Consumer Price Index Plunges In October

The consumer price index plunged “by the largest amount in the past 61 years” in October.  This may be an indicator of a very deep recession, if not a depression.

A depression is characterized in part by a persistent, sustained, deep, general decline in production. They are typically preceded by a deflationary crash.  A deflationary crash is characterized in part by a persistent, sustained, deep, general decline in people’s desire and ability to lend and borrow.

Deflation requires a precondition: a major societal buildup in the extension of credit (and its flip side, the assumption of debt). Austrian economists Ludwig von Mises and Friedrich Hayek warned of the consequences of credit expansion, as have a handful of other economists, who today are mostly ignored. Bank credit and Elliott wave expert Hamilton Bolton, in a 1957 letter, summarized his observations this way:

In reading a history of major depressions in the U.S. from 1830 on, I was impressed with the following:

(a) All were set off by a deflation of excess credit. This was the one factor in common.
(b) Sometimes the excess-of-credit situation seemed to last years before the bubble broke.
(c) Some outside event, such as a major failure, brought the thing to a head, but the signs were visible many months, and in some cases years, in advance.
(d) None was ever quite like the last, so that the public was always fooled thereby.
(e) Some panics occurred under great government surpluses of revenue (1837, for instance) and some under great government deficits.
(f) Credit is credit, whether non-self-liquidating or self-liquidating.
(g) Deflation of non-self-liquidating credit usually produces the greater slumps.

Self-liquidating credit is a loan that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan – for business start-up or expansion, for example – generates the financial return that makes repayment possible. The full transaction adds value to the economy.

Non-self-liquidating credit is a loan that is not tied to production and tends to stay in the system. When financial institutions lend for consumer purchases such as cars, boats or homes, or for speculations such as the purchase of stock certificates, no production effort is tied to the loan. Interest payments on such loans stress some other source of income. Contrary to nearly ubiquitous belief, such lending is almost always counter-productive; it adds costs to the economy, not value. If someone needs a cheap car to get to work, then a loan to buy it adds value to the economy; if someone wants a new SUV to consume, then a loan to buy it does not add value to the economy. Advocates claim that such loans “stimulate production,” but they ignore the cost of the required debt service, which burdens production. They also ignore the subtle deterioration in the quality of spending choices due to the shift of buying power from people who have demonstrated a superior ability to invest or produce (creditors) to those who have demonstrated primarily a superior ability to consume (debtors).

Near the end of a major expansion, few creditors expect default, which is why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount of involuntary debt liquidation because almost no one expects deflation before it starts.

Inflation this year has crept up to a peak in July and has stayed at or near 5% ever since, until October, when it plunged to 3.66%. We all know that the oil prices have been deflationary for the past few months and it appears this is the driving factor in the deflationary prices.   I personally haven’t seen prices (other than gas) get lower, especially food.

However, given the above, the question may shift from whether inflation will eat at your bottom line to whether deflation eats away at production and dries up your clients’ ability to pay.  Based on the above, the best bet is to hold on to as much money as possible and to the extent you hold assets that are devaluing, consider liquidating to cash.  Prepare for lower income for the coming years and offset the loss in revenues by keeping your firm in sound financial condition so that you are better able to help serve your clients without the struggle of wondering how you will pay your employees.

The way to do this is to identify areas you believe will affect your income next year.  There are plenty of indicators out there but any prediction is just that.  The lower the expectation, the better opportunity to absorb worse conditions.

After you have identified where you will lose and make money, focus on assigning resources towards strategic targets that you believe will improve revenue.  Although never a fun endevour, it is time for hard decisions related to re-aligning your staff to optimize your ability to serve your clients during a time when cash flow may be strained.

Implementation must be consistent and applied universally.  This of course is the most difficult part of any change, but the future your firm, and/or your best talent, may depend on it.

As always, measure against your forecasts and in this case, worrying about others is irrelevant.  Focus on your own predictions and work towards achieving your own goals.  What happens with other firms can be compared after the economy recovers.

I’ve never lived through  a depression.  I am not sure I can even fathom it.  However, I do recognize the plethora of signs that our economy is not just taking a temporary hit – it is part of a global downturn marked by the largest expansion of credit in history.  Something others have noted invariably lead to deep losses in production.  And there is no denying that there will be massive layoffs in the coming year and our auto industry is facing its own collapse.  Production can’t improve in this environment.

Plan accordingly.

Perfect Pain: Inflation & Deflation

I have spent considerable time discussing the increasing inflationary threat to the economy over the past year. The rapid popping of the asset bubble, however, has worked its way into the rest of the economy and has had an deflationary effect that is beginning to show in core prices.  The most recent Consumer Price Index (for September) has inflation falling under 5% (4.94%) after skyrocketing to 5.6% in in July and 5.37% in August.  The inflation rate for 2008 is still 4.5% – over 1.5% increase over the average rate (3%) since 1992.

The recent “bailout” of $800b of new freshly printed money should serve to increase inflation.  However, according to Tim McMahon on his site Inflationdata.com, the loss of over $7 trillion in value from the NYSE and NASDAQ creates a “net deflationary effect” on the economy:

And that is not counting the value lost in housing prices.  And to make matters worse the mortgage industry took those initial mortgages  and leveraged them using “derivatives” to compound the gains on the upside.  This leverage was by a factor of hundreds of times.  Actually no one even knows the full magnitude of how much compounding went on.  So there could easily be Trillions more of liquidity that evaporated when housing prices stopped going up and began their downward descent.

So how do you reconcile a high inflation rate and net deflation on the economy at the same time?  McMahon explains that the consumer price index considers over 10,000 items that “take into consideration all aspects of the economy.” What is happening in the stock market is based, at least initially, on housing prices.  So, in effect, we get bad news on both fronts:  Our house values are deflating and our cost of living is inflating.

Need it be reiterated the importance of measuring performance?  The boom economy of the past two decades is unfortunately giving way to an as-yet unknown period of economic decline.  We have suffered through two minor recessions during this period, but the extent of this downturn is certain to be more protracted and deeper.  The recession in 1990 was practically non-existent and short and was arguably preventable without the massive tax increases placed on the economy. The recession in 2001 was again short and based primarily on the bust of the tech sector – with not nearly the impact on the majority of Americans as a drop in home values.

The good news for law firms is that regardless of who wins the Presidential election, there will be a rush to enact new reactionary laws to protect consumers that will invariably lead to an increase in lawsuits.  The bad news is that your personal income will be devalued based on the realities of the economy.  Also, those in transactional practices will not be as fortunate, as transactional business typically suffers during recessions.

Next week the government will release 3rd quarter GDP results.  Most expect us to report the first negative growth in seven years. The time to plan for the economic downturn was several months ago – but it is never too late.

Core Inflation Soars to 5.6%

The July Consumer Price Index was released today and core inflation soared to its highest rate since January of 2001. This follows a trend I noted on More Partner Income in March where I discussed the impact inflation has on your firm’s bottom line.

Inflation for the year is averaging 4.4%. Please keep in mind that inflation has averaged under 3% for the past two decades. Your forecasting needs to include the deflated value of your purchasing power. Expect the Federal Reserve to increase interest rates soon to counter the inflation threat.

UPDATE 8/15/2008:  Federal Reserve officials state that although inflation is a concern, it will “fade over time“.  They are even talking lowering rates.  For those who hated Chairman Greenspan’s philosophy, it looks like we will see what it’s like to not be a hawk on inflation.  My suggestion:  save money.