Financial System may be Shocked by Deflation

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Enjoy this interesting report from Bill Bonner for the Daily Reckoning Australia

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"The D-word is back," says this morning's Financial Times. "Could deflation be the next big shock to the financial system?"

Where has the FT been? The world has never seen so much deflation. Stock markets around the world have deflated by about $10 trillion. U.S. housing has deflated by about $5 trillion. Oil has deflated to only half its high; it closed at $64 on Friday. Gold, down $13 on Friday, has deflated about 25%. Bear Stearns deflated to nearly zero.

Even the bond market is beginning to deflate. Yields are rising, to 3.97% for the 10-year T-Note.

The Dow rose 141 points on Friday. But year-to-date, the U.S. stock market - as measured by the S&P 500 - is down 35%. That means that U.S. stockholders alone have suffered a loss of nearly $5 trillion. And one in every five houses in America has sunk so low that it is now underwater; the mortgage level is higher than the value of the house.

The FT must be talking about consumer prices. Prices you pay for milk and gasoline. They're not going down yet. But they're not going up so fast either.

The headline U.S. inflation rate seems to have peaked out at about 5.5% and is now headed down. In Europe, the headline rate hit 4%. Now, that too is coming down. And everywhere you look, price cuts are beginning to appear. "Sale" signs are appearing in shop windows. Cheap flights are being advertised in the subways of Paris. Auction prices, according to an insider, are much softer than they were six months ago.

One thing that is sinking to the very bottom of the sea is the cost of sea-borne transport. The Baltic Dry Index measures shipping costs...and gauges the health of the globalized marketplace. Shipping prices rise when orders are being placed...and delivered. When orders decline, so does the index. Well, based on the index, there is no need for Misters Smoot and Hawley. World trade is collapsing without them. The index has gone down 14 days in a row, so that shipping barely costs 10% of what it cost a few weeks ago.

Deflation? What does that remind you of, dear reader?

Japan! Of course. This is the trend your editor saw coming 10 years too soon - a Japan-like slump.

"A deep and prolonged recession could raise the spectre of deflation of the sort that long plagued the Japanese economy," says a fellow at the American Enterprise Institute.

"Welcome to Hiroshima, mon amour," was how we put it, with Addison Wiggin, in our 2003 book, Financial Reckoning Day.

"If the United States were to repeat the Japanese experience, stocks could be expected to return to their 1995 trend line, with the Dow below 4,000, in the year 2012, at almost the very moment when America's baby boomers will most need the money," we warned.

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