Deflation Is A Bitch

The latest Thought's From The Frontline by John Mauldin is a gem. It is about the crisis in Spain through the eyes of Variant Perception.

Please consider Spain: The Hole In Europe's Balance Sheet by Variant Perception.

VP makes a compelling case that ....

• Spain is in the same deflationary trap as Japan
• Spanish banks are hiding losses
• Spain is in deflation
• Spanish housing is much worse than people think
• Spain is creating zombie banks
• Germany, France, and other European nations will be left holding the Spanish bag

Variant Perception:

Spain, and the rest of the European periphery, can solve their problems either through massive productivity gains, which is highly unlikely, or through a reduction in wages and prices in the order of 20-30%, which is what will happen slowly and painfully. You could call such a reduction of wages and prices an "internal devaluation".

Real Interest Rates: Deflation Is A Bitch

Eastern Europe, Spain and Ireland are now all experiencing the beginning of deflation. We believe that we will see much more deflation to come, which will have broad ramifications across the European banking sector. The periphery countries are net debtors, and the rest of Europe is the net creditor. When a debtor can't pay, the creditor suffers. Germany, France and others will need to cope with recapitalizing the periphery and Spain. In the words of Plautus, "I am a rich man as long as I don't pay my creditors." A deflationary spiral means that most of the debt will need to be written off, and the creditors will have to absorb the losses.

Spain is not the only country facing deflation. It is a problem for the entire European periphery. Ireland, for example, has the highest rate of deflation in the world. Prices in Ireland are falling at an annual rate of 5.9%, well ahead of the drops in other countries - only Thailand, at 4.4%, comes even close.

We believe that Ireland's experience is what Spain will see more of in the months ahead as the economy slowly adjusts to new realities. Almost all of Ireland's banks have been taken over by the government, and Ireland is struggling to decide how best to dispose of its bad assets. We believe Spain will be much more like Ireland than any of its European neighbours.

Oddly, even though inflation is negative, and unemployment is high, unions are still winning pay rises. Most wage agreements in Spain are reached through collective bargaining on an industry level. So far, wage increases are happening above the ECB's 2% target inflation rate.

Given how far out of line wages are with unit labor costs and the reality of deflation in Spain, we see Spain's unemployment level heading towards 25%. With a 25% unemployment rate and a debt deflationary dynamic, how exactly do the banks think they'll be paid back? Who will earn the money to pay the mortgage payments, and how will housing be affordable when wages have been deflated? Assuming the worst has passed in Spain does not pass the common sense test.

We believe Spanish politicians and international investors have grossly misjudged Spain, but events will force them to change their mind. In retrospect Spain will be viewed much like subprime where all the banking results looked good, until they didn't. This is typical of bubbles, and Spain will be no different.

Spain = US?

What Variant Perception says about Spain also applies to the US, although arguably not to the same relative degree. Thus, for all the problems in the US, banks in Spain and Ireland are clearly in worse shape.

Moreover, because of risky loans to the Baltic States and Latin America, many Swiss and other European banks are arguably worse off than their US counterparts as well.

These factors are more US dollar supportive than most realize.

Decoupling Theories = Naivet� In The Extreme

John Mauldin himself typically provides little commentary, instead highlighting various authors. However, I happen to like a paragraph from his introduction to this article.

John Mauldin:

"Problem[s] from the credit crisis are worldwide. To think they are not interconnected would be naivet� in the extreme. What happens in Japan and Spain and the US will affect your part of the world, some more than others."

Indeed!

Given that the decoupling thesis is naive, I recommend placing a lot of weight on deflationary things like

• Creative Destruction
• Spending Collapses In All Generation Groups
• Greater Than One in Four FDIC Insured Institutions are Unprofitable; Bank Problem List at 15 Year High

Nonetheless, some investors already burnt once by various decoupling theories gone awry are again pointing to China, Canada, and Australia, while singing the same disproved decoupling song a second time.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Mike "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.
Visit http://www.sitkapacific.com/account_management.html to learn more about wealth management and capital preservation strategies of Sitka Pacific.

Full story at http://globaleconomicanalysis.blogspot.com/2009/09/deflation-is-bitch.html