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In late 2009, former Merrill Lynch economist, now with the Canadian firm, Gluskin Sheff, said the following:

"The credit collapse and the accompanying deflation and overcapacity are going to drive the economy and financial markets in 2010. We have said this repeatedly that this recession is really a depression because the (post-WW II) recessions were merely small backward steps in an inventory cycle but in the context of expanding credit. Whereas now, we are in a prolonged period of credit contraction, especially as it relates to households and small businesses."

Summarizing his 2010 outlook, Rosenberg highlighted asset deflation and credit contraction imploding "the largest balance sheet in the world - the US household sector" in the amount of "an epic $12 trillion of lost net worth, a degree of trauma we have never seen before," even after the equity bear market rally and "tenuous" housing recovery likely to be short-lived and illusory with a true bottom many months away.

As a result, consumer spending will be severely impacted. "Frugality is the new fashion and likely to stay that way for years," highlighting a secular shift toward prudence and conservatism because households are traumatized, tapped out, and mindful of a bleak outlook. It shows in new consumer credit data, contracting $17.5 billion in November, the largest monthly amount since 1943 record keeping began.

Surprisingly, only people over age 55 have experienced job growth. All others have lost jobs, can't get them, and for youths the "unemployment crisis (is) of epic proportions." In addition, there's a record number of Americans out of work for longer than six months, in part because the "aging but not aged" aren't retiring, and those who did are coming back, of necessity, to make up for wealth lost.

Rosenberg stresses that for a sustainable recovery to begin, the ratio of household credit to personal disposable income must revert to the mean and reach an excess in the opposite direction. In the 1950s, it was 30%. Today its 125%, down from the late 2007 139% peak, with a long way to go taking years, and when it's over, another $7 trillion in household credit will have to be extinguished.

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When banks give out loans, they do not give out money that they already have. They simply give the loan which is a promise to pay the actual money which they never really have to do. In the economy, 95% of the money is in the form of bank credit. There is no real currency backing it.

Whenever we borrow money, the bank creates new money. This process constantly (almost) expands the money supply. This dilutes the value of the existing money. This is because total debt has to keep expanding in order for people to be able to pay back what they owe, otherwise there simply won’t be enough money to earn to pay back what we owe. When that happens, we declare bankruptcy, there are foreclosures, unemployment and so on which causes the vicious cycle of deflation.


Current credit based monetary system is a game of musical chairs. As long as the music keeps playing (as long as total debt keeps increasing), system keeps running. The moment debt expansion stops (credit expansion stops), then money creation stops and it becomes impossible to pay existing debt (principal + interest) with the existing credit expanded (~existing money), thus some of us are guaranteed to go bankrupt (standing when the music stops). This is because there simply is not enough money in existence to pay the existing debt principal + interest. An interest free monetary system may be the fix.

Charging interest is bad for the society

As explained above, mathematically, we understand that the existing credit based system, with it’s ever expanding interest demand, can cause deflation and guaranties bankruptcies. The practice of constantly expanding the money supply steals from the savings of honest earners who want to use money as a store of value. Ordinary people should not need a Ph.D. in finance to figure out where to put their savings. Money, however it is defined, should be able to do that job in an uncomplicated way.

Most of us are conditioned to “make money work for us”. It is common wisdom to expect some interest for your money. Adam Smith claimed when individuals maximize their gains, that would ultimately serve the society and move it forward. This is not always the case. Here we have displayed why credit based monetary system that uses interest as a vital component falls short of satisfying the society’s needs. It creates conditions in which the human productivity is curtailed and focused on financial gain instead of supplying the necessities of life. Real economy is being burdened by a large financial economy that has to live off of the effort of the real economy.

Bad for One, Good for All

Religions (notably Islam today, Christianity earlier) forbid the practice of usury. There seems to be valid reasons for this and some think that we need to devise a new system to correct our wrongs. However, until then you need to know the dangers of the current system and operate accordingly (Threat of inflation, deflation, unemployment, risk of default, currency devaluation, business cycles to name a few).

Here are observations from the society where maximizing one individual’s gain hurts the society.

Sex Selection

In some cultures (India, China), parents prefer a male child. This is because a female child eventually requires the parents to pay a dowry, and the male carries the family name. Thus, to maximize their own good, parents decide to end pregnancies for a female baby, and keep male babies. This eventually brings an imbalance in male / female population ratio such that some males are not able to “carry on the family name” because they cannot find a bride to marry.

