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As mentioned previously, the transition from inflation to deflation often occurs in an instance. It’s the moment of panic when people, acting in herd-like concert, realize that their prior beliefs about a market are no longer valid. This is what happened during the first weeks of October, 2008, when debt markets around the world shut down and stopped trading.

These discontinuous events are only the beginning. Once a panic begins, other markets start the reset process, and attempt to stabilize given the new reality. So while this initial panic was in the debt markets, the implications for the markets that relied on that debt were soon to follow. This lead to collapses in the housing market, the automobile market, and most recently, the commercial real estate market.

Just like these major markets change in an instant, personal recognition of deflation also occurs in discontinuous spurts. One reason this happens, is that there are long term obligations on assets that prevent a fluid reduction in the market price of these assets.

For example, almost 1 out of 4 home owners are currently upside down on their mortgage. That means that they owe more to the bank, than they can likely get from selling their home in the open market. When people like this decide that they wish or need to sell, their first attempt is to sell it for just enough to cover their note. Since they are out of market, their home often just sits on the market with little buyer interest. It’s only after one of the following events occur that the home will sell:

• Seller lowers the price beneath their debt, and takes a loss on the sale.
• Seller offers the asset for less than they owe, and gets the bank to take a “short sale” on the property.
• Seller gives the asset back to the bank as a “deed in lieu of foreclosure,” then the bank sells it at the market price and takes the loss.
• The seller defaults on their payment, then the bank takes it back through a foreclosure and sells it at a discount.

These barriers to fluid price reductions in a deflating market are the reason that deflation occurs in spurts, even on a personal level. And it’s just not homes, either. Any asset that has long term obligations will have these barriers to fluid price reductions.

In the next posting, we’ll look at how this works for the commercial real estate and the small business market. That will lead us into ways you can personally benefit from the changes ahead. As always, comments welcome.

Until next time.

So far, we’ve covered deflation and how, unlike inflation, it occurs in spurts. We went on to see that deflation recurs in cycles throughout history, and explored some of the characteristics these cycles share. Finally, we recognized that the transition from inflation to deflation occurs rapidly, usually through a panic.

It is interesting to note that, before a panic, everything is it always was. After a panic, nothing is as it used to be. This is a clear sign of a tipping point, as made popular by Malcolm Gladwell. It can also be described as an inflection point, a change of trend, etc. In Chaos Theory, it is the point where a complex system changes from one state to another.

While it may take years for the changes that begin in a panic to permeate, they are typically profound. To get an idea of the scope and scale of changes we can expect, we need only look back to the Great Depression. To experience the challenges faced by the average American in the 1930s, check out President Roosevelt’s Fireside Chats. In those, you’ll find that they too had to deal with a credit implosion, and the resulting bank and business failures. They also had to deal with an intractable unemployment problem, and extremely low farm prices.

To address these problems, the U.S. Government implemented many radical ideas, including many which are a normal part of our lives today:

• Directly hired people to work, not only in construction projects, but even as writers and artists.
• Put in place agricultural controls to support farm prices.
• Eliminated the work done by minors in the workplace.
• Shortened the work day and the work week.
• Established minimum wages.

The point here, is we will likely see similar “radical” ideas put forward to deal with our problems. To survive and thrive in these pending conditions, it is important to recognize these facts, and to position yourself to benefit from these changes as the occur.

To date, we’ve been looking at the Great Recession from the macro, big-picture perspective. In the next posting, we’ll go micro, and begin looking at these changes from the individual’s perspective. This will lead us into a discussion about what you can do today to help yourself tomorrow. Until next time …

What exactly is a panic anyway?

To understand one, let’s examine the Panic of October, 2008. In broad strokes, here’s what I believe happened:

