#debt deflation

The debt-collateral spiral happens when increasing levels of debt put upward pressure on the valuation of collateral, and the increased valuation of collateral enables higher levels of debt. Debt-collateral spirals are a typical outcome of vendor financing, whether direct from the vendors, or indirect from someone who has some other stake in the level of prices.

That mechanism cannot just stall at a given level because when collateral valuations rise many or most buyers are paying the cost of borrowing to buy with a view to sell the collateral when its valuation has risen significantly: therefore if the valuation of the collateral stops rising they won't just stop buying, they will sell to cash-in the rise in collateral they have already gained. At that point many if not most of those who borrowed to buy will also sell, to avoid or minimize a capital loss.

Photo; Downtown Detroit, once America's 5th largest city now in decline.

The Unsteady States of America

It is not just Detroit. American cities and states must promise less or face disaster

State and city governments across America have made impossible-to-keep promises to do with pensions and health care. Detroit shows what can happen when leaders put off reforming the public sector for too long.

Inner-city blues

Nearly half of Detroit’s liabilities stem from promises of pensions and health care to its workers when they retire. American states and cities typically offer their employees defined-benefit pensions based on years of service and final salary. These are supposed to be covered by funds set aside for the purpose. By the states’ own estimates, their pension pots are only 73% funded. That is bad enough, but nearly all states apply an optimistic discount rate to their obligations, making the liabilities seem smaller than they are. If a more sober one is applied, the true ratio is a terrifying 48% (seearticle). And many states are much worse. The hole in Illinois’s pension pot is equivalent to 241% of its annual tax revenues: for Connecticut, the figure is 190%; for Kentucky, 141%; for New Jersey, 137%.

By one recent estimate, the total pension gap for the states is $2.7 trillion, or 17% of GDP. That understates the mess, because it omits both the unfunded pension figure for cities and the health-care promises made to retired government workers of all sorts. In Detroit’s case, the bill for their medical benefits ($5.7 billion) was even larger than its pension hole ($3.5 billion).

* I put this together a few weeks ago but never did anything with it. So here it is now. *

Several weeks ago my sister (Logan Sachon, co-editor of thebillfold.com) and our mutual friend, freelance journalist Matt Davis, had a very interesting exchange that, at its core, addresses one of the huge problems at the heart of society today - in the internet age, how do you fund and financially support not only journalism and media, but music, entertainment, and the arts in general. Each of these, in their own ways, are cultural pillars of society - they bind us together into a cohesive social group, one in which we share common ideas, opinions, experiences, etc. Modern society cannot function without them. And yet, today, each is facing a crisis of how to continue existing in the face of much turmoil and change.

The two main trends most analysts point to when evaluating this problem have to do with technology and social networks. In the former case, modern information and communication technologies have fundamentally altered a business model that was developed to serve a now outdated physical medium. All pre-existing papers, magazines, and book publishers developed in a world where business was financed through sales of physical copies of things and, in the case of newspapers and magazines, through advertising embedded in those physical copies.  Those physical mediums were then sold through retail stores, which had their own business models that were developed co-dependently with the media industry. 

As the media and retail industries matured, large bureaucratic organizations developed around the manufacturing and production of content, advertising, and retail sales. Over time, organizations at each stage of this “supply chain” increased in size and complexity, developing distinct units and departments specializing in each aspect of the production and consumption process. Over time, as these organizations grew, they became more and more rooted in and dependent upon these end-to-end production and consumption processes. 

What the invention and widespread adoption of information and communication technologies did was fundamentally change, at the same exact time, the business models of every aspect of the “supply chain” for organizations operating in these industries. All news and journalism-based media, be they newspapers, magazines, journals, and even books, slowly began to transition from physical form to digital form. For the organizations and business models that developed in the previous environment of production, this move generated huge amounts of transition and change. The organizations that were founded, developed over time, and eventually became successful in the previous environment became fragile to these drastic and fundamental transitions in the new, digital environment. And all of this was triggered by the widespread adoption of new technologies.

Furthermore, the above phenomena is not one unique to media and journalism. A similar dynamic has played out with the music industry (the switch from physical LPs and CDs to MP3s) and entertainment industries (TV shows watched on Hulu and Netflix or downloaded on torrents instead of being consumed on actual TV; movies likewise being watched at home and not in the theaters or purchased on VHS or DVD). In each case the trend is the same - a transition from physical content to digital content, with resultant transformations in the production, manufacturing, and sales processes. 

