Given the strong rebound in the equity markets since March 2009, "most investors believe that 2008 was simply a bad dream from which they've now awoken," starts Gary Shilling in his newly-released tome on deflation, The Age of Deleveraging. "But the optimists don't seem to realize that the good life and rapid growth that started in the early 1980s was fueled by massive financial leveraging and excessive debt, first in the global financial sector, starting in the 1970s, and later among U.S. consumers. That leverage propelled the dot-come stock bubble in the late 1990s and then the housing bubble."
Dr. Shilling has had a long and wildly successful career as an economic forecaster. Shilling was one of the few voices of reason that foresaw the busting of the Japanese bubble of the late 1980s, and he also correctly forecasted the bursting of the 1990s Internet bubble and the mid-2000s housing and financial sector bubble. I am delighted to find him on "our" side of the inflation/deflation debate.
It can be a bit lonely here in the deflation camp. Despite the fact that official CPI inflation has been tepid at best for the past three years and that retailers still have practically no pricing power, there is widespread belief that high or even hyper inflation is just around the corner due to the Federal Reserve's aggressive quantitative easing.
Essentially, the inflationist camp is making the mistake of believing that the pre-WWII Weimar German Republic is an accurate representation of our own conditions today. Why? Because it is example that is often cited in popular economics books and it is thus fresh on their minds. But a better understanding of history would tell you that 1990s Japan is a far better representation than 1920s Germany. Japan, like America, had a massive real estate and consumer spending bubble fueled by easy credit. Weimar Germany's inflationary spiral was a result of unpayable war reparations. Which would seem a closer parallel to you?
Similarly, the inflationists see confirmation that inflation is "everywhere" when they see prices for fuel and agricultural commodities rising--yet they ignore the fact that food prices have risen primarily due to supply-shock factors (i.e. exceptionally bad harvests in Russia and elsewhere due to extreme weather) and that energy prices are manipulated by both speculators and the OPEC cartel. They simultaneously ignore the fact that retail prices of services and manufactured goods continue to fall, as do housing prices. Furthermore, the bursting of asset bubbles is virtually always followed by a long period of deflation. Gary Shilling understands this.
Shilling believes that as a result, we have a decade or more of continued deleveraging in front of us, and with it a period of lower than expected growth and deflation.
All About Deflation
On the federal deficit and its implications, Shilling writes,
"With the prospect of huge federal deficits for the next several years, why won't significant inflation follow? After all, excessive government spending is the root of inflation. Still, it's excessive only if the economy is already fully employed, as in wartime. And that's not the case now, nor is it likely in the slow economic growth years ahead. The continuing $1 trillion deficits result from a sluggish economy, which retards revenues and hypes government spending."
Ditto, Gary. Dr. Shilling, though not a demographic expert by any stretch, does understand what demographic trends imply. On the Boomers he writes,
"A saving spree in the next decade will also be encouraged by [Baby Boomer] saving. Those 79 million born between 1946 and 1964 haven't saved much, like most other Americans, and they accounted for about half the total U.S. consumer spending in the 1990s. But they need to save as they look retirement in the teeth... Postwar babies need to save not only to finance retirement but to repay debt. The Fed's 2007 Survey of Consumer Finance found that 55 percent of households with members aged 55-64 had mortgages on their abodes and 45 percent carried credit card balances."
Yet while he sees the importance of demographics, he also misunderstands them. Shilling falls into the trap that so many others--Dr. Jeremy Siegel and Fed Chairman Ben Bernanke among them--fall into. There is this persistent belief that the retirement of the Boomers will cause a labor shortage that will lead to severe inflation. As Shilling writes, "When [the Boomers] stop working, the supply of goods and services would fall. In retirement, they might spend less on themselves and on supporting their kids, and they might have lots of greenbacks... Nevertheless, there would not be enough goods and services to go around."
While this argument might make intuitive sense at first, it is fundamentally flawed. Outside of medical care and select few other industries, spending falls on virtually all other consumer items in retirement. Yes, the elderly still have to eat. But they buy little else that contributes meaningfully to inflation.
This is not purely an academic argument. Japan has been struggling with an aging and even declining population for years now. And Japan would love to have an inflation problem. Instead, deflation persists.
You see, supply is not the problem. In the post-industrial information and high-tech economy, supply takes care of itself. Is it expensive to hire a housekeeper? No problem, buy an iRobot Rhoomba to vacuum the carpet while you're at work. Is your tax accountant expensive? No problem, fire him and buy TurboTax. In the modern economy, automation and technology can make a good deal of human labor obsolete. We bring in migrant labor to harvest crops because migrant labor is cheap. But if the price of migrant labor got high enough, rest assured that California farmers would use robots to pick strawberries. This is not idle conjecture; their counterparts in Japan already do.
Demand will determine if we have inflation or deflation, not supply.
Concluding Remarks
In The Age of Deleveraging, Dr. Shilling has published a very good and very convincing body of work. A world economy dominated by deleveraging is a very different animal than a world economy dominated by an accumulation of debts. As investors, you have to position your portfolios accordingly and--I want to be firm on this point--you have to adopt a tactical approach to investing. Take advantage of rallies when you see them, but be prepared to take profits. In a period of deleveraging, you win by not losing.
