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.