Kelly Evans has a short piece in the “Ahead Of The Tape” section of the WSJ this morning that highlights the lack of inflation.  The article, titled “Inflation Hawks Should Stand Down,” shows a tiny snippet of what we keep pointing out as one of the greatet economic drivers (in a bad way) of the next few years - deflation.

 The main chart shows money supply growth, which of course rose dramatically during the height of the crisis, but has since then fallen back and even dabbled with going negative.  Why?  The great retrenchment in lending.  As we lower the amount of debt outstanding through repayment or modification, it shrinks money supply.  This side of the equation is always left out by those who point to massive inflation being on the horizon.

This is not cause for celebration.  This is a fearful development that we have been forecasting, talking about, and generally shouting from rooftops for over a year.  The great de-leveraging is under way.  It won’t be pretty.

With March of 2010 upon us, many state legislatures are starting their sessions. Job one will be to figure out how to close the current budget gap.  Job two will be to develop a semblence of a credible budget for 2010-2011 budget year, which begins for most on July 1st. 

With traditional revenue sources dropping, state governments are in a quandry of their own making.  For decades they have gone along the politically easy path of continuing to promise and secure employment contracts for all levels of state workers.  Now that tax receipts ain’t what they used to be, these contracts (including pension benefits, healthcare, etc.) are crippling.  So, what to do?  Play hardball with the unions?  Not so fast. There is another way.

States have raised fees at an extraordinary rate (in the state of FL the tax on cigarettes increased by $1 per pack last year), even though this approach is most difficult on the lowest income earners.  Now states are beginning to take another look at taxing non-profits, pointing out that these organizations get the benefit if services (Fire, Police, Streetlights, etc.) without paying.  While that is true, the point of a non-profit is to provide services in the community that otherwise would not be available or would only be available at an increased cost to users.  Should non-profits pay some sort of tax?  I can’t say that I know the answer, but a piecemeal approach doesn’t strike me as appropriate. 

On another front, expect state legislatures to take another run at taxing internet transactions.  The sales tax lost to internet transactions is staggering, and definitely impacts the bottom line of taxing authorities.  The old argument of “It’s too hard to figure out who should pay what,” doesn’t hold water anymore either, as many retailers who have mulitple places of business in different states have already figured this out. 

My point is that as these legislative seasons get underway, look closely at what gets passed in the name of a balanced budget.  It will be much more about raising revenue than attacking the real problem - spending.  And grab hold of your wallet.  If you don’t, they will.

The WSJ reports this morning that lending by FDIC-backed banks fell at an “epic” pace in 2009.  The drop was -7.4%, or just over $500 billion.  In addition, banks wrote down $53 billion in loan value.  Keep in mind that this only lending at FDIC-backed institutions.  This does NOT include other financial institutions like the investment banks.  In the world of Asset-Backed securities, there has been over a $1 trillion in write downs/losses.  These forces are acting as a counter-balance to the the actions of the Federal Reserve - i.e., printing money - and therefore creating a seesaw between slight inflation and slight deflation.  The fight goes on.  Our view is that deflationary pressures will win, and we will all lose. 

The Fed surprised the marketplace on Thursday by raising the discount rate to 0.75%.  The fact that the Fed increased ANY rate, effectively a move toward tighter monetary policy, has sent shockwaves through the investment community.  Not surprisingly, rates are up today, Friday.  But what does that small increase in the Discount Rate mean?  In the short run, not much, but in the long run, I think it’s a test.

 The Discount Rate is the rate at which banks can borrow from the Fed. However NO BANKS use this facility if they can help it.  They choose instead to borrow from each other at the more favorable Fed Funds rate, which remains targeted by the Fed at 0% - 0.25%.  Since no bank wants to, or at this stage does, borrow directly from the Fed at the Discount Rate, then the move has little impact on the state of financing.

With that said, I believe this is a test by the Fed.  They chose the least impactful factor (since so few use it now) to move and now they will sit back and basically see what happens.  Does the market retrench because of the seemingly first step toward a tighter monetary policy stance?  Are bankers and borrowers spooked?  Does it have the opposite affect and spur a lot of borrowing as people try to secure financing while rates are low?  Or does nothing happen? 