Wal-Mart

Wal-Mart is the store that has the lowest prices. To optimize our own gain, we go and shop there. But it comes with a price. It brings lower wages to the community. Workers have less benefits. Wal-Mart may cause other competitors close down their doors causing unemployment in your community. It will have ripple effects. Therefore, in this example, even though we maximize our personal gain in the immediate future, it effects the community in a negative way.

The Tragedy of the Commons

Here is a story by Garrett Hardin, in his essay "The Tragedy of the Commons, 1968".

There is a pasture owned in common by the residents of a village. The pasture is at full capacity with regard to the number of the sheep the villagers have. It is such that if villagers add one more sheep, it will start degrading the pasture.

With their natural greed and an urge to maximize individual gain, each villager thinks if he adds one more sheep he will make more money. Thus they keep doing this. As they see the pasture land loose it’s productivity, their mentality will be “it is dead anyway, we should get what ever we can” and keep adding sheep as much as possible. This brings them to a state where the pasture will be damaged threatening their entire flock with devastating losses. It would be prudent for them to agree on a balanced production capacity and limit themselves and police the community to make sure everybody obeys. If not policed, volunteers will be hurt by others who grab their share. Thus, volunteering does not work in these cases.

This story is similar to the loan interest situation. Some volunteers may deny doing business with interest. But this is not enough to save the society. Law must forbid interest or it won’t work.

Paying Off Debt

Here is a poll, from September 4, 2009 CNN Money:



In the light of the above videos, this chart sums up the mood. People are trying to pay off debt. Since our entire money supply is borrowed money, when we pay it off, the money supply shrinks. This is why FED is trying to print money to counter the deflationary forces. That will probably have bad inflationary effects later down the road. But for now, we are heading into deflation. The credit bubble is shrinking.

more HERE

By Susan C. Walker
Fri, 20 Nov 2009 15:45:00 ET

Japan was unsuccessful in containing deflation for much of the 1990s. Interest rates were maintained near-zero for almost 15 years, with July 2006 marking the first time this policy was abandoned. Only in 2008 did Japan again sustain positive inflation rates.

One of the systemic side-effects of this long period of low interest rates is the so-called carry trade, with investors taking loans at very low interest rates in Japan and investing in higher yielding assets in countries with higher interest rates, typically emerging market economies. The 2008 financial market crisis has resulted in the unravelling of this carry trade, with many of these borrowed and sold yen unravelling causing a huge spike in the value of the yen relative to other currencies.

Systemic reasons for deflation in Japan

• Fallen asset prices. There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.

• Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.

• Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.

Investing in a deflationary economy

A period of deflation results in an increase in the burden of debt. Stores of value such as gold or cash are thus best kept out of the markets as their relative value appreciates even without interest income. This is generally a bad thing for the rest of the economy, so it is important to watch for signs that economic and fiscal policy are working to correct this potential downward deflationary spiral

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LAST WEEK Iwrote that iconoclastic economists have been warning of deflation for almost five years, based on subtle signs that Alan Greenspan hasn't been supplying enough liquidity to meet the needs of the U.S. economy. And now — finally — these warnings have come true in the form of declines in the consumer price index, the producer price index and several other widely followed measures of prices. So suddenly everyone's talking about deflation — and not just the iconoclasts.

Deflation isn't kind to stocks. For openers, deflation introduces complex distortions into the economy that make it harder for businesses to do business, and that's bad for all stocks. But more to the point, when the price of everything goes down, corporate earnings have to go down, too. And that means that stock prices will follow.

Think about it. Say Acme Widget sells a million widgets at $100 each, and it costs them $50 to make them — so their net earnings will be $50 million. Now let's say that prices fall across the whole economy by 10%, including the price of widgets — and the prices of all the things that Acme has to buy to make them. That means they'll only get $90 for each widget, but their costs will only be $45 each. If they still sell a million of them, net earnings will fall from $50 million to $45 million. All else equal, with earnings down 10%, Acme's stock will drop 10%. Probably more, because in a deflation all else will not be equal, and Acme will probably have a hard time selling a million widgets.

Some version of this effect of deflation should be expected to hit just about every company. So if you're strongly convinced of a deflationary future, and you have the flexibility to get out of stocks altogether, you might want to do just that.

But if you aren't sure whether deflation will really continue, or if you're a portfolio manager whose mandate requires you to invest in stocks — then you should at least hedge a little. You should at least understand which stocks are likely to be hurt the most, and which are likely to be hurt the least, in a continuing deflation — and position your stock portfolio accordingly.

