Deflation

There is no greater genius than the man who bounces our own ideas right back at us.

That was our first thought upon reading a subscriber's letter to Richard Russell, on his website.

The subject was the fate of the dollar...and the economy. Like Barron's and now Forbes, the writer had come to the same conclusion we had: both are headed down.

We take it for granted that stocks are in a bear market.

What goes up, goes down. That stocks are on the downside of the cycle seems almost too obvious. Of course, it if were any more obvious, the yahoos and patsies would have seen it already and already forsaken stocks. They have not yet; so the bear market must continue.

But what of the rest of the story? Whither the dollar? What will happen as the Fed desperately tries to revive the economy and the stock market? Will inflation suddenly erupt, like a pimple on a 14-year-old...and spoil the picture?

Most economists will tell you that the economic system is controlled by mood changes at the Fed. When the Fed governors feel the need for a little more bustling about in the nation's shops and factories, they administer a little "coup de whiskey", as Fed chief Norman Strong once put it. When they are in the mood for calm, by contrast, they take away the whiskey bottle and the party soon dies down.

Since WWII, the Fed's mood swings do seem to correspond with the ups and downs in the economy. But sometimes things happen even if America's central bankers are not particularly in the mood for them.

"Despite a flood of money and credit creation, and despite widespread predictions of recovery, the markets refuse to cooperate," writes Dr. Kurt Richebacher in his July letter. "Why? In short, because we are not experiencing a cyclical recession, and therefore a cyclical recovery is not on the way. Instead, the U.S. economy is sick to the bone."

The sickness doesn't seem to yield to a shot or two of whiskey. "For the first time in the postwar period, monetary easing - even the most aggressive easing in the Fed's history - is proving a flop in kindling a stock market rebound," Richebacher explains.

But all this extra money in the system is bound to have some effect, right? Won't it show up as inflation - if not in equities, at least in consumer prices?

Ah...maybe not.

"China is exporting deflation at a very rapid rate," explains Mr. Russell's correspondent. Almost no matter what Americans or Germans can make - the Chinese can make it cheaper.

Plus, "Russia is now moving towards becoming the world's largest supplier of most industrial commodities (including oil) and they too will use their competitive advantage and sell their goods cheaper than anyone else," he continues.

But as we mentioned above, nothing ruins a good economy faster than too much easy money. Thanks to Alan Greenspan and the Fed, "the U.S. private sector debt alone is over 280% of GDP," Russell's reader explains, "and is the largest debt pile in world economic history. The U.S. telecom sector alone has more debt than the entire Japanese property sector did or has."

"In the first quarter of 2002, consumers borrowed at an annual rate of $695 billion - breaking all previous records," Dr. Richebacher elaborates. "Their incomes, on the other hand, rose at an annual rate of only $110 billion. And for the 12 months ending in April of this year, $5.9 dollars of debt was added for every $1 of growth in GDP."

Adding debt to the system is inflationary: there is the illusion of greater purchasing power, which boosts up whatever market is hot at the time. Stocks went up in the '80s and '90s; now real estate is having its turn.

If only it could continue forever! Alas, that is not the way of the world. For each additional dollar of debt produces less and less economic progress...and is therefore a heavier burden than the dollar that preceded it.

At some point, people realize that they cannot afford to continue borrowing - their debt-service payments have become too much of a burden. Instead, they have to cut expenses and pay down debt. Then, prices fall...sales go down...jobs are lost...and the economy sinks into a deflationary recession.

This, of course, has been the economic history of Japan for the last 10 years.

More to come...