In the past couple years I have written quite a few blogs. One of my personal favorites has to be: Mustard Seeds for Deflation: The Deflationary Cycle Full Monty. This was my somewhat complete case for a deflationary spiral written in August 2009.

In that blog, I identified my eight risks that in some combination together or linked in time will cause a deflationary cycle. Those risks are:

1) Higher Taxes.

2) A Correcting US Long Bond Market.

3) Wage Deflation.

4) The Next Wave of Residential Foreclosures.

5) Non Primary Residential Real Estate (Farms, Vacation Homes, Commercial, and Multi-Family).

6) The Baby Boomer Switch.

7) The Local Municipal Government.

8) The Bubble State California.

In part 2, I want to visit those categories that are moving in the direction of the deflationary cycle now. It's the combination of any 3-5 of the above that will get the deflationary cycle rolling forward with more momentum.

1) Higher Taxes. In some states like California we see higher retail sales tax. In states like Illinois they have raised fees in certain areas. In some parts of California, parents now have to pay for their children to play high school sports. We see early signs of increased taxes and fees. This issue is not terribly significant now though. In the last depression tax rates didn't go up until a few years after the meltdown. So, this could be a slow process of increasing taxes and taking away loopholes for the wealthy. But any increase is a decrease in net incomes. That impacts consumer spending and the affordability of real estate. Higher taxes and fees are negatives for two of the most important parts of the economy.

2) Wage Deflation. We see wage deflation now mostly in the world of contractors. I have several clients who have cut salaries by 10% twice. I have clients who have moved employees to part time which allowed the employer to get rid of benefits. Here's where I see the next waves of wage deflation: First, as the bank industry consolidates over the next few years there will simply be too many bankers in this world. Greater supply and lower demand will force bank compensation downward. Secondly, many sales people are going to get a haircut, especially those with high base salaries. In a slow sales environment, companies won't pay top level salaries, and will move to a more commission based platform.

Lastly, the biggest current issue is the layoff of unionized municipal workers. Where in the world is a policeman going to go to work after being laid off and make $100,000 in salary with $50,000 to $150,000 in overtime, not to mention their benefits package. Policemen, Firemen, teachers, etc. are so specialized in their training, there is no way for them to integrate back into the world without taking a 25-60% total compensation cut.

Everyone in the world is focused on the budget deficit issue for so many states and cities. What gets lost in that issue is that the correction in budgets requires lower compensation from those fired and later in the cycle from those who get to keep their jobs. In the case of California we are going to lose a great number of people who make well over $100,000 per year.

Wage deflation is one of the integral parts of a deflationary cycle because it guarantees lower consumer spending and real estate affordability. Again, two of the most important parts of the economy. The layoffs coming from municipal governments this year and next will guarantee wage deflation moves forward.

3) The Next Wave of Residential Foreclosures. Last year I wrote the following:

We've experienced a large wave of residential foreclosures in this country, and there is another wave pending. The next wave stems from the Alt A. and Option ARM programs underwritten during the real estate bubble. Many of these exotic loan programs come with low teaser rates or flexible loan payment structures that only last for the first few years of the loan and then convert to a fully amortizing loan payment at a higher rate.

And guess what: Home Foreclosures Jump to Record Level in United States, No Big Surprise

Like clockwork, the residential foreclosure wave has come right on time. As a banker, this was one of the easiest things to see coming. At the core of a deflationary cycle is a correction in real estate far greater than anyone can see. This wave of foreclosures will create a supply of financially distressed real estate in the market in one form or another (foreclosures or short sales). We should see this push prices lower again.

Lower real estate values create several issues. Declining real estate values impact consumer confidence and spending. This lowers retail sales taxes. Lower real estate values pressure real estate tax revenue collections lower for municipal governments. Reduced retail sales and real estate taxes guarantee continual budget deficits forcing municipal layoffs, and cuts to salary and benefits, which lowers income taxes, which again hits the budgetary issue. Wage deflation and declining real estate are the two key ingredients of deflation.

Declining real estate will also put more banks out of business, which will force more bankers out of work, and again thereby decreasing income taxes for states. A consolidating and struggling banking industry will tighten down credit like no one has seen and businesses will not get funded.

It's this category where you get the visual of a cycle of deflation. Every wave down or negative impact causes another and another negative impact, like dominos falling.

4) Non Primary Residential Real Estate (Farms, Vacation Homes, Commercial, and Multi-Family). Within this category let's focus on commercial real estate: Commercial Mortgage Backed Security Delinquency Rate Rising Fast. Again, as a banker that's provided financing on commercial real estate for the past 14 years this was an easy development to see coming. It's amazing how many of my fellow commercial bankers failed to see this coming. An increase in delinquencies will lead to a spike in foreclosures that will happen with or just after the current wave of residential foreclosures. The current fundamentals of increased vacancies and lower rental rates for commercial real estate are as bad as it gets. This is forcing values lower.

The most interesting part of the decline in commercial real estate values is the self coined concept I call, "Correctional Unity."

We should see residential and commercial real estate declining together later this year and 2011. This will place further pressure on banks, and we will see the FDIC continue to close banks, and credit will become a lot tighter than it is now.

5) The Local Municipal Government. This might be the hottest and most contentious topic at the local level of government: States and cities face a daunting task to cure budget deficits. We are witnessing layoffs that collectively across the nation will mount to big numbers. There are roughly 20,000,000 municipal workers. If we cut just 10%, that's another 2,000,000 in unemployed. Once again, that impacts consumer spending and real estate affordability, pressuring real estate values down, and collectively they impact retail sales tax, real estate tax, and income tax collections. Again, this pressures budget deficits in the future.

Summary: We have 5 out of the 8 working in the direction of a deflationary cycle. All eight don't need to happen to cause deflation. The two key ingredients are real estate values and wage deflation. We already have them moving in a negative direction with further pressure towards deflation. Those two with any other two-three risks will cause a train wreck not seen in a generation. The cycle of deflationary implies the time cycle lasts longer than the last deflationary period. I wrote this update to help create the visual of a deflation cycle, where issues happen in waves due to cause and effect, as one negative causes one or two more negatives and so on. This will be interrupted by the government and stimulus efforts that gain minimal traction for short periods.

That's how it plays out!

Hope all is well.