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Stranguflation: Deflation and Inflation Where it Hurts America Most

Economics / Deflation Aug 03, 2010 - 07:20 AM GMT

By: Janet_Tavakoli

Economics

The U.S. is suffering from high unemployment combined with too much consumer debt in a weak economy. Current stock market exuberance reflects earnings increases at selective companies that benefited from sputtering stimulus programs. In late 2007 through the fall of 2008, our economy had an appendix attack, and Congress issued potent addictive painkillers instead of fixing our problems.


Meanwhile, the financial system has strangled U.S. growth by parasitically growing from 3% of GDP in 1965 to 7.5% of GDP currently. As Jeremy Grantham pointed out in his quarterly letter to investors, financial services were sufficient for the economy when they were 3% of GDP, but that sector grew by strangling GDP growth elsewhere. The nation's GDP growth slowed from 3.5% in 1965 to 2.4% between 1980 and 2007, and the slowdown occurred before our current crisis.

In other words, our bloated financial sector has been sucking the life-blood out of the U.S. economy for years, and recent decisions insure it will continue to feed off taxpayers, while the host economy struggles for life.

Jobless "Recovery"

Unemployment exceeds 10%, counting the underemployed it is closer to 20%, and the figures soar beyond that when one counts our unemployed youth. The recovery is being strangled in its crib by low job creation, high consumer debt, high local government debt, high federal government debt, and falling tax revenues.

Since the first meltdown, we've had rising--and still very high--consumer loan defaults. The Fed tried to monetize bad loans, which is just another way of saying the U.S. taxpayer is paying for bad lending decisions by Too Big To Fail financial institutions.

Nominal income is falling. Selected prices have fallen more rapidly than income, but we've had a negative wealth effect. Housing prices and investment assets fell in value. Consumer loan payments of debt-loaded consumers have to come from falling nominal income.

If we didn't have too much borrowing (leverage) in our system, the Fed's rapid pumping of money into the economy might have worked. Unfortunately, consumers and many financial institutions are still overleveraged and many of them will default or fail. This continues to be a drag on the economy and on consumer demand.

Deflation Plus "Staple" Inflation

The economic picture is distorted by both deflation and inflation. Interest rates are low for now, but consumer demand also remains too low. Banks are unwilling to lend to all but those who don't need money in the first place. The negative wealth effect of reduced home prices, a weak housing market, and reduced value of investment accounts and retirement accounts is combined "staple" inflation on items like school tuition, utilities, certain food items, and even mundane items like printer paper. Many prudent investors and consumers are unwilling to borrow, even at low interest rates.

Moreover, consumers are worried about potential local tax rises and federal tax rises, since many local government's are broke, and our national debt is $13 trillion.

If deflationary pressures combined with rising prices on many consumer items weren't bad enough, many investors are carefully watching long-term U.S. treasury interest rates in case demand for U.S. debt falls and inflation takes off.

The economy's stranguflation is the result of wealth destruction and the quadruple threat of the weak economy, high government debt load, asset deflation with price inflation of essentials, and the fear of future overall inflation.

In October 2009, I explained to Max Keiser of The Kaiser Report, why the economy would suffer an ongoing deflation crunch (instead of the stagflation I had originally expected):

By Janet Tavakoli

web site: www.tavakolistructuredfinance.com

Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct associate professor of derivatives at the University of Chicago's Graduate School of Business. Author of: Credit Derivatives & Synthetic Structures (1998, 2001), Collateralized Debt Obligations & Structured Finance (2003), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, September 2008). Tavakoli’s book on the causes of the global financial meltdown and how to fix it is: Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street (Wiley, 2009).

© 2010 Copyright Janet Tavakoli- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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