Over the past weeks we’ve been digging down into what might, or might not be the real story. Everybody seems to have an opinion or three, from world class money managers to yowling cretins, and none of them seem to fully add up. Whither the economy?

There is a bewildering array of evidence pointing to global inflation, except that it also indicates overcapacity, a la Hyman Minsky, which instead means it should be deflationary, except that supply is creating its own demand, hypothetically, in China at least, which should be inflationary, except that world shipping fell precipitously and is staying down, which means deflation, except that foodstuffs are gaining, inflationary, but Prechter says deflation, which Arun Motianey claims is the precondition for inflation, but consumer confidence plunged and the Politburo hates inflation and the Brits are certainly on the brink of a national collapse because they have collectively drunk themselves to terminal cirrhosis, credit card companies have run amok, people are cutting back like mad and saving every dime, in total contradistinction to the prior era where easy credit proliferated like rats in the New York subway system, which should be deflationary, except flooding the system with liquidity should be inflationary, except the banks won’t lend it to the  businesses that really need it which is deflationary, and China is running an annualized GDP growth of 10.5% which is just nuts…

Baffling…infuriating…the truth is nobody has a firm idea… even Soros has gotten it wrong, way wrong, on occasion. What’s up?

On one level we believe that we are beholden to mental models, or framing mechanisms, that no longer suffice to describe the complexity, nor the potential instability of this new economic condition; we’re tweaking prisoner’s dilemma models when the global economy is beginning to look like a  3D Julia Set in a sped up animation. Could be our metaphors and mental constructs no longer cut it. This baby has plain run off the known map. Some of those mathematical curiosities that we loved to play with more than a decade ago may be getting closer to necessary descriptors of the real world than we realized.

Which leaves us where? The Chicago Fed’s favorite all purpose indicator, the CFNAI, is flashing recovery. And we admit, the CFNAI is probably as good of an all purpose economic indicator as we know of, being a diffusion index of 85 indicators run through a principle components analysis.

The question then becomes, what kind of recovery is this actually? Optimally one recovers into a state of mild inflation, which encourages borrowing and sets into motion a virtuous cycle of credit expansion, hiring, equipment purchasing, product line upgrades, and so on. However, as Richard Koo of Nomura will cheerfully remind his readers, there is another potential scenario, the not so salubrious debt deflation. In this circumstance, even a subtle tilt towards deflation can induce large borrowers to use their profits to first pare down their existing debt load rather than invest in expansion and upgrading. Which, of course, leads to the unhelpful lost decade syndrome. Aided and abetted by a period of low interest rates. Like we have now.

Practically speaking, there is no way policymakers can entertain the idea of a prophylactic increase in interest rates without risking mini-depressions at the state level. But the problem is hardly restricted to the nitty gritty of keeping the street lights on at night in Colorado Springs. Japan too is facing a potential double dip back into grinding deflationary territory which in turn further deflects borrowing behavior into saving behavior (as deflations reward savers and punish borrowers)… only now it seems that the US consumer is finally learning the same lessons that the Japanese consumer learned 20 years ago.

We are of the opinion that economic phenomena often appear as social phenomena, at the level of shared values, ideals, behaviors, and shifts therein before they can be captured and quantified as numerical  sort-of facts that make it to the public by way of the media blatheroons. We look for trends that are slowly working their pernicious ways to the surface. Such as…..

We must admit we find that disturbing on a multitude of levels. We recall that deflations have strong historical connections with phases of breakdown and decay. In the late 19th century nearly the entire agricultural sector was driven to bankruptcy by an extended deflation era. Deflations can be insidiously corrosive, slow moving glaciers that crush everything before them, unlike the swifter moving tsunami of hyperinflation. Each is coupled with a powerful social mood.

We take the prospect of deflation with great seriousness and no small degree of angst. We have noted as well that the Baltic Dry index, which reflects worldwide shipping of dry bulk goods such as ores, cement, grains, and the like, has remained at a surprisingly low level since the great breakdown, in spite of a couple of recovery bumps. Simply judging by the BDI, world trade is not recovering to anywhere near even the 2007 LOW, not the high.

On the other hand, there is China, which seems to be living in an economic universe so disconnected from our own it solicits disbelief. Is this in fact some form of massive decoupling that no one can adequately explain? Is this sustainable, a true breakthrough, a new epoch that makes fools of the naysayers, the great engine that will pull us out of what would have been a deep, cold worldwide depression?

China, India, and the Asian Tigers are, to put it mildly, on some kind of roll. As one writer put it, hot enough to make the devil sweat. But, my friend, when you go from 400 billion Yuan of bank lending to 1.4 Trillion Yuan in 2 quarters, you either really know what you’re doing or you’re about to burn the house down.

China promoters, Dr. Megatrends himself, John Naisbitt, included, seem to have bought the Unstoppable Giant Awakens scenario wholesale and retail. And for all we know he could be completely correct, or not. We have a few statistics that might help us appreciate the impact of China, more of an importer than many realize. Sure, they export manufactured stuff, but they still have a ravenous appetite for raw materials. Which they must buy on world markets. Which explains the extraordinary efforts they go to to insure uninterrupted flows of the elements of manufacture.

Thus we think it is fair to say that the Chinese relationship with the global economy is far more complex that the simplistic model that they sell us stuff and buy our treasury debt with the profits. A lot of that economic activity is leaking back out into the primary producer world, places like Africa. So the model of capital and material flows is
necessarily a more nuanced process of transforming economies they encounter and being transformed themselves by those contacts. China, for all of its legalistic and authoritarian rigidities, may be a novel form of a complex adaptive system that the American founders could not have imagined.

