The Deflationary Cycle Full Monty: A Closure Look at Wage Deflation

On August 11, 2009, I wrote an article for www.safehaven.com titled, "Mustard Seeds for Deflation: The Deflationary Cycle Full Monty". In that article I identified 8 significant risks that in some combination over the coming years will create a deflationary spiral. Those eight risks are:

1. Higher Taxes.
2. Higher Interest Rates.
3. Wage Deflation.
4. The Next Wave of Residential Foreclosures.
5. Non Primary Residential Real Estate Foreclosures.
6. The Baby Boomer Switch.
7. Municipal Government.
8. The Bubble State, "California".

One of the above risks not getting enough press, and maybe because it's too early in the cycle for most mainstream media, is the pending wage deflation cycle.

It really started in earnest back when the airlines went through their issues and bankruptcy after 911 and many airline employees were forced to take salary cuts. But then the economy rebounded and that problem remained isolated for several years.

Then the real estate bubble popped, and most of the related industries: Title insurance companies, mortgage bankers, real estate agents, and real estate contractors/developers had to layoff people and close offices, and after they made painful cuts many then turned to salary reductions/elimination of bonuses. In the case of the self employed mortgage and real estate brokers they were for the most part working 3 times as hard for half the income. In either case, they were making less money. That's wage deflation. The hard reality is their business actively took a dive when all of those industries were bulging with employees/people, and they had to be let go and/or their incomes were reduced. That's the impact of over capacity.

When I look at the coming deflationary cycle, the pending growth of wage deflation plays a very integral part of that deflationary cycle. I'd like to highlight some thoughts on where/why we will see wage deflation to provide a visual of why wage deflation is inevitable.

1. Over Capacity: As we've seen in the real estate related fields, over capacity of talent is over supply compared with slack demand for that very same human talent. Then a re-pricing of that talent through lower salaries or being moved to hourly/part time, and/or a reduction of in part or total of employee benefits has taken place to bring a company or industry's cost structure back into equilibrium with the business environment. That's just the simple law of supply/demand taught in any economy class.

   We've seen a significant drop in annual auto sales, which is putting pressure on the entire auto and supplier industry. Because of its geographic concentration its having a devastating affect on those states that have a concentration of this industry as an industrial base for employment.

   We have over capacity in almost all industries, and it's just a matter of when these industries re-price their existing talent. One of the next industries just might be my industry (Banking). As more and more banks fail and get consolidated into larger banks, those larger banks will close overlapping locations and reduce over lapping employees. As more and more banks fail, we should expect significantly more bankers looking for employment. In addition, large banks are already closing branches to reduce cost structures. The supply/demand equation within the banking industry calls for wage deflation around the corner.

   If the construction industry is any guide, it's typical to see multiply rounds of layoffs before we get to reducing salaries of the remaining work force, so it can be a somewhat slow and drawn out process. Thus, we should expect the issue of over capacity to be more of a long term issue.

2. Technology Innovation: We've all embraced the advancement in technology for making life easier or faster. But one of the consequences of advancements in technology is the elimination of jobs. For example:

   1. Online purchasing of airline tickets has significantly reduced the travel agent industry to mostly cruises and package travel.
   2. Online stock trading has moved a great deal of business away from full service stock brokers. And can't we all wait until we can buy home, auto and life insurance directly online more easily?
   3. Technology is allowing grocery stores and major department stores to provide self check out, reducing the need for cashiers.
   4. Online technology is making it easier to get movies, books and music online, which is going to be tough on video, book and music stores, which should be closing stores in mass in the coming years and laying off people.
   5. Online telephone (Magic Jack) will negatively impact the traditional phone carries.
   6. Advancements in banking make it easier to do business from a computer, reducing the need for tellers.
   7. And just wait until video conferencing takes hold in mass, and impacts business travel for the airlines and hotels, right at a time when over capacity in the hotel industry is at it's greatest. Also, it's very feasible for the public school system to teach thousands of kids in this manner and the number of teachers might shrink.
   8. I have a client that sells and installs surveillance equipment for cities in the San Francisco Bay Area to monitor automobile drivers for infractions via a street camera. They have told me that on one busy corner, the city makes $60,000 a month from violators of red lights and California stops. And no police officer was involved. Such technology could increase city revenues which they desperately need and allow them to reduce the number of police officers.

   While technology advancement makes life easier, faster, more efficient, and reduce costs, it comes with a price. In all of the above examples, the cost is a reduction in human talent over time that used to service the old way compared to a trade for software systems that replaces those employees.

   Does this technically need to take place? Absolutely, but at a time when we have high unemployment, technology will contribute to the problem as companies seek ways to reduce head counts and expenses. And more people looking for work will reduce the value of those remaining employed and ultimately contributes to wage deflation.

