As Others Watch Inflation, Cramer Measures the Deflationary Risk

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By James Cramer

Is there a moment that we are not worried about inflation? We fret over the

Producer Price Index

. We fear the weekly jobless claims. We sweat out each and every prices-paid number from each and every

Fed

district, as if the Richmond district would reveal the inflation we knew lurked underneath all along throughout our great country.

Could all of this worry be misplaced? Could we be missing some bigger picture that's out there? Could the real worry be deflation?

Before you snicker that I have become a member of the New Era crowd, let me tell you where I am coming from. From my perch I see and hear things everyday. From all around the world. Sure, some of the things I see are inflationary. The price for a beach house has certainly gone up. My ne'er-do- well co-op in Brooklyn Heights has finally gotten back to the price I paid for it 10 years ago, which amounts to a 50% increase in value over the past half-decade. And I think I paid $8.50 to go to the movies recently.

Within the context of a giant-sized economy there is always something that is going to go up in price. But that doesn't mean there can't be deflation simultaneously occurring in larger portions of the economy. Let's take a few giant-sized examples. The price of gold has plummeted severely this year. Unless you really do believe in a new era, this plunge is predicting massive deflation.

The intellectuals out there like to dismiss the gold disarray as a product of changes in the European Monetary System or of errant sales by governments. But believe me, if gold were going in the other direction, you would be hearing these same sages cooing about the coming inflationary wrath.

The accompanying rally in bonds has mesmerized people into thinking temporary slowdown. But I think the rally is so powerful that something else may be afoot, something like fiscal responsibility by the U.S. government coupled with a secular spending slowdown by the U.S. baby boom generation. Both have huge deflationary impacts on the U.S. economy. (If you think the economy isn't slowing rapidly, then explain away the inventory build-up of new and used cars, and the decline in retail sales for hard goods and apparel. Or the king-sized jump in jobless claims that we have seen these last few weeks.)

But other signs abound. The deflationary spiral now gripping East Asia is quite simply astonishing. Thailand devaluation. Korean slowdown. Japanese banking collapse. Philippines devaluation. Are these signs anything but deflationary? Wages may be climbing here, but the marginal labor pool in East Asia is actually bidding itself down in price!

And don't forget the power of China to change the world's pricing structure downward. China is willingly underbidding the world in a host of commodity and value-added products: toys, clothes, shoes, paper goods, plastic goods. Real stuff that we all pay for. Right now.

Couple our curbing of spending with the inability of Japan to get out of first gear and the massive unemployment in Germany, and is there any real wonder that worldwide interest rates are coming down?

What does all of this mean to our stock market? Arguably very little if you are long the drug stocks or bonds: These don't need any economic growth to rally. In fact, you could argue under the scenario I am outlining, people will pay double the current price for

Bristol-Myers

if my view becomes common currency. And the 10-year Treasury, instead of yielding 6.25%, will yield 4%, one colossal move for full faith and credit!!!!

But deflation is antithetical to earnings growth for the rest of the economy, for everything from cyclicals to tech and the money-lending banks as their collateral shrinks in value and the pool of people solvent enough to take out loans vaporizes.

It's this tug of war that has marginalized Greenspan's irrational exuberance warning. Any real surge in short-term rates could tip us decidedly toward a recession despite the seemingly robust economy we found ourselves in just a few months ago.

When I look at what could derail my

Dow 9000

-by-Labor-Day-or-bust theory, it's the deflationary spiral, not the inflationary one, that could cause the bust.

What are the odds of this happening? I let the symptoms determine the odds. Right now I rate them 1 in 5, as I still hear good things from many of my companies. But if I see certain benchmarks violated: a decisive break below $300 for gold, a collapse of oil and the

Commodity Research Bureau

numbers, to name three important ones, the odds would shift to 2 in 5. Any more than that and I'd bet my new Bucks County farm on it. And I am a betting man.

James Cramer is manager of a hedge fund and co-chairman of

TheStreet.com

. While he cannot provide investment advice or recommendations, he welcomes your feedback, emailed to

Jjcramerco@aol.com.