Deflation

Deflation occurs when asset and consumer prices continue to fall. This may seem like a great thing to consumers, except that the cause for deflation is a long-term drop in demand. Unfortunately, a drop in demand means that a recession is already underway, with job losses, declining wages, and an ongoing decline in the value of your home and your stock portfolio. Deflation is a result of businesses dropping prices in a desperate attempt to get people to buy their products.

Japan itself has been wandering in a desert of deflation for the better part of two decades. Then, Japan’s most faithfully consuming customers became victim to a crisis of overconfidence, as Americans and the rest of the world are tightening their belts. So while savings rates went up to a 14-year high, Japan’s exports dropped off a cliff. The month of May recorded a year-over-year decline of above 40%.

Unsurprisingly, Japan’s government tax receipts came down below expectations too. “Overall tax revenues slid by record 13.2% for fiscal year 2008,” The Japan Times reported last week. Even more worrying, “corporate receipts sunk by almost a third (32.1%) as earnings deteriorated.”

So are the United States, Britain and the EU doomed to repeat the mistakes they warned the Japanese about two decades ago? Is the rest of the world heading toward terminal deflation, a negative feedback loop of earnings destruction and job layoffs? In many ways, the world economy is already there. In the USA the jobs loss numbers predicted of 365,000 jobs for June, turned out to be 467,000 meaning that many more people causing a further “slack” in demand bringing another wave of significant downward pressure of prices in the near future. Besides home values are still falling, while foreclosed inventory levels do increase every day.

America’s assets have only been hissing for two years, Japan’s have lost two decades worth of ‘hot air’ value. As one blogger recently quipped, “What is the natural price when everyone wants to sell?”
The natural correction for low prices, of course, is low prices.

Consequently this is proof that the feds' bailouts, boondoggles and bankers' bonus plans aren't working. At the end of last year, they predicted a total unemployment figure of 8% for the whole of 2009 - if their stimulus plans were not enacted. But these were enacted. Unemployment is yet at 9.5% halfway through 2009 and it is still rising. It will be over 10% before the end of the year. Global trade is collapsing; exports from Germany and Japan are down about 40% from a year before. Causing prices going down too. The entire Euro zone has slipped into negative inflation according to a report last week. And from Britain came data showing a contraction of 2.4% in the first quarter, bringing the year-to-year decline to nearly 5%. "Economy shrinks at 1930s rates," said the headline in last week's Telegraph.

Another cycle is starting: The beginning of a major credit contraction, with no pent-up demand, no savings, and too much capacity to turn out too much stuff that too many people don't have the money to buy. Not to mention that to turn the world out of its downturn, contrary to this analysis, the G8 summit is going to require that banks have got to lend more money!

Housing prices are still going further down everywhere and with housing values down as a result lenders’ collateral is diminishing too. Residential property prices have fallen 33 months in a row. Subsequently many houses are "underwater" meaning that the nominal mortgage value is higher than the relative market value of the property.

More foreclosures are coming. Many mortgage loans typically call for "down the road modifications" that lead homeowners into a kind of financial dead-end-road, with no way out except foreclosure.

“According to a study by T2 Partners, there are three more big waves of foreclosures still ahead - including those in 'prime’ loans, home equity lines of credit, and in commercial real estate.”

"When these mortgage backed loans start adjusting upward it will turn millions of homeowners into over-levered, underwater renters, and ensure housing is a dead asset class for years to come," according to the Field Check Group.

With incomes falling and house prices weak, consumers will miss payments, default, and cut back spending. Business earnings will decline; bankruptcies will increase. This economic under current is treacherous.

The British economist, John Keynes, famously observed, “The market can stay irrational longer than you can stay solvent.”

This crisis is a depression and not a recession. In a recession, an economy takes a rest, but in a depression an economy drops dead. Businesses go broke. The whole structure of the economy changes because of the inevitable creative destruction, as corpses are dragged away and new enterprises take their places.