This is an important e-letter. I have thought long and worked hard on it. Part two, which will offer some investment possibilities, will come next week.

For well over a year, I have been writing that I think the chief problem on our economic front is not inflation but deflation. About three months ago, I wrote an e-letter on deflation. I got more letters and questions on that article than any other letter. Many were quite long and perceptive. I promised to do another e-letter attempting to answer those questions and explain my concern about deflation in more, and hopefully easier, detail.

For the last few weeks, I have immersed myself in this issue, as it is becoming one of those things that go bump in the night in my worry closet. One of my daily habits is to read the Wall Street Journal Op-Ed page. (There are two main places the business and political elite communicate with each other. One is the Op-Ed page of the WSJ and the other is the Foreign Relations Journal published quarterly by the Council on Foreign Relations.)

A few weeks ago, Wayne Angell, former Fed governor, Chief Economist at Bear Stearns and a close friend of Alan Greenspan, wrote an article arguing for quicker rate cuts. He used much of the same logic I and others have been using for the last few months.

But the difference is at the end of the article, where he begins to focus on deflation. If you read him carefully, he is arguing that instead of the monetary activism recently seen by the Fed (by which he means rate cuts and hikes), the chief job of the Fed should be price stability and he specifically concludes current Job #1 is to fight deflation. When Wayne Angell writes such a strong piece in the WSJ, I pay attention. Frankly, it is one thing for me to get worried about deflation. When Angell joins the ranks, I get very concerned. I think you should be, too.

(Side note: I was attending a hedge fund conference in Bermuda about 10 years ago and went into the hotel gym to work out. There was one other gentleman there, older than me, but we struck up a conversation as we worked out, which quickly turned to economics and Fed policy, about which he amazingly showed a strong grasp. After 30 minutes, I finally realized my workout friend "Wayne" was Wayne Angell, Fed Governor, and I was out of my debating league. Red-faced, I began to sputter some apologetic nonsense, but he was very gracious and said he enjoyed lively discussions, and we continued, but my role then became student before master for the remaining time.)

Some Basic Theory

10-15 years ago, if you had asked almost anyone besides Gary Shilling if deflation was a concern, you would get a smile and a polite dismissal. After all, hadn't Friedman and decades of experience taught us that the chief economic concern was governments printing too much money and causing inflation? Our instinctive distrust of government and the experience of huge government deficits, not to mention Social Security shortfalls, seemed to scream that serious inflation and economic disaster was in our future. (I will never forget Ross Perot and his charts.) The power of the government printing press was what made many of us gold bugs.

We believed deflation was what happened after an inflationary blow-off, like in Germany in the 1920's, or caused by massive government mistakes like our own deflation in the 30's. In "modern" times, we needed to keep an eye on the ever increasing money supply. As time went on, Greenspan really did seem to be an inflation hawk and seemed committed to never letting inflation become a serious problem. In short, I dismissed the possibility of deflation in my lifetime.

But about 18 months ago, I began to perceive that there were fundamental changes afoot - changes which, if not checked, could lead to deflation. With that background, let's jump into the issues.

First, let's look at some of the way the money supply can grow. The Fed can "create" money by buying assets in the public market place. In the US, this means they buy government bonds and bills. The Bank of Japan is talking about buying stocks to not only increase the money supply but also to prop up their ailing stock market.

If you deposit money in a bank, that bank can lend it to someone else. In fact, they can lend it to a lot of someone else's, who deposit those dollars in a bank, who lends it to someone, who deposits it in a bank and so on and so on. Fractional reserve banking increases the money supply.

Furthermore, those who borrow money buy something or invest in something, thus stimulating the economy and increasing overall profits. This encourages businesses to increase production, which usually means they have to borrow more money to buy more machines to make more products. The economy grows, and the money supply grows along with it.

