Inflation is a sexy worry.
We can photograph it. A photo of a one billion dollar bill next to a pile of apples from Zimbabwe’s recent bout of runaway inflation stuns the imagination.
It’s the stuff of national nightmares.  The German electorate and German bankers are still traumatized by Weimar-era inflation.
And we know what to do about it: Raise interest rates, rein in the money supply, or, if worst comes to worst, send the economy into a recession.
Deflation isn’t sexy.
It’s hard to photograph money getting more valuable and falling prices just aren’t terribly dramatic.
Japan has been sunk in deflation for years if not decades without violence in the streets or even noticeable anguish. The period doesn’t even have a catchy name and it certainly doesn’t have any cache.
And we don’t know what to do about it. Increasing spending, running big deficits, subsidizing spending all work in theory but they don’t seem to have done much to solve Japan’s deflation persistent problem.
About the best we can do is coin metaphors—fighting deflation is like pushing on a string—and pursue policies designed to prevent inflation from establishing a beachhead.
Which is why the possibility of deflation worries so many investors and economists right now. And why investors need to stay on guard against both of these possibilities–and well as a third alternative that mixes some of the worst parts of both.
If you look, you can see what might be the signs of deflation.
Certain big categories of prices are falling, have fallen, and look likely to keep on falling. I’m talking about housing prices. Prices for this big ticket item are still falling in the housing boom to bust economies of the United States, Spain, Ireland, and the United Kingdom. Economists are predicting that prices in some of these economies could keep on falling for five years. In the United Kingdom, for example, PricewaterhouseCoopers recently predicted that there was a 70% chance that the real cost of a house in 2015 would be below the price in 2007.
And you can certainly make the point from recent data that consumers in the United States are following n the footsteps of their predecessors in Japan to put off purchases until tomorrow. That’s a hall mark of deflationary psychology: since money will be worth more tomorrow because prices are falling, the inclination is to postpone spending as long as possible in order to take advantage of that trend.
So the Federal Reserve reported on July 8 that consumer credit—the amount of money that consumers owe on credit cards and loans—decreased at an annual rate of 4.5% in May. Revolving credit—that is credit cards—decreased at an annual rate of 10.5%. That’s contributed to a 1.2% drop in consumer spending in the second quarter of 2010.
I think you can make a case for a rising danger of deflation—Nobel-prize winning economist Paul Krugman made just such a case in his New York Times column on Monday, July 12. (Read his column here http://www.nytimes.com/2010/07/12/opinion/12krugman.html?_r=1&partner=rssnyt&emc=rss.)
But I also think you can make a case for a rising danger of inflation. Some very large economies—China and the United States, to mention just two—have vastly increased their money supply in the last year. Neither has seriously begun to reverse those increases—just look at the Federal Reserve’s balance sheet for evidence of that. True, the Fed has stopped buying some classes of assets so that its balance sheet isn’t’ expanding at the warp speed of the months after the financial crisis. But the Fed certainly hasn’t yet begun to sell those assets back to the financial markets. And then you’ve got the traditional inflationary trappings of massive government budget deficits—often an inducement to governments to inflate their way out from under some of their debt.
I think there are two important points to make in the current deflation is a big danger/deflation isn’t a big danger debate.
First, while the data clearly shows a drop in consumer debt, I think it’s too early to say why debt is falling. It may indeed be a response to fear and uncertainty in the economy, and a desire to regain control over family balance sheets. If that’s the case, then the data is voting in favor of deflation as the bigger danger.
But it’s quite possible that what we’re seeing is just the long lingering after effects of the financial crisis. Banks, as they usually do after a crisis, have tightened their lending standards, particularly for individuals and small businesses. As part of that they’ve increased the hurdles that they’re asking borrowers to jump and the strictness with which they’re grading those borrowers.
For example, FICO scores, the credit rating metric that plays a major role in determining if a bank or credit card company will lend you money, have dropped to new lows. Roughly one in four consumers now has a score below 600. That’s about twice the number of Americans that are usually at that level. Some of that’s because unemployment remains up near 10%. But some of it is because banks, now that loose lending standards helped fuel a financial crisis, have cut grace periods and lowered credit limits. (A lower credit limit will sink a FICO score since a consumer is now using a higher percentage of his available credit. And that’s a clear Ding! for a FICO report.)
So one of the unanswered questions of the deflation danger/no danger debate is how much of the reduction in consumer borrowing is a result of the onset of deflationary psychology and how much is a result of temporarily strict bank lending standards.
