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. Last Updated: 07/27/2016

Glut and Cigars Presage Deflation and Recession

WASHINGTON -- I watch from the green of the third hole of swanky, verdant Robert Trent Jones golf course, a helicopter is lifting off from the clubhouse pad, leaning north and heading for Washington, 64 kilometers away. My partner, a smart guy who has been around, looks up from his putt. "There it is,'' he says. "The official sign that the bull market is over.''

Yes, bull markets -- and, more important, powerful economic recoveries -- end in excess. When you see business execs helicoptering to the golf course, waiters discussing the merits of Intel versus Applied Materials, 22-year-olds in suspenders smoking cigars and drinking martinis, and houses in the suburbs selling way over the asking price -- then you know that the referee has brought the whistle to his lips and is about to blow. The game is nearly over.

The last recession (defined as a decline in the economy's output of goods and services) ended six years ago. It was mild and brief. When will the next begin, how deep will it be, how long will it last? No one knows.

The traditional recession plot first has prices and wages rising; the Federal Reserve hikes interest rates to choke off inflation. Corporate borrowing costs increase and profits drop, consumers stop buying on credit, new investment screeches to a halt, the stock market tanks.

But anyone scanning the horizon for signs of inflation today is looking in the wrong direction. More likely, the next recession will start because of a glut, an oversupply.

Businesses, in a frenzy to expand, will make poor use of capital, and we'll have too much stuff to go around. Prices won't rise, they'll fall, and firms will go bankrupt. In the cascade, unemployment will accelerate, and, despite low interest rates, economic growth will cease.

In other words, what we have to fear is not inflation but deflation. If you want a preview, look at Japan, where, with long-term bonds paying just 2 percent interest, the economy is finally lifting itself out of the muck after five years. Once started, deflations are hard to stop because buyers figure that prices will drop further with time, so they delay purchases.

Do you still believe that the United States has entered a New Era, that broader world markets and technological change have created a recessionless nirvana? You may be right, but, as an antidote, listen to James Grant, writing in Grant's Interest Rate Observer, his brilliant and expensive (though not infallibly perspicacious) newsletter: "Prosperity is self-limiting. There can be no New Era because speculative markets won't stand for it. Booms, in fact, create busts. Incited by low interest rates, capitalists will build something. Stimulated by ultra-low interest rates, by ultra-high equity valuations and by the supporting New Era theories, they will build some more. They will not stop building, in fact, we have observed, until the money stops.''

If Grant is right, then we should be seeing excess, not simply among individual consumers (who are spending themselves into bankruptcy in droves) but among corporations. In the first part of this decade, these firms applied tough lessons learned about overexpansion and reckless spending. But 75 months into the boom, have they gone haywire?

Grant answers in the affirmative. He points to too many "semiconductor fabs, aircraft facilities, retail stores, auto plants, computer assembly lines, steel mills, commercial banks and commodity-chemical manufacturing facilities. There are too many hotels in Phoenix, and there is too much manufacturing capacity in China.'' In a glut like this, companies have no pricing power. There are more things on the market than consumers and businesses want to buy.