The second trend that analysts point to concerns social media. This hits journalism in particular in two separate ways. One, it’s easier for anyone to write and have their voices heard. This means that existing journalists enjoy less of a wage premium in producing content. And this is also not something that’s unique to journalism and media - its a dynamic currently confronting musicians and the music industry.

The second way it hits journalism is through advertising. Back in the print media days, you could charge a premium for advertising space or for classifieds because the layout of the physical format allowed advertising space to be both prominently featured to the consumer while also limiting the amount of advertising space to go around for companies to compete for to run their ads. The internet, with Google AdWords, targeted mobile advertising, and Craigslist as prominent examples, has crippled this old advertising model and media companies today have not found a reliable alternative funding source. 

Considering the drastic influence that technology and social media have on the organizations and business models of media, journalism, music, and entertainment industries, it’s clear that the industry that both Logan and Matt work in is experiencing incredible amounts of change and turmoil - the old models and organizations are dying, the once-mature industry is in a state of perpetual turmoil, and new models and radically innovative organizations have yet to be firmly established. One consequence of this turmoil is that there is simply not enough resources to go around - the editors and site managers make barely enough to live off of and the journalists compete for increasingly smaller opportunities for paid work. The business model for the internet right now is “free” - whether you’re a writer, musician, or tv show producer/entertainer - and it’s going to continue to move that way as the jerry-rigged online advertising model continues to deteriorate. Such scarcity of resources creates a “zero sum” situation in which talented friends and colleagues like Logan and Matt are stuck on opposing sides of this industry fighting over who gets what size slice of a shrinking pie. 

At this point, I want to introduce a third factor that’s compounding the problems of these industries, one that is rarely brought up in debates such as these. While both of these trends concerning the internet and social media are absolutely true, they’re not the only dynamic contributing to this problem. What the internet and social media problems are representative of is a shift in the competitive nature of the industry. What this should mean is that the old organizations die off, leaving new opportunities to be created for new companies with new business models to come in, set up shop, and thrive. 

We’ve seen the new business models part happen - blogs like thebillfold.com is just one example - but we haven’t seen the thriving part, at least not in financial terms. Why is that? In my view, the media, journalism, entertainment, and music industries are not only being hit with their own industry-specific forms of disruptive earthquakes, but at the very same time they’re being bombarded by a force thats slowly sinking the entire economy - debt deflation.

Here’s the essential basics of how debt deflation works (or at least how it’s happened in our case). Banks lend out money to finance investment and promote consumer spending. The loans they make can happen two ways, either through equity-based loans (owning a share in the investment) or through interest-bearing loans (lending out a set fee with a pre-determined payback schedule and interest rate payout structure). The banks of the modern age have mostly foregone the former type of investment (equity) and instead came to favor the latter kind (interest). When times are good, this works out alright - companies that are making profit can pay off the interest on their loans from the profit, and workers who are part of a productive, growing economy can pay off their loans plus interest from their rising wages.

But when you have game-changing technologies like the internet and social networks enter the ecosystem, companies start to go under. When this happens, their non-equity, interest-bearing loans don’t go down in-kind - they remain on the account books of both the companies and the banks. Then you add in the trend of globalization, which creates further pressure on industries and in turn further submarines existing companies, causing more and more loans to go bad. As the places that people work start going under (increasing unemployment) or start cutting costs (people’s wages) in order to stay afloat, less surplus income is available to spend into the economy.

So people’s wages are already being squeezed in this aspect. But when the banks have losing investments like this, and when industries are embedded in so much turmoil, investing in new enterprises becomes riskier and so less new firms are funded. The lack of employment competition means that employers can cut wages, as there are fewer other firms competing to bid wages up.

And then add in this dynamic: in lieu of financing productive investments in industry, the finance industry turns their interest-bearing loan model onto other aspects of the economy like education and housing, which puts increasing pressure on the already stagnating wages of the workforce as more expensive homes and schools (and healthcare) take more and more of the existing surplus of people’s wages. 

Less surplus means that there’s less money to go around in the economy - i.e. demand starts falling. It also means that governments take in less tax revenue, so they need to tax more to finance their operations, which further takes money out of the economy. And since previously-made investment loans aren’t dropping to mimic the decline in demand and neither are overhead costs for companies, more companies start going belly up. This reinforces the already existing pressure on wages and increases unemployment.