Signs of Deflation in China and U.S., Optimism in the Markets

Giordano (0709.HK) reported a sales slump of 4.3 percent in the first quarter.

China's vice premier Wang Qishan said the economy will get worse before it gets better, and added:
"To overcome the current difficulties, it is essential to convert confidence into credit in the market and quickly recover functions of the financial markets,"
Speaking of credit, U.S. consumer credit fell $11.1 billion in April. It's falling at a 5.2 percent annualized rate, compared to the 6.1 percent annualized rate of first quarter GDP.

Optimism is increasing regardless of the news. Bank of America is up about 70 percent since last Friday, based on pre-market trading this morning. Commodity prices are rising—copper is up again and oil moved towards $60 a barrel. Credit contraction, unemployment, and high debt levels would indicate deflation is still a risk, but one cannot ignore the possibility of inflation. American stock indexes bottomed in 1974 and tread water for almost a decade, but high inflation ate away at returns.

And we can learn lessons from Wiemar Germany. Even though the Reichsbank continued printing money, the depression of 1920-1921 caused the German price level to fall. I also looked at some other books on the library shelf, and found one titled, "Good-bye Great Britain"

Here's a snipped from wikipedia on the 1976 crisis:
James Callaghan came to power in 1976. He was immediately told the economy was facing huge problems, according to documents released in 2006 by the National Archives. Financial markets were losing confidence in sterling. The UK treasury could not balance its books, while Labour's strategy emphasised high public spending. Callaghan was told there were three possible outcomes: a disastrous free fall in Sterling, an internationally unacceptable siege economy or a deal with key allies to prop up the pound while painful economic reforms were put in place. The pound fell below $1.60 later in 1976.
Sounds a lot like the U.S. government today...

The point is, we can have inflation and it still doesn't solve the economic problems, which take time to work out. A deflation will wipe out the problems swiftly. People with too much debt will lose some property, businesses fail, and unemployment jumps. It will also allow for a quick recovery because the assets will move from the inefficient to the efficient. Low prices will lead to value buying, and prices will have natural support at the bottom. Instead, the government is desperately trying to inflate the economy. This allows the inefficient structure of the economy to live another day, another year, perhaps another decade. The transition will be long and slow, but high inflation and currency crises means the pain could last longer. For politicians, however, the only worry is the next election.

At this moment, I believe the evidence of economic recovery is slim, the stock market rally is based on emotion, and deflation remains the greater threat. Nevertheless, it pays to be prepared for any eventuality.

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