Second, you’ll notice that almost all the (perhaps) deflationary examples come from the world’s developed economies. For every deflationary tendency in the developed world I can, I’m pretty sure, find an inflationary tendency in the developing world. If (if) developed economy consumers are cutting back, developing economy consumers are increasing their demand for more goods in general and more luxury goods in particular. If infrastructure spending is falling in Germany and the United Kingdom, it’s still rising in Saudi Arabia, China, India, and Brazil. If real estate prices aren’t in recovery after the boom and bust in Ireland, Spain, the United Kingdom, and the United States, China is still facing an acute shortage of affordable housing for a rising population of what are, by China’s standards, middle class families. (This isn’t to deny the speculative boom in wildly expensive luxury apartments. Just to note that the boom in luxury real estate is taking place at the same time as middle class families can’t find affordable housing.)
The experience of Japanese deflation shows that the global economy can continue to grow while a major economy—what was then the second largest (or third largest if you count the European Union as one economy) economy in the world—goes through deflationary purgatory.
It’s not impossible that the global economy could continue to grow—and even show inflationary trends in the prices of commodities such as oil, corn, copper and the like that are in high demand in the developing world–even as the world’s developed economies show the slow growth and falling prices traditionally associated with deflation.
That wouldn’t necessarily be any more pleasant for those of us who live in those deflationary, developed economies. We’d experience slow economic growth, falling prices for many of the things that our economy produces, and rising prices for goods and services that are in global demand.
I don’t have any idea what we’d call the resulting mess. Indeflation? De-inflation? At this point, though, in the economic cycle I don’t think we can rule out such a result. Nor should we rule out the possibility that deflation in the developed world would take down the entire global economy. Or that growth and inflation in the developing world would be enough to drag the developed world along.
We simply don’t have economic models of sufficient complexity or sensitivity to give us a reliable answer.
My third way—indeflation or de-inflation—while it wouldn’t necessarily be pleasant for citizens of the developed world does at least offer investors a path through this mess. If that is the way the world economy will break, then that’s one more reason to put money into developing markets. Those markets might be able to muddle through—or better–even if the developed economies struggle. (For other reasons to bet on developing economies see my post Within six months global stock market performance will diverge–where do you want your money?)
As a frugal saver who has always been screwed by government policy favoring borrowers, deflation? I say bring it on and I will love every minute of it. Our government tries to encourage the common folk to save while instituting policies that screw us. Deflation, I say bring it on and I will love every minute of it!
Well, in 1900, people bought things, produced things and traded with other countries. Kind of like today but on a smaller scale and with less debt.
Drilling down on your argument that deflation would cause demand destruction…this would mean an industry that “suffers” from deflation would basically implode. So, how about the computer industry? That industry has lower prices every year and gosh, maybe I’m crazy, but it seems like that’s been an engine of growth for the US – one of the few.
Tell me again in what ways the 19th century agrarian economy is in any way like today’s global economy? Your entire argument seems to be based on what happened 7 or 8 lifetimes ago.
Demand destruction does not mean complete elimination of all demand. Talk about silly.
Southof8: Totally disagree. Again we had massive economic growth, with minimal debt in the 19th century and prices dropped 50% over the century. That right there refutes your argument. Now, from a real world standpoint, if your refrigerator breaks are you going to replace it? How about when the tires on your car wear down? You going to buy groceries or let your family starve because the brocolli that’s $1 pound will be 99cents a pound a year from now? Are you going to buy a new pair of $50 running shoes when they wear down or are you going to wait a year and ruin your back because they’ll cost $49 for the pair next year? Are you going to take the kids to Disney World this year for $500 or are you going to wait until next year so it will only cost $495?
Your no demand scenario is just silly.
Jim, I believe the term you’re after is called Biflation. Not a lot of work has been done on it, but I’ve been attempting to build my portfolio around its general premise.
http://en.wikipedia.org/wiki/Biflation
Oh, and a giant basket of honeycrisp apples with a $1 bill next to it is very sexy imo.
interesting discussion. But I think there is a confusion between building wealth and economic growth. And I agree that Japan’s efforts to prop up banks and bondholders has been a disaster that should not have been repeated here (and has been). But it’s not because of Keynesian spending. It’s because Obama didn’t have the balls to nationalize the banks and clear the bonds at pennies on the dollar so the debt overhang was eliminated. INteresting how the debtors and the equity holders have borne the brunt but not management or the bondholders who were dumb enough to lend the money to begin with.