Further, the Fed can cut interest rates which means corporations spend less on interest costs, which increases profits. At some theoretical low rate of interest, entrepreneurs and consumers think it becomes profitable to buy some new machine, car or building. Mortgage rates go down. Car payments go down. The amount of disposable income individuals and companies have to save and spend goes up. Profits go up. The economy grows, and the money supply grows along with it.

Now, if you add into the mix new and better ways of producing products and services at ever lower costs, you start thinking about a "New Era." Whether that New Era is caused by electricity and railroads and radio or by computers and the Internet, investors get excited about the promise of the future. Stock prices rise beyond normal values based upon rosy projections about the future. In the past, that rise usually effected only a small portion of the population. But today, the increase in wealth due to 401k's and IRAs and so forth has the majority of Americans watching the stock market.

Driving Faster than Your Headlights

In 1999, Greenspan became nervous about Y2K. Or maybe better put, he became worried that some of us who worried about Y2K might horde cash or that spending might be an issue after the turn of the century. He did an unusual thing. The economy was screaming along, and he felt he needed to slow it down, so he began to raise rates. But because he was worried about Y2K, he grew the money supply at an enormous rate. That monetary growth was like throwing gasoline on a fire. We now know where the money went. It went directly into the stock market. Much of it went into internet and tech stocks. Old Economy stocks languished. Consumers felt wealthy and bought all sorts of products. After the turn of the Millennium, Greenspan began to reduce liquidity in an effort to slow down the economy and keep inflation from becoming a problem. Or at least that is what he told us.

Combined with the eventual realization that the NASDAQ Emperor had no clothes, this reduced liquidity started to bring down the stock market. As the internet stocks collapsed, much of the growth in the tech sector which had been due to the huge buying of the internet start-ups began to slow down. But the capacity for production was still there. Eventually, this reduced liquidity began to slow things down. First it was just an earnings warning here or there, but soon it became a flood. Now we can all feel things slowing down.

Even though consumer spending grew slightly last month, one company after another is warning of decreased profits and beginning lay-offs. It could be this is nothing more than a classic beginning of a typical mild recession which could be over soon. With the Fed cutting rates so fast, even though I (and many others more important than I) think they should cut faster, they are moving more rapidly than at any time in the past. And in the economy overall, things are not falling off a cliff, they are just slowing down. We are still creating more jobs than we are losing. The stock market is just coming back to realistic value levels, which long time readers know I have been telling you it would since early last year.

My Dad always warned me to never drive faster than my headlights could see into the dark. That is just what the stock market and our economy did, however. We built too much production capacity. We planned for too much growth. The rest of the world would continue to buy our products and services. The Chinese hordes, along with the rest of the third world were going to buy everything we could produce. We assumed the growth trend we were in would continue forever and ever, world without end. Amen.

And now, we have to re-adjust. This is called the business cycle. It is written into the economic rules since the Medes were trading with the Persians.

So, what could make this recession any different than those we have already experienced? Why should we not expect lower rates and a tax cut to eventually move us back to growth and prosperity? Why are Angell and others worried about deflation?

Like a Never Ending Spiral, Like a Wheel Within a Wheel (Lyric from the theme to The Thomas Crown Affair)

First off, let me answer those who are asking why I am talking about deflation when the Consumer Price Index is rising somewhat. I am not going to spend a lot of time here, but the CPI is a rigged and somewhat pointless game when it comes to demonstrating or predicting core deflation. If and when the CPI starts showing sustained outright deflation, we are in trouble. CPI measures things like sweet rolls and women's lingerie. (Thanks to Don Luskin of the Street.com for this insight). Sweet rolls were fairly steady, price wise, for 1997 through 1999. Then in 2000, they exploded up by almost 10%. Why? Who knows? Maybe they started going to Starbucks (ouch!) to check their prices, but the cost of the stuff going into sweet rolls (flour and sugar and labor) did not spike 10%. Whatever caused sweet rolls to rise was not inflation. (More likely sugar addiction.) Further, long distance telephone costs have dropped precipitously for years. That is because of new technology and is certainly not a sign of deflation.

