Deflation: How can so many people be so wrong for so long?

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It wasn't all that long ago where we had gas lines, a prime rate that reached 20%, unemployment reaching 12%, and inflation at 13%.

All we heard - nearly 30 years ago - the problem was "inflation."

The only way to wring inflation out of the system was to let interest rates rise - and rise significantly higher than the rate of inflation.  Paul Volcker (a name we are suddenly hearing again), was the chairman of the Federal Reserve who hatched the plan to let rates rise.

Understand this: when interest rates rose to 15% and 20%... all lending stopped.  The economy, which had been limping along anyway, ground to a complete stop.  It was excruciating and grueling living through that era.
But the end result was "declining inflation" - a theme we got used to hearing for more than 25 years.
Along with it came one of the biggest economic boom cycles in the history of the world.  And one of the hottest stock markets, too.

Today we are faced with another economic crisis.

A crisis just as serious as the one faced in the late 1970s and early 1980s.

But the crisis is not similar, and this is where everybody is missing the point.

The problem is almost the exact opposite of what we had in the late 1970s and early 1980s.

The problem is deflation.

We have too much supply, and not enough demand.  Look, when there is too much supply, prices must fall.

That's not a theory...that's an economic LAW.
We've seen it happen in real estate - that's the obvious example everyone understands.  But look around -

  • Do we need a Starbucks on every corner in Manhattan?  Too much supply, not enough demand.
  • Flatscreen TVs, which used to cost $2000, are now on sale for $400.  Too much supply, not enough demand.
  • Department stores are having "after Christmas sales" before Thanksgiving.  Too much supply, not enough demand.
  • Even the stock has been sliced nearly in half.

The problem is deflation.  Too much supply.

How do you tackle deflation?

Do just the opposite of what was done in the late 70s and early 80s.
During that time we let interest rates rise high enough to choke off all lending and economic activity.  We need to do just the opposite right now.  We need to throw so much money at the problem, flood the system with cash and keep rates down to a point that will spur investment, risk-taking and economic growth.

Which tells me we are on our way.

But I can hear you...you are worried about the value of the dollar.  You are worried about when will the recession end.  You are worried about the stock market.  Don't be afraid.  For once, the government may actually be getting it right.  Maybe.

The government is throwing trillions of dollars of the problem.  Down the road, there will be inflation to deal with.  That's for later.  Maybe MUCH later.  Not now.  While Henry Paulson and Ben Bernanke are being crucified daily by the media, they may actually be getting it right.

With that in mind, I'm sticking with my story: the fourth quarter GDP numbers will be the worst we've ever seen since the Depression.  While everyone is forecasting doom and gloom throughout 2009 and into 2010, I suspect we'll start to see milder numbers and a swift improvement in many economic matters.

Thomas Mullooly  is the owner of Mullooly Asset Management, LLC, NJ Fee Only Investment Advisor, providing guidance for your 401k account. Mullooly Asset is a fee-only alternative to stockbrokers and financial planners.

Tom's popular email alerts help folks to reduce the risks in their portfolios. To learn how to stop making investing mistakes or if you would like a free look at your 401k account at work - or your 403b annuity, or section 457 deferred compensation plan at work, visit www.mullooly.net today!

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