But back to deflation.
I’ve never heard anyone advocate in favor of deflation. I’ve heard people advocate fiscal discipline, which is not the same thing by a long mile as deflation.
Niall Ferguson is a contributor to the Financial TImes, to which I suscribe, and so I read him fairly regularly. I’ve never thought he was advocating for deflation. He argues (among other things) the burdens of keynesian economics outweigh the burdens, but that is not arguing for deflation.
Deflation stops economic growth in its tracks precisely because demand evaporates. There is no such thing as economic growth concurrently with deflation. THey are mutually exclusive.
Whether you’re selling goods or services, if buyers anticipate lower prices tomorrow, they don’t spend. Once that builds a little momentum, you’ve got real problems. Exponential demand destruction causes the entire system to come to a complete halt. Buy-buy growth; hello contraction. It reaches accross borders; it effects the rich and poor alike and everyone in between.
The only folks who benefit from deflation are those living on the payments from others, because a dollar tomorrow becomes MORE valuable than a dollar today. Pensioners, coupon-clippers and trust fund babies do great; businessmen, investors, workers and pretty much everyone else gets killed. Makes no difference what you sell or what you make; there is simply no demand because wait a day and it will be cheaper tomorrow. And you can’t become a saver after the fact and benefit because there is no demand for your money and anyone who wants to borrow it likely won’t pay it back. So assuming you have an indespensible job and you’re living below your means, what do you do with your money? Not give it to banks to loan out, that’s for sure. Buy GM bonds?
Someone posted the other day about their brother in florida whose neighbor has been ignoring his mortgage and living in his house for free for quite some time (an anomoly due to Florida’s lack of non-judicial foreclosure proceedings and generally debtor-friendly laws- remember OJ moving there and buying a mansion after he whacked his wife?). That is the result of deflation. Doesn’t matter whether he had reasonable or even low levels of mortgage debt a couple years ago- once prices started dropping, if he thought all of those around him were going to default because they were heavily leverage, and thereby bring down the value of his house even more, the best way he could build wealth was pocket the mortgage payment for as long as it took the bank to sue him and get him out of the house. So why pay?
It becomes a self-fullfilling prophecy. It might be smart on a micro level for a short while, but only for a short while. but on a macro level its deadly.
Assume that guy used his fifty grand that he saved by not paying his mortgage to buy gov bonds, and his anticipated future income stream went up as a result of the deflation he helped create (because the future interest payments would rise in “value” over time, as prices dropped).
In theory, he built wealth by his stragic default in a deflationary economy. Until nobody wanted to buy whatever he made or sold because all of his neighbors did the same thing he did- and he had to sell the bonds to buy diapers for his kid. Now he’s got no job, no income, no house and an unhappy kid with a soiled diaper.
Deflation is not simply the bursting of the dot com bubble or even the housing bubble. Lots of folks lost their risk capital and in some cases what they understood to be non-risk capital. But neither situation was deflation, and neither situation led to deflation, because aggregate demand for goods and services outside tech stocks (or home flipping) was unaffected. They were examples of bursting bubbles. Painless but fairly temporary.
A world-wide credit crisis whereby deflation becomes a snowball travelling downhill is a different kettle of fish. How do you “adjust”? By lowering your prices? Of labor, of money, of materials, natural resources, whatever?…. it’s circular. It just feeds on itself. If there is no demand, you can’t drop the COGS quick enough to allow your prices to drop quick enough to stimulate demand. (ask the miners). the price of whatever you’re selling doesn’t make much difference. IF a buggy whip is cheap enough will people park cars and go back to buggies?
I’m not saying we’re in a deflationary period yet. But we’re damn close and to think it could be a good thing for anyone is hard for me to imagine.
frankatwill,
You are exactly right. That is why I am investing in the global trends which are easy to spot. Prime examples are food, energy, and raw materials. Individual countries may experience recessions and falling demand for periods of time, but that will not stop the global growth story.
Companies that satisfy that growing global demand will benefit, no matter what the local story in their domestic economy.
Christopher,
Great posts. For more on how humans compare prices, you may be interested in the book Predictably Irrational.
