Tuesday, March 11, 2008

Staggering Deflation

Standing in line in to check out of our hotel in Waikiki last week, five people in front of us had their credit cards bounce. The clerk initially assumed the machine was broken, but realized the guests with their 20 page bills had exceeded their credit card limits.

Everyone is expecting that the Fed’s lowering of interest rates and creating money to ease the bank credit crisis and fund the war in Iraq will cause inflation. But in reality the Fed would have to line the east coast with printing presses to print enough money to replace the estimated 11 trillion dollars created during the housing bubble and the additional 5 trillion dollars already lost in the world’s stock markets. As the economy moves into hyper-shrinkage, people are having their lines of credit frozen and their assets are becoming debts. This huge economic shrinkage will likely result in staggering deflation rather than inflation.

Surprisingly, the huge influx of money into the economy due to the housing bubble didn’t cause inflation because people spent most of their newly created wealth on goods from China with its new low-cost manufacturing infrastructure. The few things they bought in the US, like housing and vacations did inflate as we saw hotel prices go way up in Hawaii. The deflation we would have seen in 2002 as a result of the economic downturn was masked by the housing bubble and hid the extent of the real problems in the US economy. Unfortunately, the housing bubble resulted in an increase in bubble jobs while manufacturing and tech jobs continued to be moved overseas.

It seems everyone is focused on the housing bubble and not on what is next. The Fed’s cure to deflation, rapidly dropping interest rates, will make stocks a better investment. But what are the implications of having a large percentage of Americans declare bankruptcy? And what are the implications of people having their credit frozen and suddenly having to live within their means?

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