Deleveraging

There are several publications that I read weekly, The Economist, Bloomberg Businessweek, TIME Magazine, and the occasional Foreign Affairs when I have time.  However, there is one website that I value dearly: The Motley Fool.  The reason I like the The Fool is because it stresses investing, not trading.  It is a fantastic resource for anyone looking to dabble in the stock market and retire with more wealth than you have now.  In addition to stock advice, the Fool has some amazing articles every so often that go largely unnoticed by the public at large.  Don’t worry TMF, this Fool noticed.  On April 24th, Morgan Housel penned an article called “Why It’s So Much Better Than the Great Depression” that articulated just how bad the Great Depression was compared to the Great Recession.  While the whole article is a must read, I found the explanation put forth by Ray Dalio extremely helpful in understanding where we are and what lies ahead. 

“Imagine someone who makes $100,000 a year and has a net worth of $100,000 with no debt. That person can safely borrow about $10,000 a year for several years, meaning they can spend $110,000 a year even though they only make $100,000. The flip side to all that spending is that someone else is earning$110,000 a year. “For an economy as a whole,” Dalio writes, “this increased spending leads to higher earnings, that supports stock valuations and other asset values, giving people higher incomes and more collateral to borrow more against, and so on.” That describes our economy from 2000 to 2007.

But it can only last so long. Eventually, debt service payments take up too much of income, and everything breaks apart. “The person spending $110,000 per year and earning $100,000 per year has to cut his spending to $90,000 for as many years as he spent $110,000,” to pay down the borrowing spree, says Dalio. That means some one else can now only earn $90,000. And it means the economy grinds to a halt, as it has since 2007.”

Now that you get the idea behind deleveraging, you understand where we are and where we are headed.  We are by no means out of the woods yet, and there is still a bunch of uncertainty in the market regarding QE3, the spending cliff of Jan 2013, and the upcoming elections in November.  But thus far, this financial crisis has been handled pretty well and policy makers are just waiting to see how the economy reacts.  Take a look at the chart below to see where we are compared to what could have happened.

The Beast They Call Inflation

For anyone interested in monetary theory, the works of Milton Friedman are a must read. Based on his monetarist view, one would have expected to see inflation shoot up over the past two years with the dramatic increase in money supply that the Fed has undertaken. So why is inflation important? Inflation determines how much we pay for goods and services. Inflation risk premium is a component of interest rates and therefore affects personal and corporate investment, labor contracts and government fiscal policy. Inflation touches everyone – from retirees on fixed income to ibankers on Wall Street. When inflation is high, it acts as a hidden tax on goods because it reduces your buying power per unit of money.
So is inflation bad? Yes and No. Yes, inflation is bad because it erodes purchasing power, costs businesses more in terms of their inputs such as materials and labor (workers demand higher salary to keep up with increasing cost of living), and creates a climate of uncertainty. On the other hand, inflation allows companies to charge higher prices creating a smile for investors and allows large borrowers (governments) to repay debts with cheaper dollars. So, the answer to that question is small and controlled inflation of about 1% to 2% a year is good, high inflation or hyperinflation is a nation killer.
I just have to mention a quick something about deflation here. Deflation – or falling prices – is just as dangerous as inflation. While lower prices may sound good at first, this leads to lower profits for firms, layoffs for workers, higher unemployment, lower consumer spending, further price declines, lather, rinse, repeat. It is a nasty cycle of an economy in decline and much tougher to recover from. Think USA in 1929-1933 or Japan in the 1990’s.
So lets get back on track here, looking at the historic charts of CPI, it seems that historically the headline and core CPI move in tandem with each other, but have not followed that pattern since 2000. I can only explain this by the frequent price swings in grains and oil. Headline inflation is a measure of all goods in a proverbial ‘basket’ of about 80,000 goods such as beer, cereal, used cars or anything else you might want to buy and each category is assigned different weights inside the basket. Core CPI is the increase in price of that same basket of good minus food and energy. These two items account for approximately 25% of the basket and have a much more volatile price index than the other goods in the basket and thus can distort the true inflation picture. Back to the graphs. Core inflation appears to have bottomed in late 2010 and has been climbing steadily and rapidly ever since. Currently it sits at 1.95%, just a tad shy of the high end of the target rate.
In summary, following the financial crisis, I think Uncle Sam was extremely worried about the threat of deflation and played fast and loose with our monetary policy. So far, this policy seems to have guided us away from that black hole of deflation. However, the increase in the money supply may have triggered an uptick in inflation that is just now beginning to rear its ugly head. There is usually a two year lag time between cause and effect.
While we must keep a eye on this, I must admit that I expected inflation to be much higher by now. All this led me back to thinking about Friedman’s helicopter example in Money Mischief where money is dropped into a system to illustrate how more money chasing the same amount of goods causes inflation. So to revisit that example, lets say the same amount of money is dropped from the helicopter but only a few individuals stumble upon the money. Instead of spending more and unleashing the new found money into the system, they stash it away for a rainy day and pay down their debts. I have to assume that both businesses and individuals are paying down debts right now, thus explaining why the inflation level has been kept in check at least thus far.
One thing to make clear is that CPI is not a forward predictor of an economy. It is a lagging indicator and can merely indicate areas of inflation that could become potential problems down the road. Let’s wait and see what Helicopter Ben does now, but even more, let’s worry about what steps we can take should this turn into an even larger problem down the road.