Purewater– Without beating this topic to death. I agree that their was inflation during the war, but my post was in reference to the 20 or so years AFTER the Civil War, sometimes known as the Great Deflation. Part of the problem was a return to the gold standard and retiring the piles of paper money that you referred to. I do agree that the economy can continue to produce during deflation, as long as it doesn’t paralyze people from buying because they think they will be able to get it less for tomorrow. Thanks for a stimulating post.
bsdvg: IMO you are confusing correlation with causation…moderating prices aren’t causing reduced consumer confidence, an economy deflating from a massive credit bubble is causing the hardship. It’s the same tired argument I often hear about Japan: their GDP is falling because of deflation. That’s bogus, their GDP is falling because they’re still correcting from their massive credit bubble 20 years ago. Rather than let the economy fix itself, the Japanese gov’t spent countless trillions trying to prop up the bubble. Sound familiar?
bsdgv and others,
The truth is neither inflation or deflation determines good or bad. If inflation is running 10%, but everyone’s income is increasing by 20% people are still going to be happy. If inflation is increasing by 10% and everyone’s income isn’t going up people are going to be unhappy.
The same goes for deflation. It is not inflation or deflation that matters, it is the difference between income to cost that matters. If you lose your only source of income you are still going to be unhappy even if everything costs half as much.
So the consumer sentiment is currently being driven by this difference (or the perceived difference, which might not be exactly the same for consumers that don’t really track their finances that closely).
Heyyy Guys…thanks a bunch for the “sage” advice! Decided to tip-toe through NIV and TC instead today! 🙂
2 pieces of new about consumers:
– Consumer Price Index declines 0.1% in June
– University of Michigan’s Consumer Sentiment drops sharply in July
If declining prices are so good, why is the consumer sentiment so low?
One thing I find interesting about “inflation/deflation or boom/bust” is just the concept of normal. During the dotcom boom stock prices shot up in what most people realized was not “normal”, but after the boom crashed people didn’t compare their portfolios to a trend line of what it looked like before the boom (the real normal), they compared it to the prices at the top of the boom and said I’m down X%. The same thing is going on with the prices of houses and credit. People are comparing today with the top of the market and say it is deflationary, but in reality in most places the real estate prices and credit are pretty much just going back to where most people agree they should have bee all along give or take. If you just came out of a period of time where the prices of something were priced much higher then they should have, then “normal” prices/credit is going to look like a great reduction/tightening, but in reality it really isn’t.
davcbr,
You’ve made the common fear mongering talking points argument against deflation. Post-WWII is no comparison to today. Look at household debt levels then vs. now. Also, the industrial revolution increased prosperity at a magnificent rate. Using Purewater’s line of reasoning, you’d argue that huge productivity gains went to Americans rather than being eaten away by inflation.
Unemployment is the result of deflation when Americans refuse to adjust (minimum wage laws, union stipulations) or when debt cannot be written off. Otherwise, relative values keep the standard of living while people work for less in nominal terms.
Seaturtlelady:
I won’t touch the two you mentioned.
All:
Speaking of Paul Krugman, some consider him to be on one end of the current economy discussion because he wants more stimulus and more gov spending. On the other end, there is Neill Furguson who wants government to cut deficit and spending. Few weeks ago, I saw an user comment (probably on TheStreet) saying this:
“If Furguson’s advice is followed, buy stocks.
If Klugman’s advice is followed, but gold.”
STL… I agree with livetoride. I would not touch any financial at this point. I have zero confidence in their numbers. Not to say that you could not make some money, but I would rather invest in something that I can understand.
What’s wrong with a little deflation?
Unemployment.
How well you do depends on where you are when deflation strikes. And that depends on how much cash you have. Note that I did not say “wealth”. Remember, the value of things goes down, and that includes your investment in POT, GS, and everything else.
If you do not have cash, or are unemployed at the time, then you will be that way for a long time. A controlled inflation is a lot easier to manage than a controlled deflation as Jubak said. I’d rather put my shoulder to the wheel and figjht my way through inflation than to get caught in a whirlpool of deflation.
BTW, uncontolled inflation would probably end itself in a massive deflation. So the secret is, like everything else, moderation.
BTW, debt levels? After WWII we managed to pay that off pretty quickly actually. MAybe we could learn something there.
Well written, Purewater.
“And we don’t know what to do about it.”
I disagree and think its more of a political problem. Deflation is the result of a debt overhang and lack of sufficient liquidity to service debt. The government is trying to fight high debt with higher debt and with QE money printing. The problem with solution one is obvious. The problems with QE are too complex to discuss here, but basically, it doesn’t work to do much other than a mandatory increase in excess reserves as required by accounting identity.
