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Examining the Elemental Structure of Deflation


The primary forces in the developed world are defined by it.

The next element of deflation is massive Wealth Destruction. Two bear markets and a housing-market collapse have put the American consumer on the ropes. And the next bear market will bring him to the canvas.

Then we have Reduced Borrowing and Lending, as consumers are paying down debt and banks are reducing their lending. Both are necessary in a recession caused by a credit crisis. Bank lending is basically back to where it was two years ago, and shows no sign off rebounding. Banks, as I've written, are buying US government debt in an effort to shore up their balance sheets. Lending to small business -- the real engine of job creation -- is sadly decreasing each month (see graph below).

Next up in our elemental list we have Decreased Final Demand and its counterpart, Increased Savings. Although the savings rate has come back down to 3% from 6% a few months ago, almost every expectation is that it will rise over the next three to five years back up to the 9% level where it was only 20 years ago. The psyche of the American consumer has been permanently seared. Consumption and savings habits are being changed as I write.

And of course, we must address the element of Low Capacity Utilization. While capacity utilization is rebounding, it's still lower than at any time since the data has been collected, other than the last few months. It's hard to see where businesses are going to get pricing power when not only US, but world capacity utilization, is still extremely low. The chart below isn't the stuff that inflation is made of.

And let's just quickly throw in Massive Deleveraging and $2 trillion in Bank Losses and a Very Weak Housing Market. Which brings us to a Slowing Velocity of Money.

As I've written on several occasions, prices are a function of the amount of money times the velocity of money. If the velocity of money is slowing, the amount of money can rise without bringing about inflation. It's a delicate balance, but nonetheless the hyperventilation in some circles about the coming hyperinflation is, well, overinflated, simplistic, and economically naive.

In my opinion, the Fed is going to do what it takes to bring about inflation. But they won't monetize US government debt beyond what they've already agreed to. If they need to "print money" to fight deflation, they can buy mortgage or credit-card or other forms of private debt, which have the convenience of being self-liquidating. Read the speeches of the Fed presidents and governors. I can't imagine these people will recklessly monetize US debt. You don't get to their level without having a stiff backbone. (I know the gold bugs will call me terminally naive. We'll have to wait to see who's right. Peter Schiff -- care to make a bet on this one?)
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