This admission will date me from the generation of kids that sat glued to our after-school televisions, captivated by the antics of a wise-cracking Brooklyn-accented rabbit, but I’m an enormous fan of Bugs Bunny. Bugs always outsmarted Elmer Fudd, Yosemite Sam and his other nemeses with a cleverness that created in viewers a sense of his inevitable victory.

One of my very favorite Bugs Bunny animated short films was released in 1946 called “Hair-Raising Hare.” In it, Bugs encounters a mad scientist who’s searching for a meal for his orange fur-covered monster. Frustrated at his attempts to capture Bugs, the scientist (a caricature of Peter Lorre) releases his monster to the chase and, as usual, hijinks ensue.

GRAPHIC:Cartoongallery.com

Bugs prevails, of course, but only after a few near misses (and after having hilariously given the monster a manicure).

The economy, in Harmonic Investment Advisors’ view, lacks the senses of humor and inevitable success that we enjoyed from Bugs performance. In this missive I will outline a central component of that forecast that I’ve been discussing with clients recently.

Hair-shirt Economics

I commented in a recent Economic Insight that I believe we are currently caught in a deflationary spiral, a statement which raised the eyebrows of more than one client. Given that the central issue facing the economy and markets is whether we must contend with inflation or deflation in our future, my assertion is not an inconsequential one. Further, my position may seem unorthodox, since the consensus among economic observers seems to be that inflation (or even hyper-inflation) is our destiny.

My observation is simply this: The global economy was, at the beginning of this crisis, grotesquely overleveraged. That indebtedness was particularly egregious in the United States. By one widely cited statistic, by 2007 the total debt in the US equaled about 340% of GDP, after having 200% of GDP from roughly the end of World War 2 through the mid-1980s.

GRAPH: chrismartenson.com

The 2007 implosion of the subprime mortgage market exposed the fallacy that the global economy could continue to accrue greater and greater amounts of debt, since that belief was underpinned by the assumption that asset values would continue to increase. Those falling asset values triggered a cascade of debt repayments, forced sales, decreased consumer demand, lower corporate earnings, increased savings, and layoffs. In order to keep the economy from collapsing in short order, global central banks enacted a number of monetary and fiscal measures that attempted to plug the financial dike by stimulating demand.

Now, all of these observations are simply history and aren’t likely to spur much debate. However, whether the government actions were the correct ones, and what the appropriate go-forward path should be, are very controversial. The prevailing Keynesian school of economic thought suggests that the government’s actions were appropriate; indeed, they argue that government’s economic role should be to combat recessions with monetary and/or fiscal policy. I mostly agree, but I admit to feeling a bit of resonance with a lesser known economic school, the Austrians. Their dogma suggests that government should not intervene but should rather allow the economy to reach equilibrium on its own as businesses fail and unemployment rises. Hair-shirt economics, if you will. I believe that many consumers, businesses and governments need a good dose of personal responsibility: That they need to experience sufficient discomfort to reduce the chance that they will suffer from short memories with respect to the dangers of overleveraging and simply resume destructive habits.

GRAPH: Zerohedge.com

A Hair-raising Forecast

Harmonic Investment Advisors believes that a fundamental shift is taking place in the mindset of the American consumer, much in the way that most of the generation of individuals that experienced the Great Depression eschewed debt and financial risk. We don’t believe that the US is in or will enter a second Great Depression, but this period is a shock to the system of many American consumers and businesses that will, we think, spur a new frugality in which spending is semi-permanently reduced in favor of saving and debt reduction, feeding the cycle described above.

We expect the economy to settle into “natural” rates of demand, employment and economic growth at some point, because (1) not everyone is laid off, (2) we still buy toothpaste, toilet paper and such (even cars and houses!), and (3) credit availability, while scarce, is not nonexistent.  So we will slowly and painfully settle into a lower rate of demand, a structurally higher level of unemployment, and a lower overall economic growth rate. This less robust economic situation could make more difficult dealing with the asset value inflation that may later result from the massive monetary and fiscal stimulus injected into global economies. A “hairy situation”, indeed.