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Some Thoughts on Deflation

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The Super-Trend Puzzle

The Elements of Deflation

Maine, New York, Turks and Caicos, and Europe

By John Mauldin

The debate over whether we are in for inflation or deflation was alive and well atthe Agora Symposium in Vancouver this this week. It seems that not everyone is ready tojoin the deflation-first, then-inflation camp I am currently resident in. So in this weeksletter we look at some of the causes of deflation, the elements of deflation, if you will,and see if they are in ascendancy. For equity investors, this is an important questionbecause, historically, periods of deflation have not been kind to stock markets. Letscome at this weeks letter from the side, and see if we can sneak up on some answers.

Even on the road (and maybe especially on the road, as I get more free time on

airplanes) I keep up with my rather large reading habit. This week, the theme in variouspublications was the lack of available credit for small businesses, with plenty ofanecdotal evidence. This goes along with the surveys by the National Federation ofIndependent Businesses, which continue to show a difficult credit market.

Businesses are being forced to scramble for needed investments, generally havingto make do with cash flow and working out of profits. This is an interesting quandary forgovernment policy makers, as 75% of the rich that will see the Bush tax cuts go away

are small businesses.

There was a great graphic (that I now cannot find) showing that all net new jobsof the past two decades have come from small businesses and start-ups. And yet as ofnow, when structural employment is over 10% (if you count those who were consideredto be in the work force just a few months ago), we want to reduce the availability ofrevenues to the very people we want to be hiring new workers, and who are cash-starvedas it is.

It is not just that taxes will go from 35% to just under 40%. It is the increase inMedicare taxes coming down the pike, too. We are taking money from private hands,where it has the potential to increase productivity, and putting it into government hands,where it will do nothing for growth of the economy. There is no multiplier forgovernment spending. And tax increases reduce potential GDP by a multiplier of at least1 and maybe 3, depending on which study you want to cite.

I understand that taxes have to go up. I get it. But we would be better off having adiscussion of where we want to tax dollars to come from before we risk hurting aneconomy that will barely be growing at 2% in the 4th quarter, and may be well below that.It is the increase in taxes that has me concerned about a double-dip recession.

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That being said, the announcement by several prominent Democratic senators thatthey think we should extend the Bush tax cuts is significant. As I said a few weeks ago,we should not experience a double-dip recession absent policy mistakes. A slow-growthworld, yes. But an actual double dip is rare.

If Congress were to extend the Bush tax cuts for at least a year, until thepresidential commission on taxes is done with its work and THEN have the debate, itwould make me far more optimistic. And it would be quite bullish for stocks, I think.Businesses would know how to plan, at least, for a year, and the economy would be givenmore time to actually recover. I am not ready to channel my inner Larry Kudlow, butfrom what we see this summer it would make me more optimistic and reduce the chancesof a double-dip recession significantly.


Inflation in the US is now just below 1%, whether you look at the CPI, the

Cleveland Feds measure, or the Dallas Trimmed Mean CPI. The Feds favorite, the PCE,is also approaching 1%. The Dallas numbers are a little behind, but they are at all-t imelows.

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The classic definition of deflation is an economic environment that ischaracterized by inadequate or deficient aggregate demand. Prices in general fall, andnormal economic relationships start to fall apart.

The Super-Trend Puzzle

I am a big fan of puzzles of all kinds, especially picture puzzles. I love to figureout how the pieces fit together and watch the picture emerge, and have spent many anenjoyable hour at the table struggling to find the missing piece that helps make sense ofthe pattern.

Perhaps that explains my fascination with economics and investing, as there areno greater puzzles (except possibly the great theological conundrums, or the mind of awoman, about which I have only a few clues).

The great problem with the economic puzzles is that the shapes of the pieces can

and will change as they rub against one another. One often finds that fitting two piecestogether changes the way they meld with the other pieces you thought were alreadynailed down, which may of course change the pieces with which they are adjoined; andsuddenly your neat economic picture no longer looks anything like the real world.

(Which is why all of the mathematical models make assumptions about variablesthat allow the models to work, except that what they end up showing is not related to thereal world, which is not composed of static variables.)

There are two types of major economic puzzle pieces. The first are those piecesthat represent trends that are inexorable: they will not themselves change, or if they do itwill be slowly; but they will force every puzzle piece that touches them to shift, due tothe force of their power. Demographic shifts or technology improvements over the longrun are examples of this type of puzzle piece.

The second type is what I think of as "balancing trends," or trends that are notinevitable but which, if they come about, will have significant implications. If you placethat piece into the puzzle, it too changes the shape of all the pieces of the puzzle aroundit. And in the economic super-trend puzzle, it can change the shape of other pieces inways that are not clear.

