There is disagreement among economic observers regarding whether the economy is more likely to experience troubling inflation or deflation in the next couple of years.

Some who expect increased inflation reference current fiscal and monetary policies that, alone, are inflationary. Examples include recent government stimulus packages, historically low discount and federal funds rates, issuance of massive amounts of government and municipal debt, and expansion of the currency base, among other factors. Essentially, the more currency being created from nothing other than one’s good faith results in higher prices for goods and services (and a correspondingly lower value to said currency), ceteris paribus, to paraphrase my former economics professor. 

As is the case with most theories I’ve been taught while sitting in an ivory tower, ceteris paribus is noteworthy concerning whether theories are useful practically.

According to many who expect deflation, the rationale references value of assets and social psychology.  Regarding the former, we’ve experienced the effects of decoupling the price of an asset and its underlying secured cash value.  There are many thought experiments.  Think of houses: if everybody had to pay cash for a house, home prices would likely be a fraction of what they are today.  If municipalities could not issue bonds at reasonable interest rates or assess taxes beyond a moderate amount, then their cost structure (compensation, pensions, contracts) and prices would be lower.  These are just two of many examples, albeit presented in a simplistic manner.

What we have experienced in the past two years regarding some banks, companies and municipalities is that the price they paid for their assets exceeded the current and ongoing value of those assets: residential and commercial mortgages, stocks, credit default swaps, and tax receipt streams, for instance. 

As such, by printing more money and issuing more debt, inflation can be expected.  But, if debt of all kinds must be written down, some by 50% or even 100% (bankruptcy), then deflation is most likely to occur (prices of many goods and services decrease*).

So, the question to ask yourselves, Dear Loyal Readers, is “do you believe the current stated value of debt instruments and future obligations (on-and-off the balance sheets of companies and banks; derivatives; social security and pension funds; mortgages; credit card balances; sovereign and municipal bonds) accurately reflects reality?” 

If your answer is yes, then expect inflation.  Otherwise, expect near-term deflation.

--------------------
* In this scenario, falling prices are likely attributable to reduced spending and money supply contraction (e.g., reduced value of debt/liabilities more than offsets FED monetary expansion policies).  See The Anatomy of Deflation by Professor George Reisman for an expanded explanation of deflation.

The federal estate tax, also dubbed the “death tax” by some, will be repealed for 2010, at least as of this writing.  This means that wealth transferred upon death, regardless of amount, will incur zero federal taxes.  Or, expressed differently, wealth transfers won’t incur egregious double federal taxation (once when the wealth is earned and once when it is transferred).

In contrast, the applicable exclusion to a taxable estate tax was $2.0 million for 2006-2008 and $3.5 million in 2009.  Amounts above these values had a maximum tax rate of 45% to 46%.  Nevertheless, to paraphrase Ben Franklin, there’s nothing certain except death and taxes.  In this case, there is a lot of uncertainty regarding the permanence of the 2010 federal estate tax repeal.  

The primary concern is that Congress might revisit the topic early 2010 and reinstate the tax retroactively to Jan. 1.  Regardless, under current legislation, the estate tax will reappear in 2011 with a 55% rate and $1.0 million exclusion.

There are many blogs about this topic: Die Broke Blog discusses estate taxes in a broader context; Mish’s Global Economic Trend Analysis addresses some personal unintended consequences; and, Wallet Pop highlights historical changes since 2001.

A hat tip to the Immobilienblasen blog for the cartoon and observations:

"So this remains the Houdini rally — no jobs; no pricing power; no broad participation; and no volume."

Two reports about strategic M&A and private equity were released recently.  

Paul Weiss, a well-known corporate law firm, prepared a concise survey of the top 25 non-financial M&A transactions, highlighted at Research Recap here.  The report focuses on terms and characteristics.  However, a notable data-point is financial sponsors were nearly nonexistent (accounting for less than 3% of total value in the twelve-months ending July 2009).

The private equity summary was prepared by PitchBook, an independent private equity-focused research firm.  The report is updated quarterly and includes value, number, most active firms and sectors, among other criteria.

There were fewer and smaller transactions in comparison to peak 2006-2007 levels, with a reversion to activity during the last recession of 2001-2002.  For example, total number and value were down about 55% and 70%, respectively, from twelve-months ending June 2007 to same period of 2009.  Also, the median value for buyouts during 1H 2009 was $37 million, down from a 2007 high of $104 million.   

Still, private equity firms are originating and closing transactions, but some assert a competitive advantage has shifted to acquirers such as holding companies, strategic buyers, individual investor groups and fundless sponsors. 

The argument seems to reference smaller deal-sizes, less, if any, dependence on debt financing, longer-term investment horizons (some prefer to hold indefinitely), a focus on cultivating one or a few investments, and even a more personal approach with family-owned companies.

The implicit point to note about the ebb-and-flow of leveraged transaction volume is all that debt used to finance the record number of deals of yore (at premium valuations) comes due in the next 3-5 years. 

