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Debt and Deflation

By James H. Nolt

Two recent news items highlight the close relationship between debt and deflation, a relationship of great significance in numerous economic crises but virtually ignored in economic textbooks.

Starting from their first economics course, students are taught that producers reduce output when prices fall; thus the supply curve is always upward sloping, showing a positive relationship between prices and the quantity produced. This is what textbooks claim both for the aggregate level—macroeconomics—and at the level of individual firms and enterprises—microeconomics. As so often in the mythic world of economics, textbooks typically ignore the consequences of debt or credit.

The two new stories, however, contradict this familiar refrain. First, despite the drastic fall in world oil prices, countries and companies are pumping more supply into the market than ever before. Lower prices are not lowering supply. Similarly, an article in the business section of The New York Times on Wednesday explained that many Chinese industries are flooding the world market with goods despite low prices. 

In both cases, the proximate cause is debt. During boom times, countries and bullish companies load up with debt to accelerate their growth. When demand slackens and prices fall, textbook economics says that suppliers should cut their output; but if both prices and output fall, their debt burden becomes intolerable since their total income is a product of price times the quantity produced. Consequently, many firms prefer to increase output during a slump and thereby hope to pressure others out of the business while they gain market share.

For example, in the oil business, low cost producers like Saudi Arabia and the Gulf States can afford to ship much more oil, even at much lower prices, and still cover their production costs. Other poorer and more densely populated producing countries like Iran, Venezuela, Mexico, and Indonesia depend on oil revenue to balance their international payments, including servicing foreign debt. If prices fall, they need to pump even more in order to pay debts already incurred. This can create a vicious circle of falling prices and increasing output, until high-cost, high-debt producers are bankrupted and forced to liquidate. Most national oil companies cannot suffer this fate, but private producers, such as those that created the fracking boom in the U.S., are more likely to find themselves over a barrel.

One possible solution for American producers is that an “environmentally-minded” President Hillary Clinton bans fracking and uses taxpayer funds to bail out the indebted producers and their creditors for this “public spirited” action. Am I too cynical? I predict a similar deal is in the works to bail out the creditors of some of the $1.3 trillion in student loans now facing unprecedented default rates. It will be sold to the public as a solution for debt-strapped ex-students, but I expect that it is creditors (i.e., banks and bondholders) who will be compensated and the public will pick up the tab.

Other industries are under similar pressure from Chinese “dumping.” I put “dumping” in quotation marks because I found in past research that much that is called dumping is not legally that. Legally, dumping refers to selling internationally below cost or selling at a loss. You might wonder why any firm would do that. The answer requires understanding political economy strategically, not according to what textbooks teach. More bearish firms may initiate such a price war to bankrupt more vulnerable bullish competitors to gain market share. If the tactic works, it is usually not because of costs the way they are described in the textbook “theory of the firm,” but because of the burden of debt service. The firms that lose prices wars are the ones that run out of financing first. It is similar to real wars, where the countries that lose are often those whose financing runs out first. Bankers pull the plug.

Historically, in deflationary crises such as the great depressions of the late 19th century and the 1930s, creditor banks often intervene to end price wars by forming competitors into a cartel, such as the 19th century railroad pools, or even into a single giant firm like U.S. Steel. Price competition is replaced by monopoly power to limit output, raise prices, and service the debts from the joint income of an entire industry. Economic textbooks say that cartels are unstable because they assume each firm is an independent entity and ignore the power that creditors have over debtors and the incentive the creditors have to force cooperation in order to raise prices and avoid loan defaults.

In today’s globalized world economy, the solution of past debt-deflationary crises seems harder to achieve. Whereas during the 19th and early 20th centuries, the largest banks, such as J. P. Morgan and the Rothschild banks, superintended loans for entire continents, today even behemoths like Citigroup and J. P. Morgan Chase have limited reach into key manufacturing centers like China. Such private creditors also lack decisive power today in the oil industry, where the largest producers are either self-financing giant companies like British Petroleum and Exxon or state-run companies such as those of most of the producing states. There is no one capitalist headquarters able to force cooperation.

Whatever else happens, China is something of an outlier, so it will remain the whipping boy of this world economic crisis. It is beyond the discipline of creditors, other than those internal to China who are themselves swayed by political motives at least as much as by economic ones. Chinese companies, whether truly bankrupt “zombie companies” or not, will be kept afloat as much as possible and export their troubles abroad, if necessary by what looks like dumping. It is no wonder that presumed Republican nominee Donald Trump has latched onto this issue.

The obvious solution for a more trade-friendly Clinton administration would be a Chinese version of the “voluntary export restraints” policy the U.S. imposed on Japanese automobile exporters during the latter part of the 20th century. The U.S. “persuades” China to restrict output and raise export prices. The deal looks good for many Chinese producers because they sell less, but at higher prices, which creates fatter profit margins. American producers like it because it allows them to raise prices and suffer less pressure from Chinese competitors. A similar deal could reinforce OPEC and raise oil prices. Of course, consumers pay the higher prices, but creditors avoid losses on loans, which often matters most to the political class. Restricted output that allows for higher prices also does not necessarily improve employment much. But when push comes to shove, I predict the powerful creditors will be first in line to recover their due.

Even this “solution” may be impossible though because there are too many parties in the world who need to be induced to join the deal. The globalized world of the 21st century is rather complex. I will say more on that next week.

*****

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of lalabell68]

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