Deflation: Everyone Wants a Lower Price
by Richard P. Halverson

SO WHY IS ALLAN GREENSPAN WORRIED ABOUT DEFLATION?

Virtually everyone is familiar with inflation.  The price of everything from candy bars to haircuts keeps rising.  Deflation is just the opposite.  If you follow economic news over the years you are aware that the Federal Reserve Board has spent decades trying to track a course between economic growth and inflation.  When the economy grew at too fast a pace the prices of all kinds of goods and services increased.  Too much inflation can be ruinous for an economy. Consequently, the FED would try to slow the economy down.  This often led to job losses, lower profits and even recession.  Recessions are bad things.  They result in pain and suffering for real people.  These inflation fighting activities may have been necessary from an economist’s point of view but they are rarely popular with ordinary citizens.

CONCERN FOR DEFLATION IS NEW

Popular or not very few people alive today can remember a time when inflation was not a fact of life and when the FED was not worrying about controlling it.

It has been a shock, therefore, in the past six months to hear the FED, and it’s well respected chairman Allan Greenspan, expressing some concern about deflation.  Their words are very carefully chosen but in effect they have been saying that the risk of a falling prices is as great as the risk of a rising prices.

BARGAINS ARE GREAT AREN’T THEY?

A person’s first reaction might be that declining prices are great.  Everyone likes a bargain.  Wouldn’t it make everyone happy to pay less for food, clothing, cars and movie tickets?  The answer is “No!”  Broad declines in prices are usually associated with broad declines in the economy.  This results in declining jobs and declining wages for those who are employed.  So, even though everything a person wants to buy is cheaper there is even less money available to buy them with.  The standard of living actually falls.

Few of us can conceive of a deflationary environment because inflation has been such a fabric of the economy for so many years.  The last deflationary cycle in the United States occurred in the 1930’s.  You will also recall that was the era of the Great Depression.  The association is not an accident.

CONFIDENCE IS KEY

The economy is an interesting thing.  It is made up of billions of transactions on the part of hundreds of millions of consumers and businesses.  Each of these is buying and selling in their own best interest. General confidence and feeling of well being are an important factor in many of these decisions to spend or hire or invest.  If people feel good and optimistic they are more likely to buy.  If they are pessimistic they are more likely to restrict their buying.  Normally, the majority of these decisions are fairly steady.  People need to eat, buy clothes and replace broken appliances.  But we also know that consumers and businesses get caught in wide mood swings.  Events can cause wide spread enthusiasm or despondency.  These cyclical fluctuations can wreck havoc on the economy. 

Here is what might happen during an inflationary spiral.  Prices rise, consumers begin anticipating rising prices by purchasing more than they need and stock piling.  Or perhaps they make a purchases before they are needed in order to avoid the next price increase.  They may buy 10 boxes of cold cereal when 5 boxes are adequate. Evidence of this is everywhere and has been for decades.  You will see it in ads telling you to hurry and buy before the price goes up.  This mentality results in accelerated buying that sends a signal to producers that demand is higher than it truly is.  They respond by expanding and hiring to produce more.  That in turn makes labor scarce, which drives up wages and so on.  It sounds good for a while but once it spirals out of control money becomes valueless.  Confidence is lost and the economy plunges into a type of economic anarchy.  Readers with good memories will recall that the United States moved perilously close to hyperinflation in the 1970’s and early 80’s.  Others may have first hand experience with economies where the value of money was declining so rapidly that no one would accept currency and barter became the standard for the economy.

Economists know something about controlling inflation.  The FED can restrict the money supply.  Very simply less money makes it more valuable which is another way of saying prices are not rising.  Unfortunately this process is painful. Innocent people will lose their jobs. This makes such policies a very difficult thing for elected officials to do.  The members of the FED are not elected.  At least not directly.  They can inflict the pain.  However, even then you can be certain the FED Chairman will be hauled before the elected officials in congress and the White House and threatened with everything from being replaced to a complete take over of the central banking system by congress.

Contrast, inflationary mentality with deflationary mentality.  Every time a consumer buys something the price drops.  The consumer constantly feels he/she is over paying.  This leads to delayed buying decisions.  Rather than buying the 5 boxes of cereal that are probably needed the consumer buys 2 boxes.  Decisions are made to delay buying a car because next year’s model will actually be cheaper.  This mentality results in decelerated buying that sends a signal to producers that demand is lower than it truly is.  They respond by restricting production and laying off workers.  That in turn makes jobs scarce, which drives down wages and so on.  Lower prices sound good for a while but once it spirals out of control money becomes so valuable that people hoard it and refuse to spend.  Confidence is lost and the economy plunges into a type of economic anarchy.

