The D word

Sorry, for the delay, but I had issues with my internet connection and I was away for a few days attending the U.S. Open in New York. The weather caused the tournament to be a bit hectic, but nonetheless it ended with a bang. Not going to lie...I was rooting for Mickelson. With everything he has gone through in the past weeks, and will have to face in the near future, it's hard not to root for Lefty. It was great to see Duval, who overcame vertigo, make a run for the championship as well. Congratulations to Lucas Glover for playing well on Monday to win the Open. I would have liked to see the Open played in better conditions but it is what it is and the tournament was a success. The atmosphere was great. It was my first major and surly won't be my last. I like the fact the PGA gives public courses the opportunity to show they are worthy of hosting a major.

While in New York, I attended a Mets game as well. If you weren't aware, they recently built a new stadium, Citi Field. The amenities were great and the staff was friendly. The lines for beer were quick and they even served corona...a major plus. A far cry from Fenway, but still great to see a new stadium. The overall atmosphere doesn't compare to that of Boston, but what else can you expect after watching most of my professional sports games in the most diehard sports city in the country.

I'd like to talk about one of the major debates going on in the economy today. The inflation vs. deflation issue. For the sake of keeping the blog quick and concise, I'll talk about the side which I strongly believe will play out.

Most of the people you hear talking will this side with inflation. In fact, I'd go as far as to say about 80% of pundits believe inflation is the major concern. Sure, inflation will no doubt be an issue down the road, but it could be years away before we see a whiff of it....at least the runaway inflation scenario which everyone seems to be so concerned with. Being a contrarian, I like to go against popular opinion and side with the deflationists. Any practical economist should be able to see deflation looking straight into the eyes of the U.S. economy.

Listen, the Fed would not have throw trillion upon trillions of dollar at this mess, to re-inflate our economy if they didn't see the deflation locomotive heading right at them. Even after they've thrown trillions of dollars at this, the phantom of deflation is still winning the battle.

First off, the U.S. is a credit (debt) based economy. Simply put, this means there is far more debt in our economy than cold hard cash, thanks to the fractional reserve lending system. As I've discussed before, debt (credit) was cheap (low interest rates) after the burst of the tech bubble. This cheap debt inflated nearly every asset class. Now that that debt can't be repaid, asset prices need to readjust back to reality. This is called debt destruction. Debt destruction is deflationary because money is destroyed which causes general decline in prices. This can easily cripple an economy and was the monetary phenomenon that took place during the Great Depression, which is why the Fed is trying to avoid it all costs....literally.

To avoid deflation the Fed has given trillions of dollars to the banks to shore up their balance sheets. If the banks don't have money to lend, businesses cannot operate, consumers cannot borrow and the economy will slow. Prices will need to drop in order for people to be able to afford goods and services. Econ 101 - supply and demand: Banks have the supply, but their isn't the same demand for the debt as there use to be. The household debt to income ratio is about 130%. This basically means that for every $100 earned, the average household has $130 in debt payments. This could be in the form of credit cards, mortgages, auto loans, student loans, etc. The consumer is beginning to deleverage (reduce debt) and is no longer willing to borrow money, which it cannot repay. Add to the fact that lending standards have tightened and you can see the strain that has been put on our credit based economy.

Now, you need to also factor in the massive job losses the U.S. The more jobs lost, the less money in the system. This slows the down the velocity of money, which is deflationary. Debt payments cannot be met, which will hurt the banks holding securitized assets even more. We are seeing record high credit card write downs now. People literally do not have the money to pay their bills. It's a scary situation. The banks have these massive reserves they are sitting on. I believe they are sitting on these because they see the economy getting worse and will need the money to keep there balance sheets in somewhat decent shape. Go back and look at the mortgage reset graph I posted last month and you'll see the other crisis which we will soon be facing. Money will be needed to offset these massive losses. This is, once again, deflationary.

The consumer makes up about 70% of GDP. Now that they aren't spending, businesses are slowing down. The government is trying to step in to replace where the consumer has fallen off, but they don't have the funds nor the brains to allocate the capital properly.

From a business standpoint, the PPI (producer price index) recently dropped to its lowest level since 1949, capacity utilization has fallen off the cliff, and industrial production has slowed down massively...all major signs of deflation.

So while most economists continue to be infatuated with inflation, I expect more deflation to be coming our way. I'm not sure if they just want to ignore the signals or just look at all the money the Fed has printed and associate inflation with that. There are many valid arguments made for both sides, but from where I sit, deflation is the major concern and will continue to be for the foreseeable future.

Without going into too much detail, this provides the premise from which I base my deflation bias upon. If you have a different point of view, feel free to share it and we can discuss the matter.