Deflate/Inflate

In a severe recession or a depression, “deflation” – the fall of prices – is often one of the consequences. While prices fall, making goods and services cheaper for those with the ability to buy, the reason for this decline is a reduction in consumer demand precisely because people can’t afford to buy or are clinging to their dollars out of fear because of a contracting economics. High unemployment, a credit freeze, market uncertainty, a horrible housing market and the worst GDP (“gross domestic product” – America’s “output”) contraction since The Great Depression are the drivers of the current “depression” of the cost of goods and services and the erosion of the tax base that supports government activity (look at California as an extreme American example). But with that reduction in cost comes a lack of consumer demand that sustains unemployment, GDP contraction, and a bad housing market, which in turn fuels market uncertainty. A vicious circle.

So to stimulate the economy, to break that circle and to replace the missing “consumer demand” and “restart” the economy, Washington has passed the huge stimulus bill that has the right and left arguing over “socialism” versus “free market, let the chips fall where they may.” The Democrats argue that those desiring “free market” adjustment are the same Republicans who deregulated the economy to create this mess in the first place, and the Republicans (including those who voted for President Bush’s TARP stimulus package) point to the huge deficits and the borrowings that are necessary to finance the stimulus package; they fear inflation. Who’s right?

Strangely, they both are. First, there is no clear “right answer.” Whatever path is taken will be very uncomfortable for a very long time. Most mainstream economists place restarting the economy as a priority above avoiding massive deficits, and this really is a “red alert” emergency (like a war) no matter how you look at the situation. The stimulus package (which actually may be inadequate!) will takes years to move the economy into the “acceptable” range, but proponents say this is better than the decades of damage expected in an unregulated free market free fall adjustment.

The Republican point, focusing on the impact of excessive borrowings, is that inflation – serious double digit inflation – is the probably consequence of massive deficits. And as the dollar declines, at it clearly seems to be doing, selling our national debt instruments … indeed the very status of the dollar remaining as the global currency… become problematical. While some European nations are incurring massive deficits as well, in the most recent few decades, Europe’s sustained willingness to tax its businesses and citizens at vastly higher rates than the U.S. (in part to support social safety nets and healthcare) provides a much better cushion against inflation (they can actually pay their borrowings down faster because they have more government money to do that).

American policies over the past years have been driven by huge pre-meltdown spending (the Iraq and Afghanistan wars) with massive tax cuts, mostly favoring those in the highest income brackets. With U.S. taxes relatively lower than most of the Western world, we have been more reliant on deficit spending to support our ways – living above our means. But financing a deficit by selling long term treasury bills into the global marketplace with a sinking currency means that we have to pay increasingly higher rates of interest (which increases our federal budget by the higher debt service) to attract buyers for our bonds. While some have suggested that inflation is more likely later in the cycle when flattening out (and perhaps even slight recovery) begins, evidence in the markets tells us that the road to higher inflation is already here. The handwriting is on the wall.

The U.S. dollar has slipped to five month lows against the British pound and the Euro. The May 23^rd New York Times: “Crude oil futures rose above $60 a barrel this week, and gasoline prices climbed to a nationwide average of $2.39 a gallon, according to AAA, the automobile club. The price of gold — a hedge against inflation — rose to nearly $960 an ounce, its highest price in two months, and investors also raised the prices of copper, wheat and corn… Interest rates were higher. The Treasury’s benchmark 10-year note fell 22/32, to 97 9/32, and the yield, which moves in the opposite direction from the price, was at 3.45 percent, up from 3.36 percent [on May 21^st].”

The problem with inflation hitting the U.S. so early in the period of adding stimulus dollars to our markets is that we don’t stop the deflation, but the dollar is still falling – stagflation – the government has, to date, specifically committed well less than 10% of the huge American Recovery and Reinvestment Act stimulus approved by Congress and signed by the President months ago. This early fall in the dollar and concomitant rise in the cost of our borrowings and commodities means that the government may have to continue subsidize American interest rates by keeping the rate at which banks borrow from the Federal Reserve fairly low (which also depresses the value of the dollar; hard to invest in a country when you get a low interest rate return) while borrowing that same money in global markets at higher rates.

The bottom line is that the complexity blending of economic variables suggests that our hitting bottom will take longer and recovery will be slower and intermittent; Americans will probably have to deal with rising prices and expensive money in the future – perhaps even double digit inflation as we saw in the late 1970s. There are no absolutes, no certainties, just trends. Political reality, new economic chaos from any part of the globe, conflicts and instability shifts (particularly in the Middle East or Pakistan/Afghanistan), natural disasters and changes in consumer perception can alter the best projections of the most qualified economists. It just helps to understand the pieces, even a little bit at time. Complexity yields to understanding when the bits of information are digested a little at a time.

I’m Peter Dekom, and I approve this message.