• Mortgages that had been packaged and sold start to default in large numbers in 2007, leading to the imminent failure and sale of Bear Stearns in March of 2008.
• Continuing defaults on mortgages lead to a run on the banks with large exposures to these products, including Lehman Brothers. When Lehman Brothers was allowed to fail on September 15th, 2008, investors lose confidence in any packaged mortgage products, including Mortgage Backed Securities (MBSs).
• As investors try and determine the value of their portfolios, they start to make claims against Credit Default Swaps (CDSs) which were supposed to act as insurance policies in the event of such a default. Since these CDSs were not regulated, companies had been selling them naked, without any loan-loss reserves. With a large portfolio of unfunded claims, AIG becomes insolvent practically overnight.
• Had AIG been allowed to fail, banks, companies, and investors around the world would have also become insolvent. Instead, the Federal Reserve and the US Treasury bailed out AIG on September 17th, and honored their CDSs at 100 cents on the dollar.
• By now, the game was up. People finally understood that MBSs were not worth what they thought they were, and neither were their CDSs . From this point on, the markets for all Collateralized Debt Obligations (CDOs – bundled residential real estate loans, commercial real estate loans, credit card loans, auto loans, student loans, etc.) started shutting down as well.
• Since many banks and other companies had these investment products in their portfolios, and since no-one knew for sure what their total exposure was, all debt markets world-wide started to shut down in early October, getting so bad that banks refused to loan money to each other.
• In response to a total shutdown of global debt markets, central banks around the world announce extreme, coordinated measures to restore confidence in the first weeks of October, 2008. They’ve been attempting to restore confidence ever since.

The end result, what were once highly valuable portfolios of debt and equities, are now worth less (in some cases worthless) to the tune of an estimated 16 TRILLION Dollars world-wide. Not only have borrowers defaulted, lenders have incurred losses. In turn, many of those lenders are now in jeopardy of defaulting on obligations of their own. And so it continues, until the “great reset” completes.

In the next post, the fun begins – that’s when we’ll start exploring things that are likely to occur, and how we can benefit from the changes ahead. Until next time …

In 1926, three years before the Great Depression, a Russian economist wrote a paper titled “Long Waves in Economic Life.” He was one of the first to observe that capitalistic economies undergo decades-long cycles of inflation, followed by deflation. The economist’s name was Nickolai Kondratieff, and his observations are today known as the Kondratieff Wave:

Kondratieff also noticed distinct phases within each cycle that related to people’s mood and sentiment. Today, these moods are often described as “seasons,” or economic trends. Wikipedia describes these seasons as Spring (Inflationary Growth), Summer (Stagflation), Fall (Deflationary Growth), and Winter (Depression):

the “Winter” stage, that of severe depression, includes the integration of previous social shifts and changes into the social fabric of society, supported by the shifts in innovation and technology.

While many may discount or ignore these patterns as coincidence, there is no question that there have been previous episodes of manias/bubbles, followed by depressions and collapse. Here is a partial list of historical events:

• 1929 – The Great Depression
• 1837 – The Panic of 1837
• 1720 – The South Sea Bubble
• 1637 – Tulip Mania

Whether you believe that these events are part of a recurring series or random events, the important point is that these events have happened in history, and that we can learn about our current situation by exploring these historical events in detail.

In the next post, we’ll explore the anatomy of a panic, and how it changes the world in an instant. For a head start, you can review the events leading up to the current collapse, that culminated in the panics of October, 2008.

Until next time …

We all know inflation. We’ve been living with it for as long as anyone can remember. Slightly higher wages, paying for slightly higher expenses, demanding slightly higher wages. Those that did better, had wages growing faster than expenses. Those that did worse, didn’t. Either way, it all felt normal.

Now apparently, things have changed. But what? The stock market is up, but so is unemployment. Houses are selling again, but prices are down. Interest rates are low, but gold is high. The news says we’re rebounding, but the vast majority of small businesses that I work with are not. So what’s really happening?

I believe that we are entering a long-term deflationary cascade. While many may disagree, I suspect the reason they disagree is that they expect deflation to look like inflation in reverse: slightly lower wages, paying for slightly lower expenses, leading to slightly lower wages.

Unfortunately, deflation doesn’t spiral — it collapses one market at a time. This view is consistent with those who say our economy is undergoing a great reset. Consider the following chart:

Even after residential housing started to collapse, commercial real estate continued to inflate like nothing had changed. Until it too, started to collapse. In these examples, deflation doesn’t occur incrementally. It occurs in rolling collapses (aka panics, sell-offs, etc).

If this analysis is correct, then we can expect other markets to follow. While everything may appear normal, it is just a matter of time before other markets take their hit. Wages will continue to inflate, until they collapse. Commodities will continue to inflate, until they collapse.

To successfully navigate these changes, the best course of action is to move out of inflating markets before they collapse, and move into deflating markets as they approach their reset point.

In the next post, I’ll continue to explore this topic with a focus on deflation in history – both causes and solutions. As a teaser, consider the following chart, paying special attention to the red line (actual wholesale prices):

As always, comments welcome.

Until next time …