By Daniel A. Barnes

Unemployment is 11%, there is no pricing pressure, credit isn’t available, and the savings rate has skyrocketed, from negative to over 7% within two years. People are spending a lot less money, almost 10% less, than they were just two years ago. Rising unemployment will continue to keep downward pressure on assets, wages, and the inflation rate.

Last month I talked about Inflation. I believe that Inflation is a serious future problem; however, Deflation is a serious current problem.

Deflation is when the prices of things get cheaper. We are used to a certain amount of deflation in some industries like electronics or computers, but deflation is not otherwise a common modern event. Deflation is abnormal because governments tend to overspend–then print more money in order to more easily amortize accumulated debt. But sometimes, exogenous events occur that reverse the virtuous cycle of rising prices. When this happens, wealth and credit are destroyed and a vicious spiral of asset deflation ensues.

The US economy has been teetering at the edge of deflation for nearly two years. By one estimate, the government has printed $2 Trillion dollars but the recession has destroyed $15 Trillion in credit and other assets. The destruction of asset value is a deflationary event, because it literally means there is less money in the system.

Deflation is a problem today because of the decline in real estate and financial markets, as well as the weak position of employees. Worker compensation comprises 70% of the total economy. With 2,146,000 unemployed Californians (11.6%) employees are hesitant to ask and unlikely to receive raises. Further, employee’s inclination to leave their jobs for other opportunities, is at its lowest level since the Bureau of Labor Statistics began tracking this data point fifty years ago.

Why should you care? I’ll tell you, its because if workers can’t get raises, it’s very difficult for inflation to rise. Without inflation, deflation occurs. Deflation reduces cash flow (income) and creates a very difficult situation for anyone carrying debt because debt needs to be amortized from cash flow. If cash flow (including income from wages or other sources) is falling, then it is hard to keep up with debt payments (think mortgages and foreclosures and other bankruptcies).
Last month I made the case that inflation is going to become a problem. And I still believe that over the next three decades, it will be higher than in the last twenty years. But what the future portends, does not necessarily apply today, tomorrow, or even this decade!

The Bottom Line

But don’t despair: there is reason for hope over the long-term. The current high savings rate indicates an opportunity for higher economic growth; particularly once that savings is invested productively to educate our children, overhaul our infrastructure and transportation systems, and support the development of new growth industries like clean-tech and alternative energy sources.

In the short-term, it’s Deflation that we must worry about. Expect the federal government to continue massive deficit spending in order to move us from the edge of the deflationary abyss.

Barnes Capital is a Registered Investment Advisor located at in downtown Lafayette. With RB Capital Management, Barnes Capital develops custom tailored portfolios for its clients. Specialized in retirement income portfolios, financial planning in an integral part of our process. Call 925-284-3503.

This entry was posted on Saturday, August 1st, 2009 at 8:10 pm and is filed under Monthly Column. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.