Deflation is in the latter category. I have often said that when you become aFederal Reserve Bank governor, you are taken into a back room and are given a DNAtransplant that makes you viscerally and at all times opposed to deflation. Deflation is amajor economic game changer. You can argue, as Gary Shilling does, that there is a goodkind of deflation, where rising productivity and other such good things produces ageneral fall in prices, such as we had in the late 19th century. And as we haveexperienced that in the world of technology, where we view it as normal that the price ofa computer will fall, even as its quality rises over time.

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But that is not the kind of deflation we face today. We face the deflation of theDepression era, and central bankers of the world are united in opposition. As PaulMcCulley quipped to me this spring, when I asked him if he was concerned aboutinflation, with all the stimulus and printing of money we were facing, "John," he said,"you better hope they can cause some inflation." And he is right. If we don't have a

problem with inflation in the future, we are going to have far worse problems to dealwith.

Saint Milton Friedman taught us that inflation is always and everywhere amonetary phenomenon. That is, if the central bank prints too much money, inflation willensue. And that is true, up to a point. A central bank, by printing too much money, canbring about inflation and destroy a currency, all things being equal. But that is the trickypart of that equation, because not all things are equal. The pieces of the puzzle canchange shape. When the elements of deflation combine in the right order, the central bankcan print a boatload of money without bringing about inflation. And we may now bewatching that combination come about.

The Elements of Deflation

Just as every school child knows that water is formed by the two elements ofhydrogen and oxygen in a very simple combination we all know as H2O, so deflation hasits own elements of composition. Lets look at some of them (in no particular order).

First, there is excess production capacity. It is hard to have pricing power whenyour competition also has more capacity than he wants, so he prices his product as low ashe can to make a profit, but also to get the sale. The world is awash in excess capacitynow. Eventually we either grow the economy to utilize that capacity or it will be takenoffline through bankruptcy, a reduction in capacity (as when businesses lay offemployees), or businesses simply exiting their industries.

I could load the rest of the letter with charts showing how low world capacityutilization is, but lets just take one graph, from the US. Notice that capacity utilization isroughly in an area that we associate with the bottom of past recessions (with oneexception).

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Deflation is also associated with massive wealth destruction. The credit crisiscertainly provided that element. Home prices have dropped in many nations all over theworld, with some exceptions, like Canada and Australia. Trillions of dollars of wealth

has evaporated, no longer available for use. Likewise, the bear market in equities in thedeveloped world has wiped out trillions of dollars in valuation, resulting in rising savingsrates as consumers, especially those close to a wanted retirement, try to repair theirleaking balance sheets.

And while increased saving is good for an individual, it calls into play KeynesParadox of Thrift. That is, while it is good for one person to save, when everyone does it,it decreases consumer spending. And decreased consumer spending (or decreased finaldemand, in economic terms) means less pricing power for companies and is yet anotherelement of deflation.

Yet another element of deflation is the massive deleveraging that comes with amajor credit crisis. Not only are consumers and businesses reducing their debt, banks arereducing their lending. Bank losses (at the last count I saw) are over $2 trillion and rising.

As an aside, the European bank stress tests were a joke. They assumed no

sovereign debt default. Evidently the thought of Greece not paying its debt is just not inthe realm of their thinking. There were other deficiencies as well, but that is the mostglaring. European banks are still a concern unless the ECB goes ahead and buys all thatsovereign debt from the banks, getting it off their balance sheets.

When the money supply is falling in tandem with a slowing velocity of money,that brings up serious deflationary issues. I have dealt with that in recent months, so Iwont bring it up again, but it is a significant element of deflation. And it is not just the

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US. Global real broad money growth is close to zero. Deflationary pressures are the normin the developed world (except for Britain, where inflation is the issue).

Falling home prices and a weak housing market are one more element ofdeflation. This is happening not just in the US, but also much of Europe is suffering a realestate crisis. Japan has seen its real estate market fall almost 90% in some cities, and thatis part of the reason they have had 20 years with no job growth, and that the nominalGDP is where it was 17 years ago.

In the short run, reducing government spending (in the US at local, state, andfederal levels) is deflationary in the short run. Martin Wolfe, in the Financial Times,wrote the following last week (arguing that that the move to fiscal austerity is ill-advised):

We can see two huge threats in front of us. The first is the failure to recognizethe strength of the deflationary pressures The danger that premature fiscal andmonetary tightening will end up tipping the world economy back into recession is notsmall, even if the largest emerging countries should be well able to protect themselves.The second threat is failure to secure the medium-term structural shifts in fiscal positions,in management of the financial sector and in export-dependency, that are needed if asustained and healthy global recovery is to occur.

Finally, high and chronic unemployment is deflationary. It reduces final demandas people simply dont have the money to buy things.