Ouch… 

Remember the Saturday Night Live sketch with actor Christopher Walken portraying a music producer who prods a rock band to use more Cowbell?  Quite comical.  

Now, replace Cowbell with Education, and we get a sense of the laments of many highly educated, motivated and personable people.  Two blogs at Mish’s Global Economic Trend Analysis expose the proverbial elephant in the room.  The topics relate to a structural economic shift and the educational system.  

The broad theme is the U.S. has an oversupply of highly educated and experienced professionals and an undersupply of employment opportunities that align with said talent.   

The current economic environment accentuates this point, yet it has been an undercurrent for more than a decade.  The subtext of the topics highlights the rampant inflation of the cost of higher education and a preference for mediocrity, or worse, at many organizations.

Perhaps an outcome to these dynamics will be a resurgence of individual creativity and innovation, which doesn't necessarily equate to earning college degrees.

For those interested in strategy, adapting to a changing environment, consumer behavioral trends, and, well, outright mismanagement, then analyzing the newspaper and print media industry provides a real-world, in-progress case study.

Although headlines of the death of the newspaper might be an exaggeration at the moment, there is clear and present danger.  The business model of newspapers depends on advertising revenue, which comprises about 80% of its total revenue.  In 2008, advertising revenue dropped 16.5%, according to the Newspaper Association of America.  Barclays Capital projects a 22.0% decline in advertising revenue in 2009 (see Mint.com below).  Startling, but also mirroring the economic recession.

Nonetheless, organizations that will most likely survive the economic challenges and thrive will create a new business model, with digital media being more prominent.  The extinction of the traditional daily is not likely in the near term, although it will probably play a more niche role.  Similar dynamics are occurring with telephones, internet connections, software, music and movies, to name a few.

Mint.com presents a concise one-page visual of key metrics of the top 25 U.S. newspapers.  Many others have written about the struggles of print media; Slate.com highlights the strategic and mismanagement aspects of this topic.

Well, that’s all for now, as I need to check my favorite news and entertainment blogs.

Say it ain’t so.  How many more obscure, undercapitalized financial institutions are lurking in the midst?  According to a New York Times investigative article, and summarized here, Customer Asset Protection Company (Capco), based in Burlington, Vermont, may be at risk.

Capco provides catastrophic insurance to wealthy clients in the event their brokerage firm collapses.  Basically, it provides coverage above the $500,000 offered by the Securities Investor Protection Corporation (SIPC).

The concern with Capco sounds eerily similar to the abuses regarding credit default swaps in which some firms, including AIG, sold protection without having adequate reserve capital.  In Capco’s case, the article indicates that it might have only $150 million of capital to support an estimated $11 billion of potential claims.

It is prudent for investors and customers to hedge their hedges.  One example is to retain a public company as a hedge provider and then create a hedge on that hedge-providing company via puts/calls, short position, or both.  

There are two software tracking applications of the federal government stimulus package (formally known as the American Recovery and Reinvestment Act).  One is the government’s, found at recovery.gov, which is oriented towards taxpayers who want to know how their tax dollars are being allocated. 

The other is provided by Onvia (ticker: ONVI), a Seattle-based public company.  Its application, found at recovery.org, is directed at businesses interested in bidding on projects, before it’s too late to do so.  An Onvia representative stated the application is free to use, since it's a means to attract incremental customers to the company’s subscription based data.  Fair enough, in our opinion.

Read more about it on GreenBiz.com’s blog by Marc Gunther or listen to an interview with the CEO on reason.tv. 

To many Clevelanders and Ohioans, the economy never recovered from the last recession, or several prior to it, for that matter.   Today’s headlines and stories in the Cleveland Plain Dealer highlighted the state’s 10.2% unemployment rate in April, exceeding the nation’s 8.9% rate.  Even worse, foreclosures and Sheriff’s sales in Cleveland have pummeled the median sales price of existing homes, down 73%, from $62,000 in 1Q 2007 to $17,000 in 1Q 2009.

Understandably, citizens have looked to a sports figure - in this case, the prodigy of Akron and Fighting Irish alumnus, King James - to deliver temporary relief in the form of an NBA Championship.  It was not to be.  Instead, fans were brokenhearted witnesses of the importance of team composition, despite the immense talents and leadership qualities of one member. 

Accordingly, it’s a timely reminder to all, whether it’s a business or a sports team such as the Cavaliers, that to compete and succeed among the best, appropriate and complementary team members are vital.

That said, it’s not all gloom-and-doom.  Today’s headlines also mentioned that the Cleveland area has become the U.S. leader in Alpaca farming, and will host the Second Annual World Alpaca Conference this week, where Alpaca Farmgirl will be blogging and tweeting.

And, if that doesn’t adequately lift one’s spirits, then those “At Least We Are Not Michigan, err, California” bumper stickers might deliver some sort of consolation.