Distortions and Deflation

Distortions and Deflation

There is an interesting article on Zero Hedge with commentary by Bill Gross. There are two take-home points that I’d like to look at:

1. Investment decisions are distorted by low interest rates
2. Is “deflation” a rising dollar or debt defaults?

It seems that corporations actually consider the rate of interest when determining how to allocate their capital–Quel Surprise! Lower rates encourages seeking lower marginal returns and this manifests in the real economy as avoidance of real projects in favor of financial gimmicks.

The other point is a discussion of “Helicopter Ben” and his intellectual forebear who is none other than Milton Friedman. It seems Friedman first proposed to “fight deflation” by dropping bags of money out of helicopters. A precocious 8 year old can tell you that no good will come of money drops from helicopters, and this is not controversial outside the feed lots of Washington DC and the Ivory Grain Elevators which exist to support them.

I have said that defining inflation as rising prices (and deflation as falling prices) is a sleight of hand. And this article puts a sharp point on it.

Let’s say you borrow $90,000 and adding $10,000 of your own capital, you buy a $100,000 house. You have 10:1 leverage. But it’s OK if you are renting it out, and the rent after all expenses is $5000 per year. You are getting 5% return on assets or 50% return on equity. Life is good.

But then your tenant loses his job, and jobs for other tenants become scarce. You can rent the house, but it will only produce $50 per year in free cash flow (it would be even worse if rent could not pay to cover taxes, insurance, maintenance, etc.) Is the house worth $100,000 any more? No.

What if the house is now worth $75,000. You have negative equity! You owe more than the value of your asset.

The point of this story is to show the problem of a busted balance sheet is not solved by debasing the currency. Sure, each dollar you owe is worth less. But assets + liabilities still equals equity and now this is a negative number.