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.