Deflationary Depression: The Simple Explanation

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Includes: BAC, GS
by: James Wood

90% of the people believe the economic problem is in the process of being resolved and that 2010 will be significantly better, even though many admit there might be some short term set backs on the way to the recovery. Government officials, many economists, and the vast majority of market analysts are saying it is so. This writer and a very small minority say the truth is that a terrible, deflationary depression is probably starting in the coming months. Here is why people like me think this.

It is all about the amount of money and the prices for assets when there is less money. The American government has pumped several trillion dollars into the economy in the last two years. However, the value of real estate has gone down many trillions more, in both commercial and residential real estate. The value of stocks has still declined many trillions from the October 2007 high, even taking into account the substantial recovery since March 2009. In short, there is a lot less money going around today than there was in October 2007, even when you add back in the trillions put back into the economy by the US government.

How does this affect prices and cause deflation? Look at a hypothetical country that has assets of only 4 apples and $4,000. What is the price of each apple? Inevitably, the price of each apple is $1,000. While economists do not have a problem with this simple example, it is much tougher in the real world. Yet the fact is that if the amount of real assets remains constant and the amount of money goes down, the prices of things are going to go down.

In spite of the government pump priming of trillions, the real money supply is down because the value of assets that define money is down dramatically. Furthermore, the prospects for 2010 are a continuing and likely dramatic further decrease in the amount of money. Approximately one quarter of the nation’s mortgages are owed by people whose house is currently less than the value of the mortgage. (See details of housing risk). Mortgage workouts have not worked and a new explosion is coming. Commercial real estate values are dropping. Savings are going up as people are realizing they must borrow less meaning that debt at the consumer is level is not increasing which could help further new purchasing for business. In short, the driving force of the economy, the consumer, is pulling back in part because of necessity and in part because he realizes that he cannot go on as he has, particularly if he is now in the 1 in 6 people who does not have a job or works in an unsatisfactory part-time job.

One problem in understanding this for many people is knowing what money is. Traditional definitions of what is on commercial bank balance sheets have become almost meaningless. The massive creation of bonds that keep getting repackaged and then resold as new bonds shows how we can now almost have infinite money creation, since for practical purposes there are no meaningful reserves to limit the creation of new money by relending.

While few people doubt that money is created when stock market prices are going up, most people find it illogical that money disappears when stock markets go down. People say that someone must have the money, but it is not so. If Google (NASDAQ:GOOG) sells for $500 per share and there are 1 million shares, there is a monetary value of $500 million. If just one person sells one share for $300, and no one comes along to argue with that evaluation, then all shares are worth $300 until someone comes with a new price, either higher or lower. The reduction in value did not go into someone's pocket, the money simply disappeared. As the stock market is 30% less today than October 2007, the holders of those stocks have collectively lost 30% of the value that existed in 2007. Likewise, all the owners of homes in America have lost something like 20%, with some markets taking as much as a 50% loss. The decline in the value of stocks and housing far exceeds the stimulus money put in by the government, and it is for that reason we are at the beginning of the deflation, not the inflation currently expected by those buying gold.

Many readers may, at this point say, I understand how there can be deflation, but why is it necessary that this will lead to a depression? The simple answer is that we have had decades’ long monetary creation that has little justification for the price except for the amount of money chasing it. When there is a dramatic decline in the money supply, something which is clearly started but far from finished, this means that there will necessarily be a dramatic drop in prices.

A dramatic drop in prices means that those people living with high debt levels will now proceed to go broke. This is true at both the consumer level and the business level. As individuals go broke, their capacity to consume drops dramatically. As businesses find they have far fewer customers, particularly those who live with high debt levels hoping for ever increasing sales that will not now develop, end up going broke. In short, declining prices means that people in debt will now go broke in large numbers. These individuals and businesses going broke is what will bring on the depression.

We have had massive monetary creation for decades now which we have finally come to the day of reckoning. Alan Greenspan in 1996 talked about “irrational exuberance” and was right on. The only problem was that he was a decade or so early in picking the top. We do not know if the top will be next month, next year or even later. But we certainly are getting to the top where we cannot buy our way out of the problem through a new stimulus injection.

There are many measures of a market and monetary top. But one of the clearest is when the government virtually is assuming all the risk. There is virtually no private sector housing financing going on. Virtually all lending is being laid off to the government (Fannie Mae (FNM), Freddie Mac (FRE), etc) and these government agencies are all bankrupt. The government lends trillions virtually for free, and it is not really fixing the problem. When nearly interest free stimulus does not work, will the government pay to you to take money? Money 1) that has little or no cost, 2) that is all borrowed and 3) with few opportunities to invest beneficially, cannot offset the economic collapse. Government stimulus works in the early and mid stages of economic expansion, but is largely wasted money in mature stages of the economic cycle where everything than can be done beneficially, has been done.

Thus, it is not surprising that government stimulus money is going to the wrong places with the wrong result. The payment of B of A of the TARP money is extremely illogical, worsens the position of the equity shareholders and exposes the banks to a much worse downside scenario when the economy further weakens. (See this article on B of A.) The payments of Goldman Sachs (NYSE:GS) to its employees are equally bad. The payments are made now before we see the results and the shareholders are left to hold the bad bag of problems likely to come. The government money does not find good places which stimulate useful investment and is going to make another financial bubble which the world citizens will pay for shortly. Dubai is providing a cannon shot across the bow about the risks of unjustified massive spending that basically relies on the presumption that a government will bail them out and the borrower never really had good financial analysis, enough to justify the loans.

This seems old fashioned, but government stimulus can only work where there are beneficial areas to invest. Since we do not have good investment opportunities, the money is wasted and ultimately worsens the amount of problems that we have to deal with.

In short, what can we expect if this writer's view point is correct? In the coming months, we can expect to see a return to the down side with a loss of value in almost all categories of assets with the exception of the dollar. Oil, gold, silver, and commodities generally, long term bonds, both government and private, currencies other than dollars, emerging market debt, high yield debt, municipal debt, stocks of all kinds and countries should be collapsing at some point during the next year or so. While the dollar will be viewed adversely, it will look better than most of the rest. Even so, this period will represent the end of the dollar’s dominance as the world’s reserve currency and countries such as China will come more into their own. Protection of your assets' principal value is your first priority, not "making money" on your investments.

For an analysis with many points in common with my analysis above, read this summary of an International Monetary Fund report.

Disclosure: No positions