The first stimulus package was a total failure. So what’s the solution? Lather, rinse, repeat!
Gary Shilling believes that we are about to enter a deflationary period and that President Obama will be forced to implement a new stimulus package. Since the first package failed, the second will fail as well, and we’ll be even deeper in the debt hole.
The obvious solution for the government is to inflate its way out of debt. But what if they cannot do this?
The bond and stock markets switch back and forth between a deflationary position and an inflationary position about once a month since mid-2008. The bond markets are now in inflationary mode but, if the past six months is any indicator, they will switch back to a deflationary mode in a few weeks.
Why deflation is bad
The short answer is that deflation prevents you from paying your debts. Say you have a $200,000 mortgage on your house and it is valued at $240,000. Your annual household income is $140,000.
When deflation kicks in, prices and salaries drop. If we have 50% deflation (not an unreasonable number), your house now has a value of $120,000 and your income has dropped to $70,000. How are you going to pay off a $200,000 mortgage with that income? You’re not. And if you owe a lot more on your house than it’s worth, you might find that it’s better to let the bank have it back than continuing to make payments.
What is the likelihood of deflation?
The signals are mixed now, as witnessed by recent stock and bond market swings. The government is borrowing money at unprecedented rates and they would rather see inflation than deflation. However, higher taxes and a downward turn in the stock markets will dampen the economy, which could lead to deflation.
Watch for signs that the economy is faltering. Watch also the prices for basic commodities, such as oil and precious metals. If the economy fails and commodities fall, then deflation is likely. If this happens and bond yields increase, shift more of your assets into bonds. Corporate bonds have higher yields than treasuries, but have a higher likelihood of default. However, if you’re judicial in your choice of bond purchases, you can breeze through the recession in style.
Go to Tech Ticker to watch the short interview:
There was a great clamor last week for a second Federal stimulus - because the first one wasn’t working. President Obama threw cold water on that idea over the weekend, when he rejected calls for a second stimulus and suggested that we need to be patient and give the first stimulus time to work.
Well, President Obama will soon be changing his tune, says our guest Gary Shilling.
By the third or fourth quarter, Gary says, the government will launch a second stimulus. Next year is an election year, and despite ballooning deficits, politicians won’t sit idly by and watch themselves not get re-elected because the economy has failed to recover.
The second stimulus will finally trigger an economic recovery…but it won’t happen until next year.
In the meantime, Gary thinks, the stock market will crash again, with the S&P dropping 35% to 600.
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