12.3%) executives were in negotiations Friday night with authorities over a plan that could involve a debt-for-equity swap and the government's purchase of mortgage-backed securities from AIG.
The FT said talks might still collapse, but noted that the insurer was pressing for a decision before it posts third-quarter results on Monday.
American International Group Inc. is expected to report third-quarter loss of 90 cents a share, according to analysts surveyed by Thomson Reuters.
Leading industry analysts have said that turmoil in equity and credit markets has been hampering AIG's efforts to sell some of its businesses, a crucial part of the insurer's plan to repay billions of dollars in expensive government loans.
Rival insurers that may be considering bidding for AIG businesses are now facing their own problems as slumping stock prices and wider credit spreads cut into capital, Andrew Kligerman of UBS wrote to investors about a week ago.
That's slowing what investors hoped would be fast asset sales by AIG, possibly preventing the insurer from quickly repaying the Federal Reserve's loan, the analyst wrote.
Wider credit spreads may be triggering more demands for AIG to post collateral to support the credit default swaps it wrote. That likely increases the amount of money the insurer has to borrow from the Fed, which, in turn, means even more asset sales, the analyst explained.
Kligerman said he expected that AIG would take about $25 billion in write-downs on its credit default swap exposures when the insurer reports third-quarter results.

 

I think AIG is a jokehouse , Allianz offered to buy them out but they turned it down.

They have expressed a desire to continue to write property & casualty business taking on further risks and it seems that no-one in the US Treasury is prepared to stop them doing this.

So everything we have heard down through the years about subsidising EU firms has proved to be a crock - the mother of all bailouts wears the star-spangled banner - not only that but the ship is allowed to continue to take on more water....

 

Heading for another stonking loss

http://uk.reuters.com/article/ousiv/idUKTRE51M6LT20090224

Any comments, opinions Parnell?

 

And so they should continue to write P&C business - they were hugely successful and well regarded outside the credit book. If they stop writing P&C business then their new shareholders (the US Public) won't get any return on their investment...

 

I wonder how the US public will feel if there is a cat somewhere outside of the US and they are paying billions for it

Also, I am not sure how fair it is that they are still dictating rates in some areas given they are state backed, hardly in the interests of competition.

 

Well Fiend, that Cat has arrived and its outside America!

http://uk.reuters.com/article/2011/03/13/uk-air-worldwide-japan-idUKTRE72C1LH20110313