But complex adaptive systems can fall victim to their own contradictions and instabilities as well, and as far as we know, no imperial administrators for the entire duration of history have escaped an encounter with such systems suddenly taking on an unpredictable and frustrating life of their own. No rider has fully mastered the beast, although many have tried, and many have been seduced into the illusion that this time we have finally mastered it. We should be so lucky. And we never will be. Great Moderation, anyone?

With growth come growing pains. With hyper-growth come hyper-growing pains. Lao Tzu warned of this 2,500 years ago. Sudden wealth breeds envy, unfathomable greed, lust for power, ruthlessness, and often, terrible errors of hubris. We have noticed many reports of criminality, of the organized entity sort, and abuses of power.

Does this become a long running institutional struggle between power bases or will a central authority be able to impose a stable, uniform standard and rule of law across the extremely diverse population?

We cannot help but notice that the Western structure, as relatively wealthy as it is, with its excellent university system, with a long history of economic booms and busts, could have gone from the most overweening arrogance and sense of historical imperative to one of confusion and despair in less time than it takes to grow a fairly impressive plant behind one’s house or to put a child through one stage of education. Didn’t we also think that we had conquered risk and parked our vehicle at the end of history ?

Granted,  this World Bank study of per capita electricity consumption is 4 years out of date, however, it is suggestive of how great the development gap actually may be between the USA and China/India. We tend to see this as an indication of the degree of “standard of living arbitrage” that exists between cultures.  Our energy hogging ways speak to an outsized standard of living, just as the Chinese and Indian levels of electrical energy consumption point to the degree to which they are positioned to catch up to our levels of usage, which would be correlated with square footage of living space, the use of heating and air conditioning, lighting, entertainment systems and so on.

Given this metric we would infer that there remains an enormous upside potential for their consumer economies, and perhaps a degree of downside potential for ours as more and more highly skilled, highly educated work migrates East. One might infer as well that we have lifestyle addiction issues that will only be reframed by significant changes in flows of capital, goods, raw materials, and knowledge.

Paul Krugman is clearly concerned about the deflation scenario as well, but perhaps he does not see how intimately this dynamic is tied to the almost steroid driven drive for an improved standard of living in Asia.

We wanted to double check Krugman’s  source of concern, so we composed the following two charts. In the first case, we compared the Dallas Fed’s trimmed mean deflator (the blue line) with the CPI–minus-energy chart for the same period (the red line). In both cases these do show, expressed in % change YoY, what might be taken for the beginnings of a deflationary process.

On the other hand, there is energy, our national equivalent of pure glucose intravenous drip. Here we see an entirely different process unfolding. If everything else is a reasonably steady process slowly trending, energy pricing and energy’s effects on our economy are downright manic-depressive.

We see the deflation conversation in areas like the convenience store industry, where the vice-chairman of Wal-Mart hopes to see deflationary pressures ending soon in his industry.

Hopefully, yes, we’ll be seeing that.

We are decidedly in interesting times. Precisely which times those may be is highly dependent on what information one is considering at the moment.

Tacitus has dug into the Federal Reserve databases seeing what might rear its head. One the surface, the Fed’s economists are quite upbeat, predicting a robust recovery in several sectors. But then, their job is to function as official cheerleaders, as much as they can get away with.

Looking at the Fed’s own official background radiation detector for hints of inflation and deflation, the venerable CFNAI (Chicago Fed National Activity Index), we do see an energetic rebound from the recent low. However, the index remains in potentially deflationary territory, which means, cheerleading or not, the Fed definitely plans on erring on the inflationary side.

We’ve done a little deeper analysis of CFNAI, this time taking the entire data series going back to 1967 and applying a Fourier Transform to see if there are any internal cycles that might help us anticipate the comings and goings of the economy. Indeed, we did find two cycles, roughly a 5 year cycle that coexists with roughly an 8 year cycle. This did a nice job of picking up the last major cycle and seems to suggest a moderate rebound as the 5 and 8 year cycles are out of sync this time.

Contemplating the year over year percentage change in retail sales (which can be unpredictable) it looks like business has snapped back to normal levels. This may have been a relief rally of holiday buying though, as it suspiciously coincided with the Christmas shopping season.

Under the circumstances, it would not be surprising if government economists were cooking the books as a confidence sustaining measure. They have been known to do such things. The “financial media” are often surprisingly gullible, taking statistical releases at face value. We’re not so sure. It’s a little TOO pretty for our comfort.

On the other hand, when we look at housing starts, as opposed to toaster ovens, the picture doesn’t communicate the same brio. As a matter of fact it looks downright miserable. The Chicago Fed insists we’re do for a nice springy real estate rebound in 2010. Judging from the data, anything will be able to qualify as a rebound off of this base!

And for the grand finale, we have a chart of the federal Surplus/Deficit going all the way back to 1895. Right. That’s not a typo. Not 1995 (ancient history by most standards) but no, 1895, when Grover Cleveland was president. Many people never heard of Grover Cleveland. He probably was responsible for this statistical series. A toast to President Cleveland!

You may notice that the gross federal deficit looks, well, downright bizarre compared to its entire history. As in absolutely, breathtakingly monstrous. In case you were wondering just how much it cost to, ummmm, underwrite this magnificent recovery we are currently enjoying, you might begin with this.

For some final thoughts… in the following video Marc Faber discusses his perspective on the medium term investment environment and the concern that the market may be fully priced for now.