3. The Baby Boomer Switch: The soon to be retiring baby boomers bring a wide variety of issues or negative implications to this county. Currently, the lead edge of this demographic is roughly age 63. They are heading into retirement age in mass very soon.

   As it relates to wage deflation, they have a negative impact on the problem. As a Commercial Banker that reviews personal financial statements, I've noticed over the years that the typical boomer has failed to set aside enough money to retire completely by the ages of 62-65.

   Add on top of that the recent decline in real estate values, which is typically at least half of someone's net worth, and additional declines in the stock market impacting retirement plans, and the boomer's under funding retirement is even further diminished right as they approach retirement age.

   This has changed the retirement plans for many boomers and forcing many to work well into their retirement years. Many that I know are keeping full time jobs with the idea they can't afford to retire now and must work several more years. Others are working part time during retirement to make ends meet.

   The very issue this creates is they're a huge portion of the population and as they need to continue to work, they as a demographic, will create an over supply of working talent. Instead of retiring and leaving the work force, they are going to hang around as employed. And as they remain in the working class in mass they cheapen the value of all that work by creating and maintaining an over supply condition of human talent. Over supply and slack demand equals a lower value (compensation) for people in general.

   You can already see it one simple form. Have you noticed how many more retired aged individuals are working behind the counter at Starbucks or other retail businesses? In California, that used to be work dominated by the very young, and while it still is, I've noticed those of retirement age creeping into those jobs. I only expect this trend of not retiring to continue and gain momentum.

4. Public Unions: Currently, the compensation packages of most public union employees at the municipal level are a significant reason why so many states, cities, and counties are broke, dead broke. On average, public employees make 50-100% more than private employees. These budgetary issues are not going away any time soon, and while politicians have made some cuts and raised some fees, they aren't even close to resolving their budgetary problems.

   To solve this problem in earnest, politicians are going to have to get a back bone and deal with the compensation and benefit packages of public union employees. It's not going to be easy because these unions are fighting it tooth and nail, which forces reductions in other government services, which is highly unfair to the citizens of the municipalities, but the unions don't care about that.

   Eventually, the math behind budgetary deficits will resolve this issue whether the unions like it or not. And, it's not a minor change in their compensation package that will work; it's going to take large reductions of greater then 20-50% in salary and huge roll backs in retirement benefits.

   These unions will negotiate in a proactive supportive manner for substantive change, or the bankruptcy/insolvency process will eventually force it on them. Either way it will happen. This change in municipal employee compensation will cause wage deflation in this segment and add to the national wage deflation picture. There are over 8,000 municipalities in this country, and collectively the total employees can really add up and contribute to wage deflation.

   If the real estate related sectors are any guide, unions will fight sizeable salaries cuts forcing municipalities to lay off Policeman, Fireman, etc. This creates a unique issue. It's such a specialized position, when laid off, where do you find work in your field? You don't, and a change in profession is likely, and the new income will likely be 50-70% less than your prior compensation.

   Then, just like the real estate related fields, after the layoffs, the budgetary problems at municipalities will continue because the unions are noting providing a fundamental solution of lower compensation for all union members, and eventually those remaining public employees will see their salaries and benefit packages rolled back.

5. Healthcare: The majority of the problem we face in the healthcare system is the over use of fee for service, which has inflated compensation levels for doctors and raised the costs for health plan insurers. Raising premiums is like raising taxes, it's not a complete or affective solution as we'll chase out insured members who can't afford it and compress gross revenues for insurance companies. The issue needs to be tackled from the expense side of the insurance company, which ultimately means lower compensation levels for doctors at some point in the future.

SUMMARY:

Wage deflation might be one of the more key components of the over all deflationary cycle because it not only creates it's own financial issues of less income, but it also compounds or impacts some of the other risks I've identified above.

As wage deflation settles in, it will reduce taxes collected at every level of government, and since every level of government is broke, they won't be able make cuts substantially enough to cure the problem, so part of their solution will be higher taxes in the near future. You've already seen it start in some areas of the country.

While wage deflation alone reduces the affordability of real estate through less gross and net income. The combination of wage deflation and higher taxes reduces one's net income much further, which reduces the affordability of real estate even further, which ultimately reduces the value of real estate in the future because there will be less demand for current prices as net incomes diminish. It's simple math in a linear equation of cause and affect. None of these issues are currently priced into the value of real estate. NONE!

At the core of deflation is a correction in the one asset owned by the majority (real estate)! For deflation to occur, that correction has to be far greater over time than anyone could imagine. Wage deflation is a key component negatively impacting real estate. While no asset goes up or down in a straight line forever, the value of real estate seems to have substantially further to go on the down side over time thereby spurning the deflationary cycle to come.