"We shall go on to the end, we shall fight in France, we shall fight on the seas and the oceans, we shall fight with growing confidence and growing strength in the air, we shall defend our Island, whatever the cost may be, we shall fight on the beaches, we shall fight on the landing grounds, we shall fight in the fields and in the streets, we shall fight in the hills; we shall never surrender…"

---Winston Churchill, June 4, 1940

Earlier this year economist Gary Shilling had those words, probably the most widely repeated Churchill quote, inscribed on a plaque along with lesser-known and more recent words from a gentleman named Ben S. Bernanke. 

Then he went to visit Mr. Bernanke at the Federal Reserve Bank in Washington. He gave Mr. Bernanke, one of the 12 governors of our central bank, the plaque.

"He said he had been compared to a lot of people in his life, but this was the first time he had been compared to Winston Churchill," the puckish economist told me in a recent phone interview. A speech Mr. Bernanke gave last November at the National Economists Club in Washington, however, sounds a bit like the Federal Reserve vowing to fight deflation "whatever the cost may be," including printing lots of money.

Mr. Shilling thinks it's a sign that the Federal Reserve, after decades of inflation fighting, is now worried that it has a new, and tougher, beast to fight.

"You can stuff the banks with money but you can't make them lend. He (Bernanke) really admitted that the Fed was pushing on a string when it comes to deflation. They're scared silly of this. But I don't think they can do much about it. The banks take money in and they're buying Treasuries," Mr. Shilling said.

I asked if there was some limit to Treasury purchases by banks.

"Not really. During deflation cash goes up in value. Any positive return is just added to deflation and looks good."

Where would deflation start?

"If we're right and we see a crack in the housing market, then the two asset classes that people own--- their houses and stocks--- will change their views and habits," he said.

What about economist Karl Case  who says that housing prices are slow to sink because, unlike stocks, you can always live in them?

"It's the lower end that's vulnerable. There are all these programs that require little or nothing in down payments to become a homeowner. But if we're going into a second down leg (of recession), jobs disappear and demand (for housing) disappears. The buyers remain renters. Some owners become renters. If you need a roof over your head you have to look at the total market. There's a lot of rental property out there."

How much did he think the rate of homeownership could change?

"It was about 64 percent back in the late 80's and early 90's. Now it's about 68 percent. It could go back, perhaps to 66 percent. If you look at the figures what you see is a big increase in homeownership by households under age 25. It went from about 15 percent in the mid-nineties to 24 percent, before starting to back off.

"Couple that with tightening lending standards. Add the current delinquency rate. And you're at a point where any significant income loss from layoffs will reduce demand."

Significantly, recent figures show the delinquency rate on FHA mortgage loans has risen from 8 percent to 12 percent in the last 5 years while the delinquency rate on VA loans is now 8 percent compared to only 3 percent on conventional home mortgages.

"The sub-prime market is one of the phenomenon that's coming unglued. It wrecked manufactured housing. It's making trouble in credit cards," the economist said.

What about the signs of reviving inflation--- the producer price index appears to have bottomed, the consumer price index has up ticked, and there is pressure to revalue the Chinese yuan by as much as 25 percent. If the yuan changes, everything from underwear to electronic equipment will rise in price. How does he read those figures--- temporary blips or important?

"More likely temporary," he said.

Then what do we watch out for?

"If (housing) prices break you'll have a saturation, like Texas in the late 80's. The things to watch are houses and consumer credit. We'll have to work off the excess."

How long could that take?

"Didn't it take about six years in Texas (in the 80's)? It will be rougher this time because if we're right about deflation, debts will cost still more," he answered.

Mr. Shilling was quick to point out this wasn't just about housing. He pointed to excess capacity in virtually all areas. He also pointed to a broad shift in spending.

"For twenty years we've had consumer spending outpace income by half a percent a year. Now we're moving to a savings spree." That, he pointed out, takes spending out of the economy.

Websites:

"Deflation: Making Sure It Doesn't Happen Here," by Federal Reserve Governor Ben S. Bernanke

Two earlier columns about Gary Shilling

September 13, 1998: Can You Pronounce "Deflation"? 

January 18, 1998: Drifting Toward "Good" Deflation

June 23, 2002: Economist Karl Case on housing prices and slumps