Long the markets right now? Get ready to have your lunch money taken…for the next 50 years. | Eastern North Carolina Now

     Since the March 2009 lows in the major American indices (S&P 500, Dow, NASDAQ), it’s been a wild ride straight up as markets attempt to digest information and find a new equilibrium in the aftermath of the largest private sector debt bubble in history (not to metion the world wide public sector debt crisis set to take place within the next 5-10 years). Many investors are thoroughly convinced that we’ve found that equilibrium here in the 9,500- 10,700 range.

    They are optimistic, patriotic Americans who are once again putting their faith in the wise old sages of Washington and Wall Street to connive some way to weather this storm of massive debt de-leveraging in the private sector, massive leveraging of the Fed’s balance sheet through the monetization of those bad debts (see: throwing good money after bad), and the resulting debasement of the currency through massive reflation (we won’t call it inflation since the massive influx of cash has done little inflate asset prices across the board to pre-crisis levels), all while keeping the debt collectors of the world (namely China, Japan, and Saudi Arabia) at bay. Unfortunately, the case for success defies logic.

     Conventional wisdom concerning market psychology tells us that markets tend to overshoot in both directions when in search of equilibrium. However, when considering this particular nugget of market wisdom, it is of paramount importance to remember to view the current circumstances in which we find ourselves, against the backdrop of history.

    Historically populations increase, and, as a result of this increase in consumers, demand for scarce resources increases (think corn, oil, cattle, soybeans, services, everything under the sun, etc.). As a result of increased demand for said resources, production of these resources must rise at the same rate in order to maintain price equilibrium. If production increases lag demand, you get rising prices (inflation). Conversely, if production increases outstrip demand, you get falling prices (deflation).

     Many very qualified, however misguided, market analysts are expecting massive inflation in the future because they are focusing only on the massive increase in money supply over the last 40 years since Breton Woods II removed the gold standard and replaced commodity based money with debt based currency. Indeed, massive increases in money supply have caused steady inflation as one may clearly see by observing the price movement of every major asset class of the period.

     By looking at this price action one could reasonably conclude that debt isn’t such a bad thing when it’s used to produce future growth. That is true. When your ROI is positive, that’s fantastic. You’ve borrowed money, made investments to produce more of whatever it is you’re making, and demand should rise with population growth…life is good, right? Well you’ve made one dangerous assumption; what if populations don’t continue to grow exponentially? What if, as many of you see when you look around yourselves, consumers that spur demand for your product aren’t replacing themselves, never mind growing in number?

     Well, then you’ve got a problem, a demand problem. As we established earlier, falling demand and rising production capacity equals one thing, deflation of asset prices. Some will argue that that isn’t true; they will point to production cuts as the answer to falling demand which should result in price stabilization. To this argument I would reply that underutilization of production facilities leads to higher unemployment thus further reducing demand and making your problem worse. Since production facilities, without the help of growing populations, are likely to continue to be underutilized, the value of the excess production facilities must fall.

    Eventually, through population reduction (policies were instituted in the 1970’s to make this a reality, thanks to our pal Mr. Kissinger.), an equilibrium will be reached; but there is still the problem of excess production facilities.

    Sans retooling or recycling of these assets to produce some unknown product or service of value to the shrinking human race (which is entirely possible, mind you) we are in for a long term deflationary spiral rivaling the length of the inflationary cycle we’ve experienced of the last 40 years.

    Let me leave you with a real world example that many of us can relate to. Let’s say you owe your credit card company $10,000. Let us also assume that you are paying an interest rate of 10% annually you’re your minimum payment is $100 monthly. And while we are assuming, let us also assume that you plan to pay the minimum payment every month on time until you’re done. The current dollar value of your debt to the holder of that debt is $21,300. That is the amount that they expect to collect from you over the next 17¾ years.

    Well, what happens to that figure when you lose your job (tax paying population) and can no longer pay? If you guessed that the value of your debt to the holder of that debt went down significantly, you my friend are a smart cookie. If you went a little further and realized that gigantic debts which cannot be paid by income are a common occurrence in a place called Capital Hill, then you are seated near the head of the class. If you went even further and realized that the paper that you spend the majority of your waking hours working for, which all of your obligations are paid in, is no more than a promissory note backed only by the word of this serial debtor who consistently and without restraint consumes more than he produces, then you my friend, may join me at the head of the class to pray for deflation instead of hyper-inflation.