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Economic and Market Commentary – September 1, 2010

The Case for Deflation

Now that August is finally over, which turned out to be the worst August in 10 years, investors are now looking for direction. The big question on most people’s minds is, will it be inflation or deflation? You can find lots of information on this subject on our website and my recently published Mid-Year Economic and Market Forecast.

What is deflation?

Deflation is a general decline in prices, income, and credit.  Right now we are seeing all three. For the last twenty years we have spent a dime for every nickel earned, and to do this we borrowed.  We came up with things like “teaser rates,” and “liar’s loans,” and “ninja loans,” and that’s just in housing.  To accommodate all this new borrowing, the shadow banking system sprang up, satisfying our thirst for more credit, more debt.  We rang up almost $18 trillion at the top of the biggest party ever.

Cheap rates and easy credit helped create the largest bubble the world has seen since the great Tulip Bubble in Holland in 1637. As of just 2 years ago, consumers had over 130% of debt to discretionary income, as you can see from the chart below.


This is the highest level in history and almost twice the long term average. Unfortunately, we depended on this growing flow of debt to keep our spending high and our country employed. 

Now it’s time to pay the piper and actually pay off our debts (imagine that!), either by choice (not renewing loans, paying off cars and credit cards) or by force (mortgage foreclosures, boat and car repossessions, credit card charge-offs). Very simply, this is no way to run a nation and certainly doesn’t lead to a robust economy. 

In an effort to ease the inevitable pain, our beloved government is borrowing at a pace that would rival that of a banana republic, and throwing the money into our economy. This has many thinking that this is likely to create inflation. However, what many fail to realize is that the private sector is destroying capital, largely debt, more rapidly than the government can spend it. This creates deflation.

As you can see from the chart at the top of the page, the government may be adding debt, but the private sector is dramatically lowering their debt levels at a torrid pace. 


Interestingly, over the past few years, our debt has been in steady decline and will continue to do so no matter what the government does.

Eventually the government will be successful in its bid for inflation, so stay alert. For now however, deflation is upon us so prepare your finances accordingly as it requires an entirely different investment approach than we are all used to.

That’s where we can help. Our active hands-on approach to managing portfolios can help you manage risk and deliver returns. If you would like to discuss the market, economy or get a free second opinion on your portfolio, simply call for a free consultation (916) 925-8900.

Warmest regards,
 – Keith Springer

P.S. – Be sure to add my email address to your address book so messages do not get blocked.

*Some information provided by HS Dent

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