Debt – or rather the mass buildup of debt – plays a key role in the great “inflation versus deflation” debate. Today, a closer look at just how we got here, and where the deflationary pressures are coming from.

There were a number of great responses to last week’s Taipan Daily topics. Your e-mails have provided some intriguing food for thought as to where to take the discussion over the next few weeks.

“Inflation versus deflation” remains the big question. On Friday we clarified how it’s possible to get both at the same time. But how did we get here? What are the major factors at work? To get a sense of how the inflation-versus-deflation smackdown could ultimately play out – and to lay out a survival strategy for protecting and building wealth as it happens – it makes sense to think about those questions. To better assess where we’re going, we need to get a handle on what’s important and where we’ve been.

So much of it goes back to debt. It’s hard to overemphasize what a key role debt plays in all this. Not just a short-term buildup of debt either, but a quarter-century’s worth of gorging on the stuff. We got way ahead of ourselves... and now that excess has to be unwound.

Pizzanomics

To explain America’s plight, let’s use a simple business example.

Imagine a scrappy pizza chain – we’ll call it “The House of Pizza” – that enjoys modest success in the early 1980s. Management then decides to expand the chain by taking on long-term debt. The company borrows money, uses it to build more restaurants, and then uses the profit (cash flow) from those additional restaurants to service even larger blocks of debt.

In this manner – leveraged expansion via aggressive borrowing – the House of Pizza grows from local, to regional, to nationwide chain.

The story looks great for many years. Pizza consumption is increasing. Better still, customers are splurging on more expensive toppings. Life is good. The House of Pizza’s investors are very happy.

But then, after two-plus decades of ratcheting up, the unthinkable happens. The American public starts to cut back. Consumers start scrutinizing prices and buying a little less of everything, including pizza.

This change catches the House of Pizza completely off guard. For the longest time, the strategy of steady expansion by way of increased debt load looked like a surefire winner. But now, all of a sudden it’s a loser.

Here is a quick snapshot of how the books changed:

In recessionary times, a 20% decline in gross revenues is not a major event. That’s just the typical family cutting back to four pizzas a month instead of five, or the result of lower average dollars per sale as customers buy fewer toppings and price wars intensify.

Meanwhile production costs stay the same, even as the volume of pizzas made goes down, because food and energy prices are rising (though not reflected in the CPI). Marketing and rent costs remain stubbornly high. Property taxes and local compliance costs are going up too (thanks to cash-strapped states). Debt costs stay the same, of course, because debt is debt... you owe it no matter what.

In the simple table above, you can see how a leveraged business that was making money hand over fist in flush times can suddenly turn into a bleeder in hard times. The hypothetical House of Pizza, a successful chain with a long-term expansion strategy built on debt, swung from a $20 million per month profit to a $24 million per month loss, thanks to a modest yet unexpected shift in consumption trends.

And that was just a 20% dip. Think what happens if general pizza consumption falls still further, or price wars intensify even more. The business goes from reliable profit generator to potential bankruptcy candidate, depending on how much cash they have left.

No wonder the House of Pizza’s management is forced to start laying off workers, cutting back wages, and obsessing over ways to survive. The heavy weight of expansion debt is like a millstone around the company’s neck. Remember, too, that consumer spending has long accounted for more than two-thirds of U.S. GDP. That percentage is set to trend downward, and could do so for a number of years, as concerned baby boomers head into their retirement years. Pizza sales could be down for quite a long time.

As the same declining revenue story plays out in business after business, more jobs and hours and wage levels are cut. Strapped consumers then treat themselves to even fewer discretionary “luxuries,” like expensive pizza, further intensifying the cycle of contraction. After many years of complacency, the inherent leverage of borrowed money turns from blessing into curse.

Again, this “pizzanomics” example is an extremely simplified one. And yet it is pretty much a microcosm of what’s happened to the entire United States these past few decades.

Basically we took a successful business model, leveraged all kinds of credit on top of it for a quarter-century or so, and ultimately put ourselves in the position of being guaranteed to fail by way of overreaching. When you consistently press your luck and live beyond your means, it becomes just a matter of time.

