The Real Risk in Today’s Economy

House prices are falling. Stock prices are falling. Car prices are falling. Prices for most merchandise (especially electronics) are falling, thanks to the continuing glut of cheap imports from China.

The real risk in today’s economy, my dear reader, is not recession (even though we are going to get one). The real economic risk today is the dreaded opposite of inflation:

Deflation, I believe, is the single largest threat to the American economic machine. I also believe that home prices, stock prices, car prices and general merchandise prices will continue to fall over the next 12-24 months, setting the stage for deflationary times in the U.S. Of all three states of price movement (deflation, inflation and stagflation), deflation presents the greatest risk, as deflationary periods prolong economic recessions.

Think of deflation this way: A consumer buys a house for $300,000 with a $270,000 mortgage. That home deflates in price to $260,000. Is the consumer not served better to walk away from the home and give the bank the keys because they have negative equity? The home price fell $40,000 but the mortgage stayed the same! Is this not happening right now in the U.S. housing market?

Look at another example of the investor who bought Starbucks stock at $35.00 a share one year ago and is holding it today at $18.66. The smart investor would have used a stop-loss and gotten out a long time ago. But only 10% to 20% of retail investors use stop-losses. The rest hold on to see their losses. Is this not happening right now in the stock market?

In both my examples, once a homeowner or an investor is “burned” in a transaction, they will be less likely to return… the reason deflationary recessions extend for longer periods than regular contractionary recessions.

There are two insurmountable problems facing America today that would result in any deflationary period being extremely difficult for the economy to steer away from. Firstly, and unlike Japanese consumers during their deflationary years, American consumers do not have savings to spend their way out of a recession. As we know, the savings rate in the U.S. is near a record low.

Secondly, the falling U.S. dollar makes a free-fall in U.S. domestic interest rates almost impossible. The world, which once ran on American dollars, is now running away from what became the world’s reserve currency. You can see this in the action of gold bullion prices. Yes, Bernanke will decrease rates aggressively next week and in other Fed meetings as the year progresses. But it would be very difficult for the U.S. to bring interest rates down to one percent and hope that foreign investors (that finance our debt) would be attracted to U.S. government bonds.

Prepare for the worst economic period ahead that we have seen in years, my dear reader, as that is what I see coming.

(Just a note: I’ve written over the past three years how, in the late 1920s, real estate prices fell first before the stock market and how I felt the same would happen this time. Home prices in the U.S. peaked in 2005 and started falling in 2006. The stock market is following suit here in 2008.) Is a depression coming? No… How about a severe deflationary recession? Yes!