The obvious solution with a lack of money is to truly print money. We must either default, slog through and repay the debt overhang, or grow our way out of it. Technical default would be easiest by purely printing money.
Congress could get creative and do something like print money and trade it for gold at above current market prices. That would increase liquidity, thereby providing the means to service debt, and would be done in a stable manner. You get the spending you want with no extra debt! And, if it worked too well then you could simply reverse course and suck up those extra dollars. Call it a reverse FDR.
Drillan: Prices almost doubled during the Civil War because both sides resorted to printing money to pay for the war. Besides the Civil War period, prices gradually fell throughout the entire century. They fell for the reason you stated: productivity gains. The money supply actually wasn’t stable it grew at about 2% per year (the amount of gold mined)…but productivity gains were greater than the increased money supply so prices fell.
My overall point is that you don’t need inflation to have economic growth. Yes, people with a lot of debt will have a slightly harder time paying it back. That’s the point though, deflation in the future will reduce the number of people taking on too much debt and will reward the families smart enough to save more than they produce =>that’s how you build wealth.
Livetoride… well said.
Jim… Your link about the cruise doesn’t work.
Seaturtlelady, the sine qua non of any investment is clarity, that is, being confident that you understand the business model and that their financial statements accurately depict their financial status. Banks are likely the LEAST transparent corporations today. My advice, buy something more transparent and well positioned for any possible downturn, like Wal-Mart. It also pays a decent dividend.
Purewater. I think that the deflationary period after the Civil War was due primarily to a huge increase in productivity coupled to a fixed money supply. In other words, limited dollars available to chase an ever increasing number of goods resulted in falling prices to attract those dolllars. Today deflation is probably linked more to a lack of demand for goods creating the “oversupply”. Is deflation good or bad…that depends on how big your bank account is vs how much debt you have. You will either be able to buy more with more valuable dollars or paying back more with more expensive dollars.
Great post, Jim. Might I suggest that it’s also important to think about the implications of global currencies and yields?
On a relative basis, currencies will appreciate and long-term yields will moderate in countries with sustained growth and low debt (China, Brazil, etc), because that’s where global capital will flow. Meanwhile, currencies will weaken and yields will rise in countries with low growth and high debt (EU, US, etc), as global capital migrates away from these regions.
The result? The developing world may witness inflationary pressures in commodities and local real estate, but it may also experience appreciating currencies and lower long-term yields. This will tend to contain inflation and real interest rates, helping to sustain growth.
The opposite is true in the developing world. Consider what will happen in the United States if global investors demand a yield of 5% on 10-year treasures (reasonable if foreign investors are faced with U.S. debt at 100% of GDP, low growth, and appreciation of their native currency). A 10-year yield of 5% implies a 30-year mortgage interest rate north of 6%. Can American home-buyers afford 6.5% mortgages if wages and prices are stagnant or declining? This is not a recipe for growth.
Having read this article on BAC and C, would it be highly foolish to buy some BAC to sell a couple of months down the road??? The stock price has dropped almost 7% today!
http://seekingalpha.com/article/214886-a-rough-quarter-for-citi-bank-of-america?source=yahoo
Purewater, you’ve succeeded in making me pause and think. I’ve read Carolyn Balm, Bloomberg commentator, ask the same question…”what’s wrong with a little deflation?”
I really don’t think the reduction in consumer credit has anything to do with deflationary psychology. First of all, a huge chunk of the reduction in credit is from banks writing off bad debt. The balance is from the high unemployment rate, reduced working hours for those with jobs and consumers who took on too much debt in the first place and are trying to pay some of it off.
While we’re trending toward no price growth the official numbers aren’t showing deflation. And, as I’ve commented before, is deflation really so bad? People become wealthy by spending less than they earn and not taking on too much debt and deflation promotes that. Inflation pushes people to spend their money now, not save and take on debt-the exact opposite of what it takes to build wealth.
If you think deflation prevents you from strong economic growth, please explain to me why the 19th century saw the US go from an agrarian society to the greatest economic power in the history of the world – while prices dropped 50%.
An uncertain market is a falling market.
Reminds me of the term which was coined during the Carter/Reagan administration…Stagflation. Basically going nowhere. Like my portfolio has looked for the past three months.
A complex global interconnected economy is more stable, as is any complex system, then a binary or single country economy going through boom/bust inflation/deflation. Investors will be slow to realize this because it is so new.