You Can't Hide From Deflation

by: Jim Mosquera

Deflation is not what you might think — this article tells you what it is.

Deflation has one prerequisite — we've checked off that box.

Learn the relationship between deflation and the omnibubble.

Investment posture for a deflationary economy.

For fans of football, we often get that overhead shot high above the stadium from a blimp. The blimp's filled with helium to levitate the 250 ft. dirigible weighing 20,000 lbs. — quite an impressive feat. Credit can perform the same miracle for an economy by inflating it, at times in an unsustainable manner. We're currently in that state.

Inflation and deflation are two of the most misunderstood economic terms. As an investor, you need to have a firm grasp of these terms. The identification of each is typically gauged with prices — higher prices define inflation for most. Deflation is harder to understand since most alive today haven't witnessed falling prices, at least on the consumer side. My economic laws tell us much about inflation and deflation.

Economic Law #3 - Inflation precedes deflation

Economic Law #2 - Deflation is a lack of confidence

Economic Law #1 - Credit equals confidence

Inflation is an increase in the supply of money and credit. A blimp is a metaphor representing the scope of credit inflation in our economy. In order to fill that blimp, we need a great deal of confidence, since confidence equals credit. An effect of inflation is higher prices for the asset that's being inflated.

In “normal” times most of the credit created in the economy comes from the banking system. Borrowers have confidence that they can repay and lenders have confidence of debt repayment. If the economy grows, sufficient value is created to repay debt. Without sufficient cash flow, there is little hope of debt repayment. The ability to generate growth from debt is how we define self-liquidating and non-self-liquidating debt.

Self-liquidating debt is used for productive purposes. This debt usage promotes higher productivity or value creation and generates cash flow used to meet debt servicing and eventually retire debt. The cycle can continue as long as debt usage enhances the ability to meet debt service. Consider the example of buying a machine that'll produce more widgets in a shorter amount of time. The added sales will help pay off the debt.

Non-self-liquidating debt is consumptive. Borrowing for the purposes of consumption does not generate cash flow to meet debt servicing. A home equity loan used to pay for a vacation or household goods is an example of this type of debt. Neither the vacation nor the household goods will generate cash to service debt. This debt must be serviced from savings.

An overbalance of non-self-liquidating debt leads to problems. The housing crisis that became the recession of 2008 exemplified confidence (credit) on steroids and accounted for the meteoric rise and fall of a consumptive item; the roof over your head does not generate income. Housing's fall reflected my second economic law - Deflation is a lack of confidence.

Deflation is a decrease in the supply of money and credit. Since inflation precedes deflation, we can gauge deflation's potential by the size of the blimp, metaphorically speaking. An effect of deflation is lower prices for the asset that's being deflated. The financial assets that have been the beneficiaries of the omnibubble will be the ones to deflate the most.

The U.S. last experienced a pronounced, economy-wide deflation during the Great Depression. The helium expelled from that economy was the volume of a beach ball. The potential for our deflation is the aforementioned blimp.

To offer a "cure" for the last recession and the accompanying deflation, the Fed Wizards tried desperately to keep the blimp inflated through massive purchases of treasuries and mortgage backed securities. This inflation amounted to some $4 trillion. The central bank Wizards in other nations pitched in, buying sovereign debt and even equities to the tune of multiples of what the Fed did. These were massive, artificial injections of credit, and thus inflation, into world economies.

Consumers have contributed to the credit inflation via revolving debt, auto loans, and student loans. Not to be outdone, corporate America's pitched in with a surge of credit, much of it classified as marginal grade or lower.

How much of the debt bought by the Fed, added by consumers, or accrued by corporate America is self-liquidating — the debt can be paid off via productivity or value creation? The federal government does not pay off their debt, they simply roll it over. The Fed Wizards are now sellers of debt and are not replacing old debt with new. When the Fed buys government debt, it increases the supply of money/credit — inflation. When they sell, it decreases the supply — deflation. Since they inflated to the tune of $4 trillion, what happens when they deflate?

We can presume that much/most revolving debt is non-self-liquidating. While delinquency rates on credit cards are still low (2.5%), the rate was near 7% during the last recession. Non-payment of credit card debt is deflationary. Auto loans, which have skyrocketed, particularly of the sub-prime variety, added more helium to the blimp. Increasing delinquencies in this area are deflationary events.

What about student loans? The potential for deflation is astronomical with nearly $1.6 trillion of loans in existence. This amount's roughly $1 trillion more than at the start of the last recession. Some might argue that this debt is self-liquidating. I would agree that some of this debt is and much of it is not. The part that's not is deflation that we can suck out of the blimp. I'm also inclined to believe that politicians will propose a debt jubilee of sorts for student debt — also deflationary and a future burden on taxpayers.

The most important thing to understand about the inflation/deflation phenomenon is that there's no physical creation or destruction of George Washingtons, Abraham Lincolns, or Ben Franklins (the green pieces of paper in your wallet). The majority of money/credit exists in cyberspace, which is why its creation and destruction occurs far more rapidly. I haven't seen anyone burning Benjies anyway.

Here are other examples of deflation.

If someone pays off a loan, it vanishes in banking cyberspace, thus it's a reduction in credit. If a bankruptcy occurs and a creditor is not paid their due, that is a reduction in credit. If a loan is restructured, that is also a reduction in credit. If there is less credit in banking cyberspace, there are fewer units of money/credit chasing goods and services, which depresses the price, other things being equal (like money velocity).

Credit can also experience a contraction if lenders don’t want to lend and borrowers don’t want to borrow (i.e. they are saturated with debt). This is why deflation is also a psychological phenomenon.

Prices can increase or decrease for reasons other than credit expansion or contraction. If a hard freeze hits Florida and ruins the orange crop, you can bet oranges will be more expensive. Conversely, if the groves in Florida unexpectedly produce double the anticipated harvest, we would anticipate lower prices.

There will be reluctance to create or accept the credit levels of our recent history until the catharsis occurs that normalizes debt levels in the economy to match asset values and productive capacity to repay. Some of the debt existing in the economy has little chance of being repaid.

When money/credit disappears from the economy, you can bet there'll be less pricing power associated with those assets being chased by said money/credit. Stock values can disappear. The same can be said for real estate. In fact, any financial asset value can disappear based on the bid price.

Anticipate debt restructuring for businesses and individuals. During a deflationary period, cash is king, though the monetary Wizards are no fans of cash. If you have cash, you will be able to buy financial assets or businesses for less. In the meantime, recognize that you may find yourself in an environment where some prices could rise within a broader deleveraging economy. Those areas of the economy that witnessed the most credit absorption will be at most risk for deflation (stocks, bonds, real estate). This deflation will open up opportunities in short ETFs and mutual funds as well as long volatility plays.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.