Lesson: It doesn’t matter how impressive your “income” is if your “outgo” (i.e. overhead and debt service cost) is too high. And because leverage is a two-edged sword, a modest swing in revenues can turn leveraged profits into leveraged losses in a very short period of time.

Savvy entrepreneurs know this truth all too well. There is a wry saying among seasoned small-business owners that “too much growth can kill a company” – especially if that growth is powered by a heady cocktail of overly optimistic sales projections and cheap expansion debt. It’s a lesson America has long ignored.

Shine On You Crazy Diamond

One industry that’s relearned this lesson the hard way is the diamond business.

“A collapse in demand for jewelry in the U.S. triggered by the fall of Lehman Brothers,” Bloomberg reports, “led to the loss of 400,000 jobs in India, the closing of mines in Botswana, and a drop in Peru for polished stones. The industry isn’t likely to recover for years.”

Lehman might be the most visible catalyst for the diamond industry’s implosion, but the real culprit is that four letter word again – debt.

Martin Rapaport, founder and chairman of the Rapaport Group, spoke to a distraught group of diamond dealers at an industry trade show in Las Vegas this summer. In lamenting the utter collapse in the price of diamonds last fall, Rapaport noted the widespread habit of dealers sending stones to their clients on credit. A decade of rising prices had convinced jewelry stores to ramp up inventory as much as they could. The industry obliged with the equivalent of interest free merchandise loans.

“We took a cash cow and turned it into a credit pig,” Rapaport said.

The United States, too, has become a credit pig. According to calculations from the Heritage Foundation by way of the CBO (Congressional Budget Office), the current White House agenda puts us on track for $2 trillion annual deficits by the year 2019. That’s a number so huge, it’s hard to get your mind around it. With $2 trillion, you could buy roughly 40% of all the gold that has ever been mined (assuming the current owners would sell it to you).

But Isn’t America Rich?

Many people just have a hard time getting their head around the immensity of the debt problem – not just on a federal and state government level, but on a personal level too. The question that seems to pop up is, “But isn’t the USA rich? What about America’s natural dynamism and historical knack for wealth creation?”

America is rich. And America does have a knack for wealth creation. But neither of those things are an automatic solution to the problem of too much debt. Again, the problem of debt is relative. If you take on too much of it relative to your income, it doesn’t matter how much you make.

We can see this in the cautionary tale of Jim Press, the deputy CEO of Chrysler. Fortune magazine asked earlier this month, “How could a millionaire top executive with a chrome-plated reputation get in such financial trouble?”

The answer? By overspending his income, just like anyone else:

In his personal finances, Press had stretched himself thin, supporting four homes around the U.S., not long before the economic crisis hit. When his expected compensation fell, Press started missing payments. As first reported in the Detroit Free Press and Detroit News, Press is facing lawsuits and government liens totaling more than $1.4 million. (Press declined to comment for this story.)

Regional banks all over the country made the similar mistake of “stretching themselves thin” – leveraging up their loan books with commercial real estate deals gone sour. The banks, too, have a serious debt problem, as the following chart from John Reeder at RealPropertyAlpha makes clear:

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We have to understand the nature of the 25-year cycle to see why deflation pressures are so persistent. At three different levels – consumer, state, and federal – America has gorged itself on a mountain of debt. In result, the “deleveraging” process we are faced with, not unlike a heroin junkie staring down detox, is likely to persist for years.

At the same time, the downward pressure on consumer spending habits – a pressure that could also last for years – threatens to destroy the earnings power of countless debt-laden households, banks and businesses. Some market observers, like Hoisington Investment management, believe these pressures are an incredible force for economic contraction, with the likelihood of higher taxes and increased government spending only making the deflation problem worse.

Meanwhile, the major driver for the opposing force, inflation, is the government’s effort to avoid a deflationary bust by any means necessary. We’ll dig deeper into that tomorrow. Meanwhile, if you can think of any other specific questions you want answered in this whole inflation/deflation discussion, let us know: justice@taipandaily.com.

Other Related Topics: Consumer Spending , Debt Problems , Deflation , Inflation Rate , Justice Litle , Macro Trader

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