Unfortunately, I think this is the state of things - our Federal Reserve is at the point of not knowing what affects their actions will have on the marketplace.  So they move cautiously.  Which actually turns out to be not such a bad thing…

Since we first published “The Death of Pensions,” a special report we wrote in 2006, we have surprised many people with our view that cities and states would succumb to a form of bankruptcy as our economy struggled.  As you might imagine, we don’t get many arguments about this anymore.  From the idiocy that passes for fiscal responsibility in California to the sad state of Harrisburg, PA, there are too many examples of the worst among us already falling because of profligate spending and no one willing to be responsible.  This morning’s WSJ discusses cities that are either already in Chapter 9 or are considering it.  The list will grow, and that growth will accelerate.  From the smallest city to the US government, we have not yet come to grips with the fact that we must cut spending.  That’s it.  The promises made by political bodies over the past 30 years cannot be kept.  City by city, state by state, these issues will be worked out, and it will be messy!

It appears that the Vatican is well versed in our view of the world, although they didn’t exactly credit us with the research.  The article that follows is very interesting:

Vatican Economist: Recession Caused by Low Birthrate
Blames Small Families, Poor Savings Habits

ROME, FEB. 8, 2010 (Zenit.org).- Bankers are not the cause of the global economic crisis, according to the president of the Institute for the Works of Religion. Rather, the cause is ordinary people who do not “believe in the future” and have few or no children.

“The true cause of the crisis is the decline in the birth rate,” Ettore Gotti Tedeschi, said in an interview on Vatican Television’s “Octava Dies.”

He noted the Western world’s population growth rate is at 0% — that is, two children per couple — and this, he said, has led to a profound change in the structure of society.

“Instead of stimulating families and society to again believe in the future and have children […] we have stopped having children and have created a situation, a negative economic context decrease,” Gotti Tedeschi observed. “And decrease means greater austerity.”

To read the article click here

The story of the day and week is the bailout for Greece that is being orchestrated by the Germans and French.  This is the fulfillment of the dire predictions of the German people when the Deutsche Mark was scrapped in favor of the Euro by the German leadership.  Their view was that some day the profligate spenders in the EU would screw up so badly that the responsible members would be required to rescue them.  That is obviously what has occurred, as the Greeks have now “restated” their annual reports of fiscal health going back almost a decade.  But it gets better.

The Greek government, in order to show their newfound fiscal restraint, have instituted measures of austerity that requires major cuts in government spending.  The problem is, 1 in 3 (yes, that’s real…33.3%) Greeks are civil servants.  They are employed with a contract that gives them irrevocable employment for a lifetime.  It is the pay and pension of this group that is under the knife.  And they aren’t happy!  How dare they have to take cuts!  What did they do that was so wrong?  And how ungrateful of the rest of the EU to begrudge rescuing them!  After all (and this is a quote from the NYT), “…we gave the world democracy, and we expect the European Union to support us.”

This same story and reasoning is ricocheting around the world, the US, each state, and even cities.  The city of Harrisburg, the capital of Pennsylvania, has been downgraded to B2, which is so far below investment grade to be laughable.  The problem is that the city’s debt service is more than their annual income.  Wow.  I bet they never saw that coming.  How about the the States of CA, NY, FL, and AZ?  Or, say, countless homeowners who over-extended, always expecting their asset to increase in value? 

 Right now, it’s not feeling too good to be one of the Germans in this story.

What is it w/ the NYT? Lowenstein wrote that home owners should just “Walk Away!” in an article back in January, and today there is another article on more homeowners walking away.  The discussions in these two articles are lopsided, painting what could be construed as a positive picture of why walking away from one’s home mortgage is justified, but they do not adequately talk through the long term effects on either the homeowner or the housing industry. 

I have written about this subject repeatedly here because I believe it is an important component of our housing crisis.  If there is a move to somehow give mortgage defaulters amnesty or otherwise provide cover for reneging on a debt, then where does it end?  What creditor would then be confident in giving any one a loan at anything above 50-60% Loan-to-Value?  What would this mean for valuations of real estate if suddenly the ability to finance was curtailed? 

On the personal side, there is much better treatment of this subject from Bloomberg here, where the discussion is more in depth about how banks and other lenders pursue the assets of those who strategically default…even in the case of short sales.  One of the determining factors is whether or not your home is in a non-deficiency state, which is a state like CA or AZ where it is illegal for lenders to come after other assets if you default on your home mortgage.  This is unusual.  In most states, mortgage lenders can come after you, even years after the fact. 