I want to separate deflation into different sectors if you will: asset, commodity and consumer goods. We have already seen asset deflation in the NASDAQ stock market. I read somewhere that some $10 trillion worldwide has "poofed" into thin air. If we see a continued bear market and recession we could see a lot more paper net worth disappear.

We have seen deflation in commodity prices for the last several years, with the exception of a pre-Y2K 1999 as Greenspan inflated the money supply. The deflationary cycle then resumed in 2000. Prices for raw commodities, metals and products have been dropping. Copper, steel, tin, cotton, and grains are all experiencing lows. Oil, as I predicted last year when everyone was talking $40 a barrel is testing $26. That means supply has out-stripped demand for most basic commodities even in a world economy supposedly growing at tremendous rates.

And the real key indicator of inflation - that barbaric relic gold - is dropping to lower and lower levels. Gold is telling us that inflation is not something to worry about.

We are just beginning to see prices for consumer goods coming down as well, especially those made in foreign countries. If the deflationary forces that are in the world today are not checked, we will see outright price deflation in consumer prices next year. Consumer prices will be the last to be affected but will be the most devastating, because it will mean we are in a recession that is very deep.

The Fed should be able to grow the money supply and supply enough liquidity to stop outright price deflation. But should be and will be are two different animals.

Here is the issue about which many are worried. Everyone agrees the American consumer has been the engine for the world economy. But lately, we are buying less imports. That has shown up in trade problems for Asia especially. Japan is actually running deficits. Several other nations are in trouble. In the US, the National Association of Purchasing Manager-Chicago said their index of regional manufacturing in February fell to 35 - the lowest number since 1982! So now we are buying less of our own materials. The economists simply call it an inventory correction problem and suggest/hope that when we get through excess inventory that things will get back to normal.

Here is the concern. Let's say consumer A gets a little nervous and decides to pay down his credit card debt. The money supply does not change, as the credit card company now has a dollar. But consumer A did not buy something with that dollar making the economy grow. Of course, the credit card company can lend the dollar to someone else and things should go on merrily.

Without boring you with numbers, the American consumer and businesses are loaded with debt - massive amounts of debt. All things being equal, they also have enough income and net assets to manage that debt. Or they did until last year. We now have $5 trillion or so less now than we had a year ago as we were running up that debt. For the first time in decades, American families actually lost net worth last year. Even in past recessions, that never happened. And we were not in a recession last year.

The so called "Wealth Effect" made families feel capable of buying new cars, TVs, computers and so forth and even comfortable going into debt rather than selling their stocks, which were of course going to go up faster than the interest rates on the loans. In fact, many investors took out increased home mortgages to finance stock market investments.

But what if we begin to see the first fruits of a negative wealth effect? Consumers start paying off loans and buying less. They find they can do without a new widget. I am not talking about us all becoming misers. After all, we are Americans. We will spend money. I am talking about us spending a little less and saving a little more to make up for the concern about how much we feel we lost last year. For instance, car sales are beginning to increase, but the prices have been slashed to induce sales and thus auto company profits are falling.

But 5% debt reduction here and 5% savings there means an economy which grows slower. It means corporate profits are smaller. That means lay-offs. It also means that businesses borrow less money to buy new machines to make more products. Borrowing less money reduces the money supply. We are also seeing banks lending less money because they have fewer credit-worthy borrowers. If fewer people borrow money and there are fewer credit-worthy borrowers, how much will the Fed have to cut rates and increase the money supply to stimulate the economy? If you are Japan, as I will discuss later, you can go to zero interest rates and it makes no difference.

At some point, the concern is that investors start thinking bonds and cash. Less investments and borrowing and more lay-offs. More lost consumer confidence. Less consumer spending. It becomes a downward spiral.

The Cavalry Comes

But wait! What is that sound? It is the Greenspan cavalry with more rate cuts coming! It is the roar of ever-increasing money supply! And here comes Bush from the right flank with tax cuts. We are saved! The money supply grows. Hurray!