The secret to stock picking in a deflation is simple: The winning companies are those whose products' prices will decline the least — but whose production costs will decline the most. If costs decline more than selling prices, these companies could actually increase their earnings in a deflation. The losing companies are those whose products' prices will decline the most, and whose costs will decline the least. If costs decline less than selling prices, the earnings of these companies will fall even faster than the general deflation of prices in the economy.

That's easy to say, but the dynamics of it are more complex than you might think. To see how they work, let's take a look at two widely held companies, Microsoft (MSFT: 24.44, +0.32, +1.32%) and General Motors (GM). Microsoft is a perfect example of a deflation winner, and General Motors is the perfect example of a deflation loser.

Let's start by looking at the differences between Microsoft's and GM's ability to keep their products' pricing afloat against the undertow of deflation.

GM is in a terrible position because its products are commodities, interchangeable with the virtually identical products of competitors from around the world. In a deflation — when the Federal Reserve creates too little money for the needs of the economy — commodity prices are always hit first and hit hardest because they are universal and liquid, and people can easily exchange them for the money there is too little of.

But Microsoft is in a great position, because its products are unique — why, some people would even say they are too unique. There's no commodity substitute for Windows or Office. So Microsoft can hold the line of pricing long after GM has had to throw in the towel. In fact GM has been throwing in a lot more than the towel lately — it's been throwing in free financing and all the trimmings. Call it a promotion to kick-start sluggish demand if it makes you feel better, but that's deflation playing out right under your nose.

Now how about the cost side?

On the one hand, GM derives advantage from the falling costs of the commodity materials that go into its manufactured products. But on the other hand, it's stymied by its enormous labor costs — and the fact that a large fraction of its work force is unionized. That means workers are covered by long-term contracts that guarantee rising wages for many years into the future, deflation or no deflation.

What's worse, GM is cursed by hidden labor costs that extend beyond salaries. The auto maker is on the hook for pension and postretirement health-care benefits for as long as its employees live, with the amount of the benefits keyed to salary levels. The cost of these benefits isn't going to go down with deflation — but the securities portfolios that are invested today to pay those costs in the future will. Historically GM has had difficulty getting even its retirement commitments fully funded — now, if there's a protracted spell of deflation, it could spell disaster.

Microsoft, by contrast, has a small and flexible labor force, and no pension issues. It's true that Microsoft won't enjoy the benefits of falling commodity prices, because commodities aren't an input to its products. But at the same time, its nonunionized labor force is more flexible in terms of negotiating wages, and more accustomed to receiving significant fractions of its compensation in the form of contingent incentives such as stock options.

And Microsoft doesn't have to worry about pension benefits. Its retirement benefits are provided by a 401(k) plan to which the company and its employees make contributions during the employee's working life, and the benefits in retirement are strictly a function of the performance of the investments chosen by the employee. Microsoft is totally off the pension hook.

But there's one other major factor that works in Microsoft's favor in a deflation, and it could be a deathblow to General Motors: debt. Microsoft doesn't have any, while GM has a GMC truckload — $144 billion worth, on which it pays interest of $9.4 billion a year.

In an ocean of deflation, that kind of debt is a boulder chained to GM's neck. Because auto prices are going to fall, and some of GM's costs may fall. But that $9.4 billion won't. As deflation marches on, that constant $9.4 billion payment in nominal dollars represents more and more in terms of real — that is, deflation-adjusted — purchasing power that GM must expend to pay for assets that will become worth less and less.

Meanwhile, Microsoft not only has no debt, but it also sits on a mountain of cash — $36 billion, to be exact. And in a deflation that's the opposite of debt. That cash will just get more and more valuable every year, allowing Microsoft to have its pick from among a world of deflated assets any time it wants, and insulating it from the need to take on debt in a deflationary world of too little money in circulation.

GM has $9.5 billion in cash, and in their otherwise dire circumstances that's a very comforting thing. But bear in mind, they will need it. As deflation marches on and GM's revenues fall while its debt-service needs remain constant, it will automatically become increasingly leveraged — so GM will find further debt financing increasingly difficult and expensive.

I'm using Microsoft and GM here simply as examples of general principles. Obviously there are many company-specific factors that must be considered in addition to the effects of deflation. That said, these general principles can easily be applied to other companies. So here's your deflation-investing checklist:

Remember, deflation is going to be tough on all stocks. But if you follow this checklist, at least you'll avoid the worst of the damage. And you might even find a real winner. Because when you think about it, this checklist makes good sense whether or not you see deflation in our future.

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