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Deflation has been a hot topic of debate these days. People are concerned that prices and wages may actually start falling. This is a likely event given that consumers are saving more and deleveraging is on its multi-year cycle. Housing is having a hard time standing on its own two feet even with rates artificially at ridiculously low levels. Consumption is 70% of GDP and such a high percentage is not sustainable going forward. We have piled on massive amounts of debt on the government level and at a personal level that it has become too high and can lead to dire consequences.

The solution to this problem is not to create another problem which is what our government is trying to do. They think printing money is the right way to go about things in order to fight deflation. When someone is sick, you can give him or her antibiotics, but it won’t help the viral fever go away. As Einstein said “The definition of insanity is doing the same thing over and over again and expecting different results.”

The question I ask: Is deflation a bad thing? We have bid up the price of our houses beyond a fair level and have levered ourselves to unsustainable levels, that a drop in prices is a good thing so we can get to fair value where buyers equal sellers. This may cause panic and mayhem in the short term but will eventually lead to a huge sentiment shift in the right direction.

Right now, most sophisticated players know that the government has propped up housing and that the whole system is a bubble. There is no faith in the system and people are scared of buying houses even though mortgage rates are hitting lows every day. Housing prices still have a further decline coming.

Even though the government gets temporary programs out to boost housing prices, these programs only confirm the fear in the mind of the buyer if his or her home is really worth what he paid for. Why can’t we let the free market take over and bear the pain in the short term? It will hurt a lot of people but it will reinstate confidence and remove the artificial ingredients from the system.

What I fear more than a deflation and a double dip is government intervention. It becomes incredibly difficult to value an asset and hence, many investors hold back on making investments they would have in a free market in which they had more faith in the system where the rules wouldn't change every second. Why are we so scared of letting housing prices correct to where they should be? Why are we afraid of the government leaving the mortgage market?

What is surprising to me is that we may get deflation despite a weaker dollar. If Europe’s troubles show up again, we are destined to get deflation because of a stronger dollar. But now it seems as though we may get deflation with a weaker dollar. This is because the money is not coming into the system and the consumers are saving more. The banks have tighter lending standards (thank god!) and are parking money in treasuries instead of lending this money out. So this money is not getting out.

This has the potential to change because the Fed is flattening the curve which would mean the banks earn less money. So it is possible they will lend this money out in the future but there is no evidence of that yet. Once again, the government is creating complications in the system.

From the consumer standpoint, credit has been tight. Unemployment is high and people who have jobs have just started becoming more cautious as well. The consumer debt numbers that come out have negative signs in front of them signaling the ongoing deleveraging cycle. People are paying down their credit cards and the whole system is slowly unwinding and it will take a while to finish. Until then, as we save more, this deleveraging is a deflationary force that is very strong at this moment. The deflationary forces are mainly due to consumer deleveraging and housing.

We clearly have a problem, let there be no doubt about it. The entire system was running on unsustainable leverage and prices. We must find a solution but not one which creates another problem. The government needs to evacuate the dance floor because it is just kicking the can down the road which will then be someone else’s problem. The best thing for us to do is to give incentives to people through lower corporate taxes and lower individual taxes. Make the environment conducive for business and hiring. Tax cuts may mean loss of a few billion in revenue but it’s a big sentiment changer.

Meanwhile, let’s get rid of some other aspects on the budget like defense spending. Can we also please cut the overly inflated government wages? Doing so by 10% would create enough jobs to get the unemployment rate down by multiple percentage points. Clearly, we know where the inefficiencies lie.

The time to act is now. We are not going down the wrong road. We are already in the mud and headed towards the cliff. We got ahead of reality and we are catching up to it because reality can’t change. Our inflated standard of living must adjust to where it should have been in the first place. Let’s shed the arrogance and accept the painful process which may even result in deflation. The other choice is continued money printing which will one day lead to hyperinflation as the money in the system finally shows up.

The end result in the second situation of hyperinflation will be far worse because people will lose faith in the system and confidence will be shattered. Either we are going to consume less and reduce our standard of living substantially or a falling dollar will do it for us.

The American Dream can still be alive if we choose to keep it alive. Let’s get clean, come out better and stronger.When the people lead, the leaders shall follow.”

Disclosure: Author is short IWM

Source: On Deflation and Government Intervention