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Five Things: Deflationary Forces Continue to Dominate


The magnitude of the deflationary forces at work continues to be underestimated by pundits and policymakers.


1) Deflationary Forces Continue to Dominate

Ominous news today from the National Inflation Association:

"The United States today is in a short-term deflationary phase caused by forced liquidations, de-leveraging, going out of business sales, and other temporary factors."

You might be surprised to learn that I completely agree with the National Inflation Association... except for the parts about this deflationary phase being "short-term" and "temporary." But other than that, we're on the same side, in total agreement.

Having come of age in the post-World War II era of inflationary excess, a deflationary debt unwind seems so utterly foreign as to be practically unimaginable. After all, in my lifetime, there has never been this kind of sustained period of forced de-leveraging, forced asset liquidation, voluntary debt payment, rising savings and economic contraction - all occurring simultaneously, and creating a negative feedback loop which reinforces the collapse in aggregate demand.

Consequently, the magnitude of the deflationary forces at work continues to be underestimated by pundits and policymakers. Take a look at two charts below updated from the Federal Reserve's Flow of Funds report. These charts show, one, the rate of destruction of household net worth we are seeing and, two, the annualized rate of destruction in real estate owners' equity.

Household Net Worth Year-over-Year Percentage Change

Click to enlarge

Real Estate Owners' Equity Annualized Percentage Change

Click to enlarge

No wonder most of us don't much feel like "getting out there" to the shopping malls and "doing our patriotic duty." These declines in household net worth are staggering. Household "wealth" fell by $5.1 trillion in the fourth quarter alone.

To put that amount and its economic impact into perspective, let's look at it alongside President Barack Obama's $787 billion stimulus package that was signed into law last month. If you consider the magnitude of the loss on an individual basis, it's the equivalent of losing $5,100 at the racetrack one day, vowing to give up gambling forever, but finding $787 in your glove box and rushing back to get it all down on the next race.

The reality is there's nothing short-term or temporary about this "deflationary phase."

2) U.S.(Zimbabw)A.?

The National Inflation Association's ominous report continued:

"It is our belief that the monetary policies of the Federal Reserve and United States Treasury will soon put an end to this deflationary phase, and we will see massive inflation in the U.S. that could ultimately lead to Zimbabwe-style Hyperinflation

Going back to 1934, whenever the Federal Reserve has made credit available the world has accepted it. While it is true the Fed and global central banks are making record amounts of credit available, as those anticipating hyperinflation argue, that is only one side of the credit equation.

The assumption is that this record-breaking credit expansion means risk assets (stocks, commodities, etc.) will all skyrocket and the U.S. dollar will get destroyed. But what hyperinflationists fail to realize is that for an inflation (of either the tame or hyper variety) to take place, one must have both the means (credit from the fed and banks) and the motive (the desire to take on more debt) for credit expansion. For over a year now we have had record amounts of the former, but none of the latter.

Additionally, in order for hyperinflation to even be a remote possibility here there would have to be at least one economy that is both stronger than the U.S. during a global economic downturn, and larger in size than the state of Ohio's or even California's economy.

Ironically, while smaller emerging markets could potentially find themselves facing a Zimbabwe-esque hyperinflation, that would only make the U.S. dollar and U.S. debt more attractive and secure. Emerging markets are at this point the only place where it seems a possibility that credit could find a willing home and debt an eager taker, but even that is not a certainty. It is more likely that the creeping protectionism that is developing, as countries begin to wake up to the fact that the global system is too big to save, results in a more severe credit contraction globally.

Make no mistake, this is not to say that we won't again experience inflation. We most assuredly will. But there are two critical errors being made by those currently warning of either aggressive inflation or hyperinflation; one, a failure to recognize the severity of the deflationary forces at work and, two, a failure to appreciate the duration of this deflationary debt unwind.

3) When Doing Things Right Turns Out Wrong

Kevin -

Here's what I really don't understand. I just can't get my head around this:
if there are those people who did the right thing, still have their jobs and are still making the same amount of money, why does it seem everyone is so strapped for cash these days?

Good question. Going back to today's number 1), the primary reason everyone feels strapped is that a broad array of assets have declined in price; homes, apartments, stocks, investments.

Many people spent anticipating these things would only go up in value. but now that they have declined in value, even people who "did the right thing" have seen their debt relative to their assets increase. In short, people feel more strapped because they are more strapped.

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