Deflation Cometh

Until the recent stock market correction, most people viewed the financial crisis as a thing of the past. The question became ‘how slow or fast will the recovery be’ not ‘IF we will recover at all.’

There’s a few headwinds coming our way that could potentially lead to disinflation, or perhaps a full fledged double dip recession. Get out your tin hats, keep your closets stocked full of guns and canned food, and let’s consider the following:

1. The European debt contagion is well known. The Club Med countries are beginning austerity plans to drive down costs and increase tax revenue. It’s debatable whether or not these plans will work to avoid default (my bet is no). What’s more clear though is that these austerity plans will undoubtedly shrink Europe’s economies for now. Even if these countries succeed in eliminating waste and cutting down government deficits, short-term this will be a negative. After all, ‘waste’ is also ‘stimulus’ in the short run. The extra money government workers get in lavish pensions is re-spent into the world economy.

However, the problem with ‘waste/stimulus’ is that it runs up debt that eventually needs to be paid and/or defaulted upon. Europe has had their fun time of waste/stimulus and is now having to pay the piper. While it may be able to reform itself for the long-term (it probably won’t but it may), in the short-run, there will be deflationary pain.

2. America is about to embark on its own austerity plan. Beginning in 2011, there will be sizable tax increases, as well as a major withdrawal of stimulus. Americans with incomes of $200k/$250k+ will have less money due to taxes and middle class Americans will no longer have the $400 tax credit (i.e. they will pay $400 more in taxes compared to 2009-2010). Other stimulus measures will be withdrawn as well. While the stimulus is a waste of money and its continuation would result in the US becoming like Greece/Portugal (we may still nonetheless), the combo of less stimulus and tax increases are incredibly deflationary.

3. The rest of the world is going to deleverage as well. The UK is in a fiscally worse shape than the US and will need to cut spending. There is talks that China is in a bubble. Even if it isn’t, it can hardly support the entire Western world.

4. Japan is an economic tinderbox. With their debt/GDP well over 200%, their savings rate declining, and their population aging, if their bond yields rise to even 4-5%, they will go bankrupt. For decades, Japan was able to run huge deficits because it was able to fund them at 2% or less interest rates due to its high savings rate. However, the Japanese savings rate has declined recently, as the population has aged. The rest of the world will not buy Japanese bonds at less than 2%, so Japan will need to fund itself. If it cannot, it will be the next Greece….this is a flash point that is commonly ignored by the main stream media.

5. The world is relatively at peace right now….but it may not stay that way. There is a lunatic in North Korea that purposefully sunk a ship of a neighboring country. Most of the time, that’s considered an Act of War, but the world has no appetite to take on the Kim Jong unless it absolutely has to. No one really knows what Iran is planning to do. Both countries have access to nuclear materials. While hopefully nothing will happen, something could.

Flash points abound, whether it’s Club Med, the UK, Japan, China, or lunatic rogue nations. Most Americans think recovery is underway and will be smooth and natural. It very well may. But even if a few of these headwinds come to fruition, we may see a significant double dip recession and the associated deflation.

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