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Three Feet of Ice
Perspective on the News
Monday, July 05, 2010
Ed DeShields

There is a Chinese proverb that proclaims that “three feet of ice does not result from one day of freezing” which translates to mean that a predicament is not formed without a period of events creating it.

This week was the week that fears of a double-dip recession in the U.S. finally trumped the Europe’s debt concerns of the past few months.  The ability to keep the economy from collapse is becoming the nightmare of the world’s central banks.  

With U.S. Fed Fund rates now at practically zero, the government’s regulators have reached the end of their ability to encourage the market to recover with lower interest rates.   The country has been running on a massive expansion of debt to stimulate the economy that is now running out and the economy is still not self-sustainable.  

The freezing of the economy is showing up everywhere. 

This week the unemployment numbers were bad and they’re much higher than reported when you count those who would take a job if they could get one.  Incomes are weak and consumers are foregoing plans to purchase discretionary items.  Housing is in for a further drop in prices.  The stock market is not exactly turning in stellar results.  Treasury yields are falling, not from a credit crisis or a flight to quality, but because of economic conditions (dare I say it, deflation).   Money supply is falling.  Prices are under pressure.  All measures are pointing out that deflation is looming. 

And, the world’s economy is slowing. 

Manufacturing output is slowing across large parts of the world creating real challenges to leading economies as they attempt to shore up shaky fiscal positions without falling back into recession. 

In Asia, manufacturing activity indices for China, South Korea, Taiwan, India and Australia all showed weaker activity for June.   These world powerhouses of production are largely dependent on export demand.  But, as the consumers around the world buy less, their desire for manufactured goods slow. 

If we have a double-dip recession and start to fall into deflation what will the Fed do?  What can they do?  What is deflation anyway?

Deflation causes problems in business relationships.  If you are a borrower, you’re contractually committed to making your loan payments that represent more and more purchasing power.  At the same time the asset you bought with the loan begins to decline in value.   If you are a lender, the chances your borrower will default substantially increase.

In deflation there's a declining spiral.  Businesses make fewer profits so they cut back their payrolls.   People feel less like spending money.  Businesses then don't make any profits and everything works itself into a declining spiral.   Deflation has a psychological effect as it becomes self-perpetuating.   Consumers are discouraged from buying expensive items like automobiles or homes when they know those things will be cheaper in the future. 

There is great debate about whether to further stimulate the economy or to slam on the brakes of budget spending.   Budget reduction could slow the economy further and therefore lower spending won’t necessarily mean lower budget deficits as the economy slows.  On the other hand, some believe more spending is a hail-Mary economic policy.  If it doesn’t work you will surely wind up in financial ruin.   

The choices ahead of us have become a true predicament.   The only thing certain is that the next ten years will be completely unlike the past.

About Ed DeShields

Last Week: The Day the World Said No



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