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Deflation

The ads seem to bring a lot of good news.  A local clothing store advertises that if you buy one suit you get two free and a discount on dress shirts – an amazing 2/3 off!  Prices on computers and technology continue to fall with some laptops available for as little as $500.  This is a great boom for consumers, isn’t it?

The short answer is yes, but the long answer is no.  If you take all of this together we’re looking at a serious problem with deflation, something we haven’t seen since the 1930s.  It’s far worse than inflation for many reasons, the simplest version of it being that an economy based on credit cannot function if there is no reason to expect rising returns on investments.  And there are signs that deflation is going to be the watch phrase for some time to come.

The problem is a very simple one. Money, like anything else, is subject to the same principles of supply and demand as everything else.  If there’s not enough money to go around it becomes more valuable, so prices fall.  Interest rates can’t reasonably go below zero – that would be the same as paying you to borrow money, which banks haven’t figured out how to do while staying in business.  That means that there is no operating rate at which they can loan money and expect that it will be paid back. Once consumers get used to deflation they tend to put off purchases of big items like cars and computers, watching for the day when they come down significantly in price.

Let this play out long enough and nearly everything stops.

This is the reason that the Federal Reserve decided to pump up to $1 trillion more of printed money into the economy in what we call “Quantitative Easing”.  This round, QE2, brings the total to $3 trillion, to be realized by next Spring.  As the policy body that is charged with keeping the banks and other investment houses operating they felt they had to do something, even if it’s not all that popular with some politicians.  They are desperately trying to head off deflation – even as we can all see the signs of it around us.

Gary Shilling has written a new book, “The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation” (John Wiley) that outlines how we’re going to have to deal with it.  I haven’t read this book yet, but the discussion it’s started is so deep that we have a good idea what’s in it already.  (Don’t worry, Gary, I’ll buy it!)  He lists the four factors that will have to be in place for us to get to the point where consumers are waiting for more deflation and the death-spiral is beginning to twist:

1. The breadth of deflation. Declining prices have to spread across a wide spectrum of goods and services to be convincing.

2. The chronic nature of deflation.  Consumer prices dropped in 2009, but only for a few months due to declining energy prices. Against the history of nonstop inflation that experience was not long-standing enough to convince people that it would persist.

3. Decelerating prices, at least in the short run. Few Americans expect deflation, and most regard a return to significant inflation as inevitable. This probably means that it will take a pattern of smaller and smaller rates of inflation turning into bigger and bigger rates of deflation to be convincing. Inflation rates have fallen from double digits to essentially zero in the past 25 years. If deflation sets in, but at a steady rate of, say, 1% per year, it will probably take a number of years before people believe in its permanence.

4. The amount of deflation. The deeper the deflation, the more convincing it becomes. Deep deflation would be a big persuader as it promotes big drops in interest rates and unbelievable consumer bargains, but also job losses in firms that don’t cut their costs and prices. Those living on fixed incomes would feel like kings as their purchasing power grows while highly leveraged individuals and corporations would fail.

The last point is why Shilling is concentrating on “deleveraging”, or getting out of investment positions that required a lot of other people’s money which have spiraled out of control. Leverage depends on the ability to borrow money – often at attractive short-term rates that are more immediate than the investment.  That means you have to keep borrowing.  Miss getting new scratch to keep it going and the whole investment can explode, which is what happened as early as December 2007 in the first warning signs of the collapse.

Is deflation going to rule the next year?  Fortunately, great minds like Shilling are on top of this – so we may be able to avoid the worst of a deflationary spiral.  The list above is what we all should watch for to see if the message is being heard.

18 thoughts on “Deflation

  1. Deflation is the biggest recovery killer out there. This is a great article because it tells me what to look for in my daily news scanner while I make up my own mind. I wish more people would write about the economy in ways that I can use like this. Thanks!

  2. Thanks. I’d like to get this message out more widely because I’m very frustrated by the fact that economic news is far less forward looking than the weather or sports, to name two popular news segments.

    Managing risk in changing times is difficult and I fear we lack a lot of the basic tools to do it. I would like to see that change. Heck, I’d really like to have a gig helping to make that improvement.

  3. I agree that the news does a terrible job of explaining this stuff. The best I’ve heard has been on NPR, but they also rely on talking heads way too much.

    This is the best place I’ve found for information like this by far. I prefer blogs on the economy over the social media stuff that I really don’t care about.

  4. I think some deflation on the housing side is a good thing as there was an overvaluation in the prior years. On a tangent there is now talk in some policy circles of a payroll tax holiday with losses to be made up by other sources (i.e. lesser home interest mortgage deductions). Tell us what you think.

  5. Housing had to come down, so I never had an opinion on it, to be honest – it just had to happen. Payroll taxes go right to the overhead per employee that I’ve been stressing needs to be cut if we are going to create jobs, so I’m generally in favor of such reductions – but a temporary “holiday” seems a lot less interesting to me than a real reduction and concentrated effort in reducing all overhead. However, it’s a good way to get more money out there over broad base – very much like the “helicopter drop” of money!

  6. Cheap computers is not a good jumping off point for this discussion – Moore’s law predicts lower technology prices despite the general economy’s inflation situation. That aside, I’m convinced a broad deflationary problem is likely unless we can correct our current account issues.

    Decades of sending huge amounts of dollars abroad and not seeing much come back has kept our money supply artificially out of wack. I don’t want to scapegoat the Chinese; I don’t think they plotted to undermine our economy, they simply act in their own interest. By keeping the Yuan artificially low dollars flew to China, and then Chinese purchases of massive amounts of U.S. treasuries moved those dollars out of general circulation or were simply held (by a high savings rate).

    The ugly concepts of tariffs and trade wars seem close at hand when people start pushing a “buy American” agenda, but I think currency manipulation has loaded the dice against American goods. Something needs to be done now that our currency is in trouble.

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