Not Your Father’s Deflation

What heretofore has been billed as a “liquidity crisis” involving some sub-prime mortgage fallout, then a “credit-crunch” as lending standards become tighter, looms larger now as a potential “debt-and-solvency crisis” with the passing of investment house Bear Stearns at the end of last month (with attendant rumors and whispers of “who’s next?”).

In a maneuver reminiscent of the creation of the Resolution Trust Corporation to hold toxic real estate waste from the S&L crisis of the early 1990s, the Federal Reserve is setting up a $30 billion junkyard to hold and – eventually – sell the most noxious elements of the former Bear Stearns’s assets (now with a $1billion first-loss put to JP Morgan Chase as punishment for having to renegotiate the “done-deal” of March 16^th).

As asset values continue to fall, particularly real estate and stocks, as consumers rediscover frugality, and as a quickly slowing economy stagnates (Fourth Quarter 2007 GDP slowing to 0.6% from 4.9% the previous quarter), the Fed is not only following its deflation-fighting playbook but apparently calling some audibles as well. (See “Deflation: Making Sure ‘It’ Can’t Happen Here,” remarks by Dr. Ben S. Bernanke, Nov. 21, 2002.)

The Fed knows as asset values decline, related debt values stay the same and slow a timely economic recovery. It’s the story of the Great Depression, of which Dr. Bernanke is an expert: asset values plunge, existing debt remains, new debt creation is impeded, unemployment surges, consumer spending plunges and business investment languishes and the economy seizes.

The New Deal solution in the 1930s was to REFLATE the economy by devaluing the dollar 40 percent (by revaluing gold to $35/oz. which gave banks significantly more ability to lend under the then-in-force gold standard) and by government employment programs funded with deficit spending (the creation of new money, described by Dr. Bernanke as the “logic of the printing press”).

A generation later, cost-push price inflation of the 1970s gave way to a deficit-spending, Fed-induced program of wage inflation in the early 1980s as employers were forced to bid up salary and benefit packages and labor unions won generous cost-of-living concessions, resulting in annual wage growth in the 15 percent to 20+ percent range for a number of years.

In the midst of the current deflation, however, some of the older implements in the Fed toolbox may not prove to be as effective, namely massive deficit spending, but the long-term goal – reflation as a means of restoring the economy – remains the same, and we can expect the Fed to continue to embrace the logic of the printing press to accomplish this objective.

Anecdotal evidence of economic slowdown, perhaps recession, emerge daily in various parts of the country as economists, financial pundits, astrologers and other guessers attempt to parse the mountains of conflicting data now pointing every direction – commodity prices way up, stocks mixed, bonds up, real estate down, unemployment creeping upward, and on and on.

This economic event – perhaps not your father’s stagflation – appears to be unfolding much more slowly than wishful thinking believes prudent, and those troubled sectors of the economy thought “contained" six months ago, in retrospect, may only have been the opening pitches of the first inning of a very long game. And since, as with baseball, “it ain’t over ‘til it’s over,” extra innings cannot be ruled out of the realm of possibility. (Japan’s economic malaise is by some accounts in its seventeenth year.)

Our thought, more gut feeling than a conclusion validated with empirical data and continuing the sports analogy, is that if the economic event unfolding before us was a baseball game, the collapse of Bear Stearns last month would somewhere near the end of the second inning. So now we’re at the top of the third, and, as always, good pitching beats good hitting, which is why the forces of recession so far are holding on to a no hitter. First quarter corporate earnings are due in earnest by mid-month, and continued write-offs by financial institutions largely will determine the inning’s course and likely the rest of the game.

To date, financial institutions have written down about $150 billion since mid 2007. Where does it end? It’s a moving target, but the numbers keep getting larger, ranging from $500 billion to $3 trillion worldwide depending on the mood of the prognosticator and the willingness (and ability) of the Federal Reserve to continue backstopping those institutions deemed “too big to fail.”

Losses of these magnitudes ultimately are deflationary as asset values are peeled away and protracted reduced consumer consumption leads to the “stagnant” component of stagflation. The inflation element – big-time, 1980s-like wage growth – comes later should the Fed decide – again – the only way to solve a debt crisis is to inflate it away.