WE KNOW VERY LITTLE ABOUT CONTROLLING DEFLATION

If economists know something about controlling inflation they know almost nothing about controlling deflation – and that is scary.  There are theories but they haven’t worked in the past.  The FED can restrict money supply during an inflationary cycle. That forces prices down no matter what the prevailing spend like crazy mood of the public is.  But increasing the money supply during a period of deflation may not have the effect of increasing the economy.  If banks are frightened and pessimistic and the FED gives them more money they may choose to effectively store it in the vault rather than make new loans.  This chokes off the increase in money supply the FED was hoping for.  And if consumers and businesses are frightened and pessimistic they may tend to hoard the money rather than spend it.  Easy money policies by the FED are ineffective if the prevailing economic mood is fear and pessimism.  The famous line is, “You can’t push on a string.”

The Federal Government may try to help by dreaming up public works projects or simply by giving people money.  Unfortunately, in order to do this they must impose taxes.  They will succeed in taxing the very part of the population they need to be encouraging to spend and invest.  It becomes a sum zero game.

We have not experienced a deflation in the United States for 7 decades.  We should all hope we do not.  Other industrialized countries have.  Japan has been struggling through a deflation for seven years.  How they got there is very complex and included very bad banking practices and a huge real estate blow off.  Very recently there are some signs of improvement.

IS THERE A WORRY?

Is it a serious worry for the United States?  Let me be clear – I do not know.  But there are some warning signs to worry about.

·         The strong economy of the 1990’s had very little inflation.

·         Most commodities are in plentiful supply.

·         The current economy is registering growth but prices are not climbing.

·         Job creation is not yet as robust as it should be.

·         The United States has recently experienced a huge speculative blow off in the stock market.

·         Real estate prices have been the exception to the low prices and have probably increased too rapidly.

·         Technology is contributing to lower prices and lower wages.

TECHNOLOGY IS A PRIME SOURCE OF LOWER PRICES

The later point needs a little explanation.  Declining prices occur for a number of reasons.  I have talked about the mood of pessimism that can envelop a society.  That leads to reduced demand and falling prices.  But prices can fall because productivity is allowing producers to produce for less.  Frequently, this is a very good thing.  Much of our food is cheaper today than it was decades ago because so much has been learned about food production.  Electronics of all kinds continue to decline in price because the discovery of better computer chips and cheaper production techniques are so strong.  These types of examples generally result in a better economy.  The price falls but the general economic mood is good so demand for that product expands and more jobs are actually created.

Technology is, however, moving jobs out of the United States at a faster pace than ever before.  It is cheaper to manufacture goods in China or Mexico.  But those goods are only competitive in the United States if the whole complex cycle of production, transportation and inventory management can be controlled.  With today’s sophisticated electronic communications manufacturers in foreign countries can follow inventory levels at retail outlets here on a daily basis.  Perhaps a more amazing example of a shrinking world is things like customer support.  Today when you check on your credit card balance you may very well talk to someone in India.  Sophisticated computer programming is done in Moscow and managed by supervisors living in Chicago.  Labor is rapidly becoming a worldwide commodity because of sophisticated electronic communications.  This results in lower costs and lower prices in the United States.

Whether this is good or bad for Americans depends on many things.  I recently heard

An interview on NPR with workers affected by the loss of textile jobs.  The loss of a job is a tragedy for those involved.  However, these same workers acting as consumers confessed to buying imported goods because they were cheaper.

MAYBE NOT THIS TIME

Will we slip into deflation?  Once again I do not know.  And this article is not about making predictions. The mere fact that the FED is expressing some concern should catch everyone’s attention.  However, my personal hunch is that we will not slip into deflation in this economic cycle.  Here is why.

·         The economy is already well on its way out of the recession.

·         Huge economic stimulus has been poured into the economy much of which has not yet been fully realized.

o   The FED has adopted a very accommodative monetary policy.

o   A large tax cut has been implemented.

o   Government spending has been increased.

o   We are fighting a war.

o   The dollar has been allowed to decline substantially against currencies like the Euro and the Yen.

WHAT CAN BE DONE TO PREPARE?

What can individuals do to be prepared for deflation?  Frankly they are the things we should be doing anyway.

First, reduce debt.  Get out of debt all together if possible.  Repaying debt in a deflationary cycle is repaying with dollars that are more expensive than the ones you borrowed.

Second, build flexibility into your career.  I do not know how any job can be considered safe and secure in this environment.  There will be jobs.  But they may be different jobs.  Learn new skills.  Keep up with changes.  Improve your education.

Third, build up the equity in your home.  If possible make prepayments.  A deflationary cycle will reduce the value of real estate.  Your home is more than an investment.  It is your home and larger equity will help protect it.

Fourth, continue to invest for the future.  Emphasis should be on secure high quality companies.

Fifth, build up your savings.

Sixth, follow the counsel regarding personal preparation and food storage.

Perhaps we will not experience a deflationary cycle in the next few months.  Perhaps we will go another seven decades.  Or perhaps the FED’s concern will become a reality.  The wise course of action in this case is the wise course of action in any case.

Everyone loves a bargain and a lower price.  Too many bargains, however, can be deflationary and deflation is no bargain.