Ultimately, I think that is what happens. But my guess is that we are going to see lot more rate cuts than most mainstream economists think. Why? I believe consumers are going to be more cautious because their net worth is now less and they want to do something to increase their personal wealth. I believe it is going to take a lot more than another 75 basis points to jump start this economy.

Why do I say this? For two reasons.

First, in previous recessions we did not have large deflationary pressures like we have today. Today the level of asset deflation in terms of the stock market and the underlying commodity deflation due to over capacity are serious drags on the economy. Cutting rates a few hundred points might be enough to overcome this if that was the only problem. I say might because Japan only had asset deflation to deal with and cutting rates there did not help.

But there is another problem and that is the American consumer. Because I talk to middle America every day, I think I sense something different happening out in the heartland.

Think about it. Are YOU worried? Do you have as much as you did last year? If not, are you trying to figure out what to do to increase your net worth? What about your friends? Are they talking about spending less? Maybe it is just because I talk to investors every day who tell me this is what they are thinking. Many of you write me about your situation. And most of those letters either detail woes or tell me you are in cash and wonder what to do. The readers and clients I talk to, except for the very wealthy, are concerned about the economy and their future. The amazing confidence and optimism I heard a few years ago is no longer there. We are much more humble and much more in search of help and answers.

Over There, Over There!

We are now using less than 80% of our production capacity in the US. The numbers are worse in much of the world. The ability of basic businesses to control prices is slipping away as competition is eroding pricing power.

Many analysts, like my good friend Bill Bonner, wonder why the dollar is holding up against the Euro? Is it because the dollar is so strong? That may be a part of the answer. But the real answer is that so many of the world's currencies are weak. Greg Weldon documents almost daily the competitive devaluation of Asian currencies against the dollar, trying to lower their currencies to entice American and world consumers to buy their products.

But the real story of the weakness of the Euro can be seen in the ratio of the Euro to the Yen. The graph looks like Niagara Falls. It seems the Japanese need cash as their banks and institutions are in serious trouble. For some reason, they and the rest of the world have chosen to take money from Europe and not from the US. Until that process stops, the dollar will remain high.

But a strong dollar makes us less competitive. How many companies are complaining that the high dollar is costing them profits and sales? The answer is a lot, and they are having to lay off workers to maintain profitability. Eventually the dollar will fall against the Euro, but I rather doubt we will see a collapse in the dollar. More like a normalization, which will be good for our businesses which sell overseas and have to compete with European companies.

I am starting to doubt the Pollyannas who are expecting a quick recovery in the last half of this year. These are the same guys who said we would have a soft landing, meaning no recession.

The Yield Curve tells us the Recession should not even be starting till this summer. Remember in January when I said we needed to look at this quarter's numbers before we could tell how bad things would be? If we see a contraction this quarter, then things could get much worse in the third quarter. Rate cuts typically take a year to take effect. If things get worse in the next quarter and a recession starts this summer, where do you think the stock market will go?

The Japanese Problem

While I have written that I think there are some real differences between Japan in 1989 and the US in 2001, it is instructive to look at their problems. They have dropped interest rates to zero and are still in a deflationary recession, and have been for a decade. Their consumers are saving an astounding 19%! The loss of wealth they felt this last decade has made them very worried about the future and each individual is doing what they think is best for them, and that is to save money, even when they are getting very little interest. Cash has become King in Japan.

Now Japan has not shriveled and gone away. Japan and the US account for 46% of the world's economy. They are a force in the world. But all the king's rate cuts cannot stimulate the Japanese economy.

That, I think, is Angell's and Yardeni's and other mainstream economists main worry. It is not that American businesses are just going to wither on the vine, or the world implode. It is that American consumers lose that "King of the Hill" feeling. A little contraction can be healthy as it wrings out some excess and makes businesses focus on profits and costs.

