This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Monday, November 30, 2009

The Deflation Debacle and Our Road to Recovery

The Deflation Debacle and Our Road to Recovery
Dock David Treece

As the endless stream of economic data continues to flow, let’s review our calendar of economic and monetary events.

Over recent weeks we have heard arguments back and forth by bankers, economists, et al, all weighing in on the inflation/deflation debate. Much of the disagreement in the inflation/deflation debate can be traced back to varying definitions and underlying assumptions. As a prime example, we have seen commentators bounce back and forth with regard to how they define inflation, as well as how they measure it.

After hearing references to everything from money supply growth and CPI to foreign exchange, we consider it of utmost importance that all commentators work from the same textbook. Without going into excessive detail, let us say that our definitions, which have remained consistent, are the following:

Inflation: a monetary event consisting of an increase in money supply in excess of growth in GDP over the same period.

Deflation: a decrease in the money supply circulating through the American economy that is not due to the destruction of wealth

Price inflation: measured by CPI, a symptom of monetary inflation that might also be due simply to supply and demand

Debt deflation: a loss of value on an asset that serves as collateral for a loan that leads to losses on the part both the bank and the creditor, who now has negative equity

In the near-term we still consider deflation to be a substantial threat to the global economy. We are particularly concerned with the prospects a second wave of debt deflation, spurred by another surge in real estate defaults, this time in commercial properties.

What’s more, with troubles in commercial real estate rapidly approaching, housing is still hardly out of the woods. With nearly 15% of Americans are behind on their mortgages (Mortgage Loans: Record number are late,, 23% are underwater on their homes (now having negative equity) (The Negative Equity Report, First American CoreLogic), and 7 months of inventory is sitting on the market (October 2009 Existing Homes Sales, Bloomberg), it seems hardly likely that housing will be returning to its glory days anytime soon.

As a brief side-note, after watching the activity of the Treasury and Federal Reserve for months and wondering why they continued to let banks hoard cash in excess reserves, be believe that we have finally found an answer in this theory.

We now believe that the Fed and the Treasury are both aware of the coming problems in commercial real estate, and they are allowing, nay encouraging banks to stockpile massive reserves – rather an extend credit to individuals and businesses – in order to cushion their books for a coming wave of write-downs in commercial real estate.

We find support for our hypothesis of coming debt deflation not only in bank losses/write-downs, money supply growth numbers, and a still-decreasing demand for consumer credit, both new and outstanding, but also in price indicators which typically measure the symptoms of inflation, namely CPI and PPI.

Consumer Prices as a whole are down from this time last year (CPI, St. Louis Fed), and since stopping their decline a major portion of increases in prices can be accounted for by increased energy costs that are more a function of a weaker dollar in foreign exchange – remember, oil is priced in dollars – than inflation.

In the longer-term we consider inflation to be a substantial threat to the global economy, particularly in the United States. Remember that an incredible amount of money was created out of thin air by massive government bailouts, and in all likelihood will continue as a result of quantitative easing.

That new money is presently creating a bubble in stocks and commodities that is being perceived by many economists as inflation. They’re wrong; the real inflation, an increase in money supply beyond growth in GDP, occurred with the expansion of money supply over the past decade, culminating with the government bailouts. “Inflation,” as defined by increasing prices and a currency declining in value, won’t occur until all this new money makes its way into the economy.

Inflation ultimately will become an issue. The government can’t double the monetary base without consequence (St. Louis Adjusted Monetary Base, St. Louis Fed). However, price inflation will not become a real factor until a true economic recovery begins.

This recovery will be characterized by the free flow and expansion of credit, otherwise known as an increase in velocity, which is thus far still contracting as the US savings rate climbs. Once velocity does pick up and the real recovery starts, inflation will be a major concern. However, it will be characterized not only by an increase in prices, but also in wages.

Remember: even Zimbabwe, with its recent run of hyperinflation that left its dollar worthless, experienced wage inflation along the way. Wage inflation is something that this country is, in our opinion, far from experiencing.

At this point unemployment is too high, too long, and still growing for there to be any kind of significant economic recovery. In our opinion, seldom are jobless recoveries are the real thing. This is evidenced by recent reports, durable goods among others.

It’s important to remember that the stimulus plans that were passed were never meant to foster an economic recovery, just to give the banks the keys to the Treasury. This administration, in the words of Hilary Clinton, does not want to waste a good crisis. The problem is that the crisis has gotten way out of hand, and the administration’s total lack of understanding of economics is becoming well-known.

At some point we as a country have to get beyond this crisis. If this administration doesn’t get us past it, rest assured that the next one will. What we desperately need is to find a sector that can provide the kind of jobs needed to pull us out. Unfortunately, we can safely say that the sector to lead this recovery will not be auto (which led in the 1980s), housing (as it did earlier this decade), tech (1990s), or green jobs, especially after everything that is now coming out about the Hadley Institute.

In our opinion, the only two sectors that might foster the kind of job growth that is required in an economic recovery could be energy (of all types, not just “green”), which also led a recovery in the 1980s, or possibly manufacturing (which led almost every economic recovery before 1980), if the recent trend continues of bringing back these kinds of jobs from overseas.

One major problem is manufacturing coming back to this country is that it is a long process. It took years for manufacturing to move abroad as outsourcing became popular. To bring it back requires massive investments in facilities, commercial processes, etc.

However, an even bigger obstacle standing in the way of creating both energy and manufacturing jobs is government. In order to encourage the kind of investment that is needed to create jobs, encouragement is required in the form of both deregulation and tax incentives. However, neither of those, much less job creation in any form, is on this administration’s agenda.

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