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UPDATE: The following essay was submitted to The Bulletin on February 2, 2010 and published February 25, 2010 with the title, “Continued economic weakness is a very real possibility”:

Economist Alan Beaulieu recently visited Central Oregon with a message of opportunity, more specifically a “wealth-creating opportunity.” In a piece published by the Bulletin last March titled, “There’s money to be made during even the worst of times,” I made a similar case for opportunity mainly discussing the stock market but also appealing to a broader idea of optimism and “fortitude in the face of crisis.” In between my message and Beaulieu’s stocks rallied roughly seventy percent and the economy emerged from recession. After listening to the duration of Beaulieu’s speech I believe he, along with most investors today, is overlooking some major potential pitfalls for the economy and financial markets including the real estate market over the next few years.

The credit crunch is still on and shows no signs of improving. Last year, private sector lending declined for the first time in history. Banks are reluctant to lend money, instead focusing on shoring up their beleaguered balance sheets. In addition, after being burned by the internet and real estate bubbles both consumers and business are reluctant to borrow. Despite the lowest rates in history mortgage purchase applications have fallen to a ten year low. According to Federal Reserve surveys demand for consumer credit is also anemic.  Just like the banks consumers are focusing on improving their financial strength.

One factor behind consumer reluctance to borrow is that they simply cannot afford any more debt. Statistics clearly show just how debt-dependent American consumers have become over the past twenty years. Historically the household savings rate has averaged roughly ten percent of disposable income. From the mid 1990’s the stock market boomed leading into the internet bubble which was then closely followed by the real estate bubble. Over this period consumers felt no need to save at all and for the first time since the Great Depression the savings rate actually went negative by 2005. This caused household debt relative to gross domestic product to soar to levels not seen since prior to the Great Depression, the last major period of deleveraging.

Ultimately, the past two decades of fiscal debauchery by both businesses and consumers have caused an economic hangover that can only be healed with time and increased fiscal conservatism. This is precisely the situation that leads to what Richard Koo, Nomura Chief Economist, has dubbed a “balance sheet recession,” the likes of which has plagued Japan for the past couple of decades. What makes a balance sheet recession unique is this zeitgeist of deleveraging, the process of paying down debt in order to improve the balance sheet.
Over the long term this process of putting our financial affairs in order is healthy for the economy. Over the short term, though, it can be very dangerous. Consumers make up the largest portion of the U.S. economy. Even a small shift toward saving more creates a large economic headwind. In fact, it is the perfect prescription for a deflationary vicious cycle.

Signs in the financial markets suggest this is precisely what we are seeing right now. The once-in-a-generation crash in asset prices, including stocks, real estate, and commodities over the past few years ultimately signals a dramatic drop in demand for assets and investment. The dollar has also recently begun to rally signaling that deflation is currently a greater risk than inflation.

In stark contrast, Beaulieu told his Central Oregon crowd to prepare for significant inflation without making any case for such a scenario. He even went so far as to recommend investors purchase multiple properties with borrowed funds in anticipation of runaway inflation.

Real estate prices are, indeed, much more attractive than they were a few years ago and this advice may prove to be well-timed. However, I believe that we must recognize that Mr. Beaulieu’s advice represents precisely the attitude that created the financial mess we now find ourselves in and that there is a very real possibility this advice will have disastrous consequences for those that follow it. As Warren Buffett has said, “even smart people can get clobbered with leverage.” What’s more, the possibility of continued economic weakness as described by the term “Balance Sheet Recession” is a frighteningly real possibility for our country even it is not the most probable outcome. Beaulieu briefly mentioned the idea but quickly dismissed this deleveraging thesis out of hand. I believe investors should give it more credence and would do well to consider its associated risks.

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