But we have never had a business contraction after consumers have lost $5 trillion. And if the markets continue down, because the recession is just starting, how will they feel when they have lost another $5 trillion?

That is why so many very savvy people feel it is so important to cut rates faster and pump up the money supply. They want to keep the markets up and the consumer feeling like the party is not over.

They feel rate cuts as usual will not be enough because we are in completely unknown territory following the bursting of the NASDAQ bubble. They would rather risk some inflation in the future than see us go into a Japanese type deflationary spiral. I can't agree more.

We are very close to where we have too many goods chasing too few dollars or Yen or pesos. Most of the rest of the world's central bankers are following our lead and cutting rates as well. The notable exception is Europe. Fortress Europe thinks they can go it alone. If the US catches a cold, Asia will get pneumonia. Europe will suffer as they are part of the global economy just as much as we are.

Now, you are all wondering what I think will happen. I am now thinking it will be a hard landing. I think we will pull out, but not this year. Earnings growth on the S&P 500 will be negative for the year. Not small, single digit growth but outright negative earnings growth. You heard it here first. Well, maybe first. I admit there are others who are saying the same thing, but extremely few big name analysts and investment banks.

Remember, analysts and investment bankers are cheer-leaders. They are on the sidelines as the players are fighting it out between the goalposts. You don't see them getting carried off the field. Their business is to make you feel good so you will buy stocks and investment services. The TV talking heads know ratings go down if the stock market drops or if they get negative, so they keep trying to find positive things to say, always looking for the silver lining.

If rates are going to have to be cut more than traditional analysts currently think - if you buy my reasoning - then there are opportunities.

Next week, I am going to tell you one way to invest and make money in this economy. You won't want to miss this next letter.

Investor Sentiment

This letter is already long, but I should make two quick notes. Investor Sentiment Percentage Uptrends is dropping rapidly. That is NOT good. It means that there is very likely more pain coming. I keep looking for the classic bear market rally. Looking back at history, the Dow should go back above 10,000, perhaps substantially, before we see the real bottom drop out. But the NASDAQ bubble is messing up all sorts of historical relationships. I hope that this week's three day run at 10,000 was not the top in this cycle. We will see.

The large institutions are still negative and significantly down from their usual levels of market participation, while the rest of the market is still in positive territory. Mr. Average Investor is still buying the dips. There are still lots of investors who keep thinking bottom and buying opportunity. They are hoping Greenspan will sprinkle more Pixie Dust on the economy and the markets will take off. I think it will only take some good piece of news or another 50 basis point rate cut to temporarily move the Dow back to the mid 10,000 levels.

If this is accompanied by the large institutions coming back into the market then I may have to alter my bearish stance, and will do so. But we could easily see enough buying by smaller and mid-level investors to make the markets run up substantially one more time. But we need something to trigger the move. I continue to counsel you to do the opposite of buying the dips. I think you sell any spikes. Get out of debt and any stock that is not a true value stock and part of your long term core holding. And one last comment:

Buffet on the Death Tax

I confess. I didn't make the connection. I missed the dotted line. But Porter Stansberry didn't. I have found it strange that Warren Buffett has been such a strong and vocal advocate for estate taxes. But then Stansberry reminds us Buffett owns lots of insurance companies. They sell the main vehicle to beat the estate tax - extremely profitable life insurance policies (when combined with trusts, etc.). I know of a number of insurance firms who are very worried about the elimination of the death tax. And now I see why Warren is so worried.

IF the death tax is not repealed ( a basic Bush promise) I will do a series of articles on what you can do to avoid estate taxes. And for the really wealthy, there are even very legitimate ways to defer income taxes. If the bottom 50% pay nothing, and the top 1/10 of 1% can avoid a lot of their taxes, that is why those of us in the middle are the targets.

As always, feel free to write. As an Investment Advisor, I do manage money and enjoy discussing your personal situation with you should you desire to do so.

Have a great weekend,

Your looking for the silver lining analyst,

John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.

• Deflation
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