2009Apr17 Deflation Is Here

When prices are rising, consumers and businesses have an incentive to spend their money today, whether on relatively frivolous retail shopping or more significant investments in homes or industrial equipment.  It makes since to buy something today…before the price increases tomorrow!

 

 

 

 

 

Inflation offers a significant incentive to incur debts as well.  After all, that mortgage payment will get progressively cheaper in inflation-adjusted dollars over the course of 30 years.  Incomes rise in nominal terms with inflation, but existing debts stay the same.  So, inflation has a way of pulling would-be future spending into the present.  This is great for current sales and GDP numbers, though arguably a very poor plan for long-term sustainable growth.

  

 

Deflation is a much nastier animal.  When consumers see prices falling, rather than speed up their purchases they postpone them.  This creates a vicious cycle in which companies continuously mark down prices in an attempt to woo consumers who continuously wait for the prices to fall even further.  Add debt and other fixed costs into the equation, and you have a recipe for disaster.

 

 

 

 

Those fixed payments, rather than getting cheaper, now get more expensive. Profit margins get squeezed, which lead to layoffs and cost cutting.  The problem is, one firm’s cost cutting is another firm’s would-be revenue, which now causes this second firm to cut costs–very quickly becoming a vicious cycle.

 

 

 

 

This goes a long way to explaining why inflation hasn’t been a problem despite the record amount of government stimulus.  Another major reason is–as we read in today’s Wall Street Journal–”Banks Getting TARP Cash Aren’t Paying It Forward.” 

The Journal writes, “The largest bank recipients of U.S. government aid are offering less credit to businesses and consumers…reflecting and exacerbating the tenuous state of the current economic environment.”  

 

 

 

 

This is how you get deflation despite a surge in the monetary base: lending standards rise and the banking system’s credit creation process grinds to a halt. This is a slowdown in the velocity of money…and it is a condition that can linger for quite some time.  John Maynard Keynes compared this situation to “pushing on a string,” and it is an apt metaphor.  You can “print” money all day long, but you cannot insure that it will be lent or spent.  

 

 

 

 

We may or may not see outright deflation over a prolonged period, but we certainly expect prices to remain soft.  That’s our story, and we’re sticking to it–until we see strong evidence to the contrary. 

 

 

 

 

For a short cartoon explaining the problem with deflation, watch the ABC News story.