Debt Deflation and the Selling of Small Businesses

The Wall Street Journal carries the story, “Sales of Small Firms Are Up”. (http://professional.wsj.com/article/SB10001424052702303406104576444062140022104.html?mod=ITP_marketplace_4&mg=reno-secaucus-wsj)  “Sales of businesses with roughly $350,000 in annual revenue rose 8% from a year earlier…”

“The main driving force is the acceptance among owners that their businesses are no longer worth what they once were.  Many sellers cut their asking prices and agreed to finance a significant portion of the deals themselves.

This is the other side of the last fifty years of credit inflation.  People are in debt, business is not good, and valuations have dropped substantially. 

How do you like the story of the individual who bought a 200-seat casual restaurant in 2002 for $200,000 and “is finally selling it for just $75,000, and he is lending the buyer 25% of the selling price”?

More and more information is now coming out on the situation in the world of small- and medium-sized businesses. 

But, this has been the case in the residential housing market.  People are in debt, unemployed, facing lower incomes, and property values have plummeted.

This is also the situation in the banking industry among the small- to medium-sized commercial banks.

The FDIC has only closed 51 commercial banks through July 8 of this year, but this figure does not include banks that were acquired by other institutions.  Through March 31, 2011, there were 77 fewer insured banks in the banking system than there were on December 31, 2010.  (In all of 2010, there was a net decline in the banks in existence of 290 even though the FDIC closed only 157.)  With 888 commercial banks on the problem list the likelihood that there will be 300 or so fewer banks in existence at the end of this year is highly probable. 

My point is that this is a part of the debt deflation process going on in the economy and it is a natural progression from the fifty years of credit inflation that preceded it. (“Credit Inflation or Debt Deflation,” http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation) 

Of course, the Federal Government is doing all it can to offset the forces of debt deflation by continuing to pump more and more debt into the economy.  Yesterday, Fed Chairman Bernanke, in Congressional testimony, argued that the Federal Governments needed to get its “act together” on the federal budget.  Bernanke followed this up by saying that the Fed will “do what it has to do” if the economy remains weak.

This was immediately interpreted by the “market” that the Fed will throw QE3 on the fire if it believes it is necessary.   Gold prices rose to a new record.

Today, Bernanke backed off and said the Fed was not “prepping” for a new edition of quantitative easing.   Gold prices dropped.

The problem with the effort of the federal government to offset the debt deflation going on in the economy by more and more rounds of credit inflation is that much of the liquidity the government is pumping into the system is going offshore…that is, it is going into world financial and commodity markets! (See “Federal Reserve Money Continues to Go Offshore,” http://seekingalpha.com/article/276909-federal-reserve-money-continues-to-go-offshore.)  This is doing little or nothing to stimulate the American economy and is doing lots to inflate world commodity markets. 

And, in this condition of debt deflation we see one of the real confusing issues connected with credit inflation and debt deflation. 

To take a specific example, in the 2000s there was a terrific increase in the price of houses and the value of small- and medium-sized businesses, in asset values.  Yet, price inflation, which is measured in terms of flow price…rents and business cash flows…did not increase at the same rate.  Hence, it looked as if consumer price inflation was being kept quite low.

Now, we see just the opposite happening.  Price inflation seems to be picking up, yet the value of assets like homes and small- and medium-sized businesses are declining, sometimes quite precipitously. 

In a period of credit inflation, asset prices tend to increase more rapidly than “flow” prices and this dis-connect must ultimately be corrected.

In a period of debt deflation, asset prices tend to decrease more rapidly than “flow” prices and this tends to continue until they are brought back more nearly into line (or over adjust).

The actions of the federal government and the Fed seem to be having little or no effect on asset prices.  Owners of businesses (and houses) are forced to accept “that their businesses (and homes) are no longer worth what they once were.” 

Further rounds of credit inflation may moderate the downside of this move…but, continuation of aggressive credit inflation will only just postpone the adjustment that is needed in the economy until a later time.