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Money Supply And Economic Data Weekly Watch – Deflation Hurts The Economy Like Hydrochloric Acid Burns Through Steel

Defla­tion hurts the econ­omy like hydrochlo­ric acid burns through steel. Falling prices destroy cor­po­rate and house­hold bal­ance sheets and make it impos­si­ble for the finan­cial sec­tor to func­tion nor­mally. Demand is destroyed by defla­tion which in turn leads to more defla­tion. The weak­est sec­tors are hurt first, but defla­tion quickly burns through healthy indus­tries. This week’s eco­nomic news is a real life les­son in what defla­tion will do to the econ­omy and why it must be stopped at all costs by the Fed­eral Reserve and the incom­ing Obama administration.

The morning’s busi­ness head­lines stated “10 Per­cent of U.S. Homes in Finan­cial Jeop­ardy”. The fall in hous­ing prices, i.e., hous­ing defla­tion, destroyed the bal­ance sheets of mil­lions of house­holds which in turn caused mort­gage delin­quen­cies and defaults. The cat­a­strophic losses in the bank­ing sec­tor are a rip­ple effect of hous­ing defla­tion. While house­holds were finan­cially over-extended and should have had less mort­gage debt, deflation’s first vic­tims are always the weak­est and sub-prime bor­row­ers are by def­i­n­i­tion on the eco­nomic fringe of sol­vency. Con­sumer demand was destroyed by falling home prices which hurt fam­ily wealth and made indi­vid­u­als unable or unwill­ing to con­tinue spending.

The rip­ple effect of hous­ing defla­tion hit the over­lever­aged finan­cial sec­tor like an eco­nomic tsunami. Even with high delin­quen­cies and defaults, if house prices hadn’t declined, lend­ing losses would have been much lower because lenders would have recov­ered most of their invest­ment when they sold fore­closed homes. Home price defla­tion made fore­clo­sure a los­ing propo­si­tion and made the losses big­ger. The bank­ing sector’s past year would have been a bad dream if hous­ing defla­tion hadn’t occurred.

The Big 3 auto­mo­bile man­u­fac­tur­ers’ prob­lems are a “rip­ple effect” of the hous­ing cri­sis and falling con­sumer demand. Of course decades of mis­man­age­ment made the Big 3 vul­ner­a­ble. But, even with­out their well doc­u­mented short­com­ings, the Big 3 would be in big trou­ble. Auto­mo­bile man­u­fac­tur­ers have large fixed costs and can’t sur­vive the 35% drop in sales (domes­tic and imported) that has occurred. With­out sales to off­set fixed over­head costs, it is inevitable that the Big 3 will fail sooner or later. In fact, few man­u­fac­tur­ing com­pa­nies can sur­vive both col­laps­ing sales and falling prices. If the trend con­tin­ues, the next “shoes to drop” will be sup­pli­ers to the auto­mo­bile indus­try includ­ing logis­tics com­pa­nies, parts sup­pli­ers and raw mate­ri­als producers.

Retail­ers are drop­ping like flies after the first frost. Novem­ber retail sales were posted this week and showed the biggest monthly drop in 30 years. Falling retail sales are evi­dence of col­laps­ing con­sumer demand that started with hous­ing defla­tion. Prices are falling and traf­fic is down at most retail­ers. If retail sales don’t pick up in the near future, many more retail bank­rupt­cies will occur. Retail bank­rupt­cies will destroy other indus­tries such as com­mer­cial real estate, logis­tics, man­u­fac­tur­ing, adver­tis­ing, media and pack­ag­ing. And, of course, the bank­ing sec­tor will face more losses as retail­ers go broke and lay off workers.

Oil prices closed the week at around $40 per bar­rel which is a 4 year low. Assum­ing the cur­rent trends con­tinue, soon bank­rupt­cies are going to start in energy and energy related indus­tries. And, since many farm com­mod­ity prices are tied to energy prices, large scale busi­ness fail­ures in the food sup­ply chain are likely. This week’s bank­ruptcy of Pilgrim’s Pride, a poul­try grower, is an exam­ple of what hap­pens when prices and demand col­lapse. Pilgrim’s Pride paid for feed dur­ing the sum­mer at record prices and then when it tried to sell its chick­ens and turkeys in the late fall it was ham­mered by falling prices and col­laps­ing demand. Every turkey that Pilgrim’s Pride sold this thanks­giv­ing was prob­a­bly sold at a loss. Of course Pilgrim’s Pride was finan­cially weaker than its com­peti­tors, but that is how defla­tion works; it picks off the weak­est first as it burns its way through the economy.

Other sec­tors of the econ­omy that are being destroyed by falling prices and weak demand include edu­ca­tion, leisure, trans­porta­tion and any­thing relat­ing to dis­cre­tionary spend­ing. It won’t be long before every­one feels the cor­ro­sive effects of the defla­tion­ary spiral.

The prob­lem is that defla­tion tends to cre­ate a self per­pet­u­at­ing and rein­forc­ing cycle. As new rounds of bank­rupt­cies and busi­ness fail­ures occur wealth is ruined, work­ers are laid off and demand for goods and ser­vices are destroyed. Falling demand causes falling prices which starts a new round of bank­rupt­cies and busi­ness failures.

The Fed­eral Reserve is work­ing over­time to break the cycle and stop defla­tion. They are increas­ing money sup­ply at a very rapid pace as sea­son­ally adjusted mea­sures of money sup­ply (both M1 and M2) hit new all time records. For the last 13 weeks sea­son­ally adjusted M1 increased at the blis­ter­ing pace of 22.6% and sea­son­ally adjusted M2 increased by an amaz­ing 9.2%. Nor­mally, this rate of money sup­ply growth would cre­ate hyper demand, hyper growth and hyper infla­tion. How­ever, the econ­omy is in reces­sion because banks and house­holds are hoard­ing cash. Demand for goods and ser­vices is falling, growth is neg­a­tive and defla­tion is accelerating.

The cure for the defla­tion­ary spi­ral is large scale spend­ing by gov­ern­ment. The Fed­eral Reserve by itself can’t stop the hoard­ing of money and can­not force demand to increase. Bernanke needs the Pres­i­dent to be his part­ner by stim­u­lat­ing the econ­omy through Fed­eral spend­ing. The spend­ing needs to be tar­geted at increas­ing demand by hav­ing gov­ern­ment pur­chase goods and ser­vices and doing it quickly. Soon we will find out if the Obama Admin­is­tra­tion is going to rise to the chal­lenge and be the part­ner that the Fed needs to stop the cor­ro­sive effects of deflation.

Posted in: BANKS, Bernanke, CPI, Deflation, Economic Statistics, Finance, GDP, Inflation, M1, M2, Manufacturing, monetary policy, Money Supply, Obama, Oil, Politics, Public Policy, Retail Sales

1 Comment

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