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Deflation that comes from increased productivity is desirable. In the late 1800sthe US went through an almost 30-year period of deflation that saw massiveimprovements in agriculture (the McCormick reaper, etc.) and the ability of producers toget their products to markets through railroads. In fact, too many railroads were built anda number of the companies that built them collapsed. Just as we experienced with the

fiber-optic cable build-out, there was soon too much railroad capacity, and freight pricesfell. That was bad for the shareholders but good for consumers. It was a time of greateconomic growth.

But deflation that comes from a lack of pricing power and lower final demand isnot good. It hurts the incomes of both employer and employee, and discouragesentrepreneurs from increasing their production capacity, and thus employment.

That is why it will be important to watch the CPI numbers even more closely inthe coming months. The trend, as noted above, is for lower inflation. If that continues, theFed will act. I did a summary of Bernankes 2002 speech on deflation a few weeks ago.

For those who didnt read it, here is the link:http://www.2000wave.com/article.asp?id=mwo070210

If the US gets into outright deflation, I expect the Fed to react by increasing theirassets and by outright monetization, buying treasuries from insurance and othercompanies, as putting more money into banks when they are not lending does not seem tobe helpful as far as deflation is concerned. More mortgages? Corporate debt? Moving outthe yield curve? All are options the Fed will consider. We need to be paying attention.

One final thought before I hit the send button. Recessions are by definitiondeflationary. One of the things we learned from This Time is Differentby Rogoff andReinhart is that economies are more fragile and volatile and that recessions are morefrequent after a credit crisis. Further, spending cuts are better than tax increases atimproving the health of an economy after a credit crisis.

I think we can take it as a given that there is another recession in front of the US.That is the natural order of things. But it would be better to have that inevitable recessionas far into the future as possible, and preferably with a little inflationary cushion andsome room for active policy responses. A recession next year would be problematic, ifnot catastrophic. Rates are as low as they can go. Higher deficits are not in the cards. Yetunemployment would shoot up and tax collections go down at all levels of government.

That is why I worry so much about taking the Bush tax cuts away when theeconomy is weak. Now, maybe those who argue that tax increases dont matter are right.

They have their academic studies. But the preponderance of work suggests their studiesare flawed and at worst are guilty of data mining (looking for data that supports youralready-developed conclusions.)

Professor Michael Boskin wrote today in the Wall Street Journal:
http://www.2000wave.com/article.asp?id=mwo070210http://www.2000wave.com/article.asp?id=mwo070210http://www.2000wave.com/article.asp?id=mwo070210

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The president does not say that economists agree that the high future taxes tofinance the stimulus will hurt the economy. (The University of Chicagos Harald Uhligestimates $3.40 of lost output for every dollar of government spending.) Either thepresident is not being told of serious alternative viewpoints, or serious viewpoints aredefined as only those that support his position. In either case, he is being ill-served by his

staff.

As noted at the beginning of this letter, I find it very encouraging that there is amovement among Democrats to think about at least postponing the demise of the Bushtax cuts until the economy is in better shape. Those who advocate letting them lapse arein effect operating on our economic body without benefit of anesthesia. If they are wrong,the consequences will be most severe.

We need to think any tax increase through very thoroughly.

Maine, New York, Turks and Caicos, and Europe

Vancouver was a lot of fun. The Agora Symposium had some very good speakers,and if they invite me back again some time, I intend to stay for the whole event. TheWhiskey panel on Wednesday night was a hoot. The opinions shared were quite varied,with a lot of humor and some good-natured arguments. And I am going to try and get alink to some of the speaker presentations, if they will let me post a few.

I am rounding the corner and seeing the home stretch on my book. I hope to havea first draft in a few weeks, and then not take more than a month on edits and rewrites. Ineed to get it done, because my travel schedule the first part of August is hectic. I go withson Trey to the annual Shadow Fed fishing trip in Maine, which this year will be coveredby Bloomberg TV and radio, then Im back to New York for an evening , on to DC for

some consulting for the Defense Department, and then off for five glorious days in theTurks and Caicos, courtesy of Barry Habib and his family (ofMortgage Market Guidefame). I am sure I will get a little work done, but I intend to spend lots of time pleasurereading.

Then in mid-September I go to Europe. We are still finalizing the details and willlet you know the schedule soon.

I took the Agora team at their word and brought a bottle of chardonnay to thepanel with me, sharing some of the precious liquid. (It was a Kistler given to me by myCanadian partner, John Nicola.) Of course, it was soon gone. Some considerate attendeebrought me another large wine glass filled with chardonnay, evidently worried about thearduous, thirsty work I was doing arguing with Porter Stansberry. I really did wantsomething to drink, and for whatever reason did not sip but just took a big gulp. Turnsout it was pure scotch, not chardonnay. I did keep from choking, but I decided thatdiscretion being the better part of valor, Id better share the scotch as well. And next time,

I will sip first.

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Your just enjoying life now while I worry about the future analyst,

John Mauldin

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