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Wednesday, July 09, 2008


deflation at work

mish through minyanville offers a brilliant anecdote of how deflation is undermining wages and (yes) even prices as we speak.

I own a computer business and I used to pay techs $15-20/hr. I now have people willing to work for $8-$10/hr. While the nice guy inside is saying “pay people well” the businessman is saying “market conditions demand paying people what the market will support.”

Recently I have had to offer price discounts to obtain new business. Some contracts I picked up were for around 1/3 of my standard fees. I have cut costs to the point where they can be cut no further if I am to maintain my debt obligations. I am now at the point where my options are to work more hours for less money or “exploit” the labor market. Considering that I am already working 80-90 hour, there was no choice.

I just interviewed a single man nearing retirement age with a young daughter a couple years older than mine. He is not only willing, but trying to hide the fact that he’s DESPERATE to work for $8-10/hr. I might be able to afford to pay him $12/hr today, but with what’s coming over the horizon, wisdom dictates paying him $8 and using the difference to lessen debt obligations as quickly as possible. That would lower my costs for when the available business gets even tighter, leaving me in a stronger position to bid and win, and helping make sure he’ll still have a job in 12+ months.

this mechanism is at work in business small and large alike -- witness massive layoffs driving unemployment higher and credit standards tightening, and one can see the chances of a wage-price spiral that would drive an inflationary spiral are simply zero. there may come a desperate time when the government takes a conscious step to debase the dollar through printing -- but it will likely be in response to an incipient deflation taking strong hold of the american credit-based economy.

john mauldin passes on more excellent research from hoisington investment management on why deflation is the next war.

How is it possible that bonds, which have the ultimate sensitivity to inflation, would decline in yield and rise in price in such an inflationary environment? The short answer is that in the broadest terms, insufficiency of demand has, and will continue, to overwhelm inflationary forces, creating deflation in many categories.

In the second quarter, current dollar gross domestic product totaled an estimated $14.3 trillion, about $572 billion greater than a year ago. Of this gain, $359 billion can be attributed to price increases and $213 to higher real output. There are times, however, when GDP is not the final arbiter of the economy's performance, and this is one. The seemingly large gain in GDP pales in comparison to the loss in wealth, which GDP does not capture. Over the past fiscal year, holdings in the stock market, as measured by the Wilshire 5000 Stock Index, lost more than $2.1 trillion. Simultaneously, the 15.3% contraction in the Case Shiller Home Price Index suggests the wealth loss in value of household residences was a staggering $3.1 trillion. Without including the negative wealth impact for declining prices of automobiles and other durables the total wealth loss was approximately $5.2 trillion. Obviously, the sum of dollars being erased from our economic system has overwhelmed the amount of dollars being increased by inflation by a factor of more than 14 to one. Thus, once again, the bond market had it right--deflation is in ascendancy. Treasury bond yields fell, and they will continue to trend lower, creating an even more profitable environment over the next four quarters for long-term Treasury bond holders.

i've been harping in credit availability/contraction as the arbiter of our future path. some others view government fiscal stimulus as a potential offset for private sector trepidation. i've never subscribed to that -- the credit pie is too large, and incremental changes in it will chew through overwhelm even aggressive fiscal stimuli -- but this analysis of how government fiscal stimulus in a deep deficit condition is actually counterproductive is both straightforward and damning.

Fiscal policy would seem to be undisputedly supportive for the economy with the Treasury's $110 billion in rebate checks and a Federal budget deficit that is approaching a record $500 billion. But that is not the case. The Treasury does not have $500 billion in its checking account to cover the deficit, nor even the lesser amount for the rebates. The Treasury has to raise the funds by selling debt securities to the private sector. Credit availability may be thought of as a pie. When the Federal sector, which is the economy's premier borrower, takes more of that pie, fewer dollars are left for the private sector. Thus, deficit financing crowds out funds that would have gone to private uses. With the exception of the Federal funds rate, in the first half of this year virtually all money and bond yields rose, a clear sign that the deficit usurped funds for the private sector. This has had the impact of slowing, rather than stimulating economic growth.

in other words, the austrian model is trumping the keynesian as private credit collapses -- fiscal stimulus, while providing transient short-term flowthrough to gdp, is forcing interest rates higher and cutting off what would be private financing in the short and intermediate terms. because govnerment did not fill its coffers in the good times -- indeed, quite the opposite -- it will now have to call on resources that would otherwise take part in preventing a deeper credit contraction from materializing.

and this was observed on rebate checks totalling $150bn. what happens when government goes to market seeking financing to expand the FDIC and nationalize FNM and FRE? (for more on what awaits the GSEs, check david merkel's summary of disaster finance.)

the charting in hoisington's paper is positively deathly, showing that both consumer sentiment and the pace of private credit contraction are currently worse than at any point since the great depression. if you can find a way to spin that positively, please comment.

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