All Bets Off – Massive Deflation And Fed Still Lowers Rates

All the ingredients are coming together for protracted, painful and seriously impaired economic conditions.  As stated in an earlier post,  a deflationary crash is characterized in part by a persistent, sustained, deep, general decline in people’s desire and ability to lend and borrow.   It appears we are in the midst of one.  Consumer prices, after a record decline in October, set another record in November, pushing inflation down to 1.07%.  After a year that saw inflation hitting almost 6% in July, this is a painful indicator of things to come.  In spite of OPEC’s threat to drastically cut production, oil prices are still relatively low.

Worse, the Federal Reserve appears to be acting counter-intuitively by lowering interest rates to “zero to .25%“, leading to speculation that once our economy does rebound, hyperinflation will be the next crisis.  It doesn’t help that our government continues to spend money it doesn’t have.

On top of all this, President-Elect Obama announced that his “stimulus plan” will be somewhere between $600 billion and $1 trillion.  The spending spree never ends.

The time to voluntarily liquidate assets has passed.  Foreclosures dipped in November, but few expect that trend to be anything but temporary in spite of Fanny Mae’s Christmas gift to renters of homes in foreclosure proceedings.  Best to hold on to assets and try to keep as much cash on hand as possible.

We can hope that the aggressive moves by the Federal Government will prevent another depression, but it sure seems like we are about to embark on the same policies of the Roosevelt administration that arguably kept the country in a depression for an entire decade.  One of the proponents of further governmental intervention is oddly a scholar of the Great Depression.  Fed Chairman Ben Bernanke believes that the cause of the Great Depression was the lack of action by the Hoover administration to stop banks from failing and by keeping interest rates too high.  In Bernanke’s mind, it was Hoover’s inaction that caused the depression, not Roosevelt’s activism.

There are (at least)  two arguments as to what caused the Great Depression.  One argument postulated by Irving Fisher and furthered by Bernanke states that debt deflation caused the Great Depression and, in at least Bernanke’s case, government inaction during the 3 1/2 years between the stock market crash of 1929 and the swearing in of Franklin Roosevelt caused productivity to become depressed and unable to recover in spite of FDR’s programs for an entire decade.

Fisher was not exactly on target with his arguments in his lifetime (from wikipedia):

The stock market crash of 1929 and the subsequent Great Depression cost Fisher much of his personal wealth and academic reputation. He famously predicted, a few days before the Stock Market Crash of 1929, “Stock prices have reached what looks like a permanently high plateau.” Irving Fisher stated on October 21st that the market was “only shaking out of the lunatic fringe” and went on to explain why he felt the prices still had not caught up with their real value and should go much higher. On Wednesday, October 23rd, he announced in a banker’s meeting “security values in most instances were not inflated.” For months after the Crash, he continued to assure investors that a recovery was just around the corner.

Once the Great Depression was unavoidable to notice, he theorized that debt deflation was a major cause – debt deflation that could have been avoided (according to some) had the Hoover administration taken more aggressive steps to intercede.

The other argument is that it wasn’t Hoover’s inaction that led to the Depression but the Smoot-Hawley Act of 1930, which raised tariffs on goods sold to trading partners and led reciprocal action, skyrocketing unemployment and global isolationism.   Those who would argue this would point that both low interest rates and ample liquidity were available in 1930, but that due to economic uncertainty, few wanted to borrow and take risks.  Further, FDR prevented the economy from pulling itself out of the depression by overly taxing the population (specifically the producers) and redistributing wealth using a “trickle-up” philosophy of using government to employ the people.  Even with FDR’s policies, unemployment was still over 19% in 1938.

You can argue both arguments are right and wrong.  It is plausible that at least having a Federal Reserve that would have released funds to troubled banks could have avoided the panic that led to over 9,000 banks failing in the 1930′s.  However, there is ample evidence that government intervention did more to exacerbate the Depression than remedy it.  The primary force that led us back to economic expansion was the Second World War.

Unfortunately for Bernanke, debt deflation is intensifying in spite of his actions to improve liquidity.  What may come from all these measures, however, could spur the same depressed conditions that he is trying so hard to avoid.  If liquidity does improve, even moderately, inflation will be a large concern.  The question will then be whether it would be better to allow inflation to run amok or to raise interest rates and threaten the improving economy.

One thing I feel relatively certain in predicting:  so long as the government intervenes in the economy, there will not be a lot of certainty in the markets, which will result in further volatility.  And, it doesn’t appear the government is planning on taking its hands out of the economy anytime soon.

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.