The difference in treatment between lenders and borrowers is appalling.  If you are a homeowner who put down 20%, paid your mortgage on time every month, but now your home value is below your mortgage, well tough luck.  If you are a large lender who did a poor job of protecting your balance sheet and now you are stuck with a lot of assets that are far below what you paid for them (a lot like homeowners) then you get a massive bailout at taxpayer’s expense and live to collect not only your pay but bonuses in the future.  It is this basic difference in how poor decisions are treated that is causing so many to question the responsibility to repay their personal debt.

$1.6 trillion, then $1.3 trillion, a mere $8.5 trillion over the next decade…and that assumes (always a dangerous proposition) very rosy GDP growth numbers in the later years.   This is the best that the brightest economic minds in our administration can do.  Think about that.  The most thoughtful, determined, experienced members of our leading economic team cannot come up with a budget proposal that is balanced, near balanced, thinks about being balanced, or has any chance of coming close to balanced for the foreseeable future.  I’m not singling out the current administration because of political affiliation, I’m singling them out because they are currently in the seat of power.  They have the reins.  The previous administration was a fiscal train wreck as well.

We raise taxes (which I believe are necessary) and lower spending, but we don’t even scratch the surface of what is necessary.  Starting in 1933 we promised all citizens a safety net, which has eventually grown into a foundation of benefits that have taken on the stature of rights.  Costs have never been contained, the programs have never been actuarially sound.  There has not been a methodology for lowering payments or benefits as circumstances of the country changed.  We are not being honest - politically or intellectually.

David Walker, the old Comptroller of the Currency who is now part of the Pete Peterson Foundation, was on CNBC this morning talking yet again about “restructuring” entitlement payments.  He’s trying to get to the point of cutting payments without having to say the word “cut” because he knows, as we all do, that people stop listening.

We, as constituents, have turned a blind eye to this issue for decades.  There has never been a sustainable path outlined for our entitlement spending, and yet by its very name (entitlement) we treat it as untouchable.  It’s not.  It will be unpleasant.  It will be heart-wrenching.  The burdens will fall in an unfair manner.  However these programs are not untouchable. 

Because we as constituents were not focused on our debt and the incredible weight of entitlement spending, any and every politician that attempted to rein it in was crucified by special interest groups.  There is a reason Social Security is considered the third rail (the electrified rail in the NYC subway system) of politics.  If you touch it, you die.  So we end up with entire generations of politicians who pledge to do nothing in this area.  They have performed admirably.

Now we are turning a page in America.  There is anger, resentment, and fear.  Ordinary citizens are talking about the deficit, the budget, and monetary policy.  Imagine, everyday people discussing the role of the Fed and the printing of dollars and monetizing the debt!  This rising sense of fiscal responsibility will not cause our current elected class to change course.  They’ve seen it before and nothing came of it.  Those that took the bait and called for drastic changes were once again punished.  What must happen to convince those in public office that Americans are serious is an overturn of who is in office.  In short, throw them out.  The good ones, the bad ones, the mediocre ones.  There must be a stand taken, somewhere, to say that we see this debt as a crippling habit that will not only slow down our lives, but ruin the lives of those that come after us.  

The path is simple.  Changing the regulations require Congressional action.  To get action, the members of Congress must be motivated.  To be motivated, they must understand that their voters are focused on these issues (debt, spending, etc.).  To get them focused, they must have their political fortunes based on these issues, which means we must elect those who run on platforms that are clearly based in debt reduction and responsible tax and spend programs.  This will mean sweeping out those currently in office, those who were elected based on different platforms and issues.  With a very large group of freshman we might have a chance at change.  I’m hoping for that.  Wait a minute…I’m starting to sound like a campaign.

The Dow is off another 160 pts so far today (11:30am EST), putting us just under 10,100.  This is a far cry from the 10,700 of just over a week ago.  The reasons for the fall - Geithner testimony, banking fee, screed againt fat cats, SOTU, etc, all seem to come up short.  How about, “curren prices are ridiculously beyond what companies are worth?”  That seems like a good one.   Or, “unemployment data, housing data, lending data, spending data, and every other reasonable and halfway believable measure of economics points to a long, protracted difficult economy.”   That also would seem appropriate. 

At least today’s fall comes as we deal w/ jobless claims and manufacturing.  We’ll be going through this at length in our newsletter this weekend.