There’s a relatively recent analysis entitled “The Deflationary Impact of the Coming U.S. Commercial Real Estate Bust,” by Sean Daly, posted May 27, 2010 on Seeking Alpha, that reminds us the commercial real estate bubble hasn’t gone anywhere. And if you count the vacant windows in the strip malls, it isn’t hard to see the reality. Daly goes further, and in nearly 3,000 words of commentary, quotes, captions and attributions, and over a dozen charts, explains that commercial real estate loans generally have five year maturities, and the ones negotiated during the bubble boom are coming due starting in 2011. Daly also observes that the ultimate victims this time will be the 8,000+ community banks, not the big banks and Wall St. firms. Among Daly’s conclusions as to the deflationary impact of all this is this decidedly non-trivial gem: “this vicious cycle [widespread insolvency of community banks] starts to hurt the local economies just as the municipal bond defaults start to occur…worse case, the real estate industry in China goes bad and the two downturns hit the global economy at the same time.”
As noted on a June 8th post entitled “The China Bubble,” using data from USA Today, MoneyLife, 60 Minutes, China Expat, and others, real estate values in China have appreciated at 3 to 5 times their rate of GDP growth for a decade, commercial vacancy rates may already be as high as 50%. and the construction industry could comprise over 50% of China’s GDP. What happened to the U.S. residential real estate market, and is about to happen to the U.S. commercial real estate market, is also happening in China.
There are plenty of deflationary pressures on the global economy today, as enumerated on April 4th in a post entitled “Pension Funding Rates of Return:” (1) trillion dollar pension funds can’t appreciate faster than the rate of general global economic growth, which over the past 60 years has averaged about 3.0% per year, (2) public equities over the past 85 years have appreciated at a real annual rate of 2.8% per year, (3) central banks are already flooding the world with currency to stave off deflation, (4) money market funds are only returning 1.0% per year, (5) the stock market has been flat for the last ten years, (6) household and consumer debt are still at unsustainable levels and nobody is buying anything, (7) banks are holding foreclosed residential real estate assets to avoid further drops in asset values, (8) the commercial real estate market is hanging by a thread, (9) the bond bubble is about to pop, (10) we can’t extract abundant reserves of natural resources because environmentalists have successfully legislated or litigated development to a standstill, (11) the business community has given up and has decided the government is their new customer, and (12) public sector unions have taken over our state and local governments in California – demanding wages and benefits that are bankrupting us – and they are successfully exporting that model to other states and to Washington DC, guaranteeing the tax burden on job creating businesses will go up, not down.
Also creating a deflationary economic impetus is the relentless aging of humanity. As the percentage of retirees increases, the percentage of total consumption that must be supported through the financial return on passive investments increases. Technology-driven, ongoing increases in productivity makes supporting higher percentages of retirees economically feasible, but to avoid macroscopic speculative distortions to the economy induced by gigantic pension funds desperate to maintain their solvency when sustainable returns are no longer adequate, it may be that retirees need to be primarily supported through contributions from current workers. As it is, the aging populations of Japan, Europe and the United States face deflationary pressure because the more pensioners and bondholders we’ve got, the more claims on economic output are held by nonproductive members of society. Their savings, concentrated in pension funds and bonds, are chasing a diminishing percentage of productive assets, making these assets explode in value. When the collateral collapses, the loans go into default, the banks go bankrupt, and economic activity implodes.
To end a deflationary spiral, new investment needs to create new asset classes at a faster rate than over-valued assets correct downwards. To make this happen, government policy needs to adhere to two basic principles: First, remove the uncertainty that hangs over the private sector by backing off aggressive new legislation, and simplify and clarify existing legislation. The thousands of pages of new legislation that are as transformative as they are labyrinthine, enacted with the barest of mandates, written by interns, proofed by lobbyists, and rammed through Congress using unprecedented tactics, is not making businesses want to expand into new territory. Businesses bear the consequences of new laws more than the lawmakers do, and need to thoroughly understand what these new laws will cost and how they will comply. It is a heavy burden to lay onto business at the same time as the economy is slowing. An additional source of uncertainty facing business are the scheduled expiration of the Bush tax cuts. It is difficult to see how imposing additional taxes on the economy is going to be stimulative (ref. Art Laffer’s June 6th commentary “Tax Hikes and the 2011 Economic Collapse“).
The second way government policy can help to avoid a deflationary spiral is to invest deficit spending into projects that will yield a long-term return on investment. As argued in “Sustainable Economic Returns,” if deficit spending is indeed our economic elixir, we should be engaging in responsible development of domestic fossil fuel reserves and building nuclear power plants. We should be constructing desalination plants, canals and reservoirs (above and below ground), and we should be building and upgrading our bridges and freeways. Government should also be funding more strategic military spending, space exploration and development, and other ultra-high tech initiatives. All of these projects could be public-private partnerships, and could rely on deficit spending. But along with the temporary economic stimulus they would bestow, they would provide sustainable economic returns in the form of effective military deterrence, ongoing technological leadership, and assets of infrastructure that would yield permanently cheaper energy, water and transportation. Instead, government is channeling trillions of dollars into pension funds and public sector jobs. The economic goal of stimulative deficit spending should be to make basic resources cheaper through infrastructure upgrades and high-tech innovation, not to pour borrowed money into Wall Street’s public employee pension funds while relentlessly expanding the government employee payroll.
If consumers are spending less for basic resources, which will improve their personal cash flow, and if businesses are able to operate in a regulatory environment that is reasonable and fairly predictable, then the preconditions are met to create new asset classes whose growth may offset the shrinkage of the bubble assets. Meeting these preconditions will mean individuals and investors will be able to afford completely new products, enabling growth of new industries limited only by ones imagination – genetic therapies, cars with full auto-pilot, android care-givers, a revolution in education, even better communications, space tourism.
If deflation is the trend we’re to avoid, it is essential to stimulate the economy. But this stimulus must be implemented via policies that yield long-term appreciation to our national assets, our infrastructure, and our competitiveness, affording us the wealth to develop entire new industries and services for an aging, technologically empowered, increasingly enlightened civilization.