Friday, October 23, 2009

DEFLATION: The REAL Boogeyman to Fear

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

Over the past year, there has been so much talk about the coming inflationary problem. Some have even speculated that we would see hyper-inflation, like Zimbabwe, Argentina or the Weimar Republic post World War I, where we would need a wheelbarrow full of money just to go grocery shopping. I have not been in that camp. Rather, I am MUCH more concerned about the opposite of inflation, and that is deflation.

In the grand scheme of things, there is a very long-term cycle at play around the globe. If we start with inflation (prices going up and increasing) that leads to disinflation (prices going up at a slower pace). We then move to deflation (prices going down sharply) and finally reflation (prices going down at a slower pace). Our economies and markets tend to function best with mild inflation or disinflation.

At the most basic level, inflation involves too many dollars chasing too few goods, which causes prices to rise. Deflation, however, is too few dollars chasing too many goods. It’s a simple supply/demand analysis. Since late 1998, our economy has struggled with periodic bouts of deflation that really began with the explosion of the Internet. Think about it for a minute. Besides the convenience of shopping from your home or office, why do most people use the Internet? Because it’s cheaper for the exact same product! The Internet has actually caused many goods and services to decline, which is deflationary.

Look at computers, for example. I remember paying $2500 for laptop in the mid 1990s that wasn’t even 1/1000 as powerful as the one I am using right now for less money. Technology is actually a deflationary force that benefits the economy.

If I had to grade it, that sort of deflation would be considered mild or acceptable deflation. The problem we are facing now is much more serious. Every month the government releases a figure called Hourly Workweeks for Production and Non- supervisory Workers, which lets us know the average number of hours worked each week. During economic expansions, that figure tends to rise as companies have more demand and need to produce more so workers work more. It’s fairly simple.

Today, the average workweek is down to roughly 33 hours, which continues to make new lows month after month. Couple that with a dramatic decline in hourly earnings and the U.S. economy is left with wages at 1982 levels. Think about that. The average worker is making the same money as he/she did two decades ago! Since we already know that too few dollars chasing too many goods is deflation, this is not and has not been good news for years.

I have heard all the arguments that the Federal Reserve has printed TRILLIONS of new dollars and that is certainly inflationary. But that doesn’t accurately tell the story. I agree 100% that Helicopter Ben Bernanke & Co. are trying to print their way out of this mess. But they’re not even close. The credit market used to represent more than $50 trillion dollars. Yes, you read that right. $52T. That entire market has essentially been vaporized by the financial crisis. It really doesn’t exist anymore. The alphabet soup of products like CLOs, CMOs, SIVs, CDOs. POOF! Gone. May they rest in peace.

So if the global financial system lost $52T and our Fed, along with the European Central Bank and Bank of Japan printed roughly $10T, that’s still $42T that’s been removed the system, like a giant sucking sound! Try to fathom the global economy losing $42T of spending power. It’s not a pleasant thought! With the banks realizing trillions of dollars in credit write downs and the urgency to raise immediate capital for solvency, that doesn’t support too many dollars (inflation) in the system.

Going a step further, banks have reigned in lending (reducing credit), thereby hampering the economy from a “real” recovery by preventing money from freely flowing. Again, too few dollars in the system is deflationary. I guess this column wouldn’t be complete without mentioning housing, but that really is part of the whole credit market collapse. If the average person’s single largest asset is their house, and prices have been falling for several years, it only adds to the already worrisome deflationary condition.

Deflation is much more difficult to cure than inflation. It’s referred to as a spiral or black hole since once you get into it, gravity pulls you deeper and deeper in. There have only been two examples of this, the Great Depression and Japan for the past 20 years. World War II was the final fix for the Great Depression, but Japan has yet to find a way out. Non-Main Street experts have warned that Japan could actually remilitarize to try to solve their mess.

The most common medicine for deflation is abnormally low interest rates for long periods, coupled with running the printing presses 24/7 and enormously high government spending. In other words, exactly what’s been going on here for the past year. HOPE is one of the worst words to use when it comes to the financial markets or economy. But let’s all do it to make sure that the U.S. isn’t slipping into a deflationary spiral.

Next week: I’ll go to the other side of the spectrum and spend some time talking about inflation and what it really looks like.


  1. This is a rather sophomoric academic treatise which belongs,...well, in the academy. "Deflation is much more difficult to cure than inflation." Where does that come from? Says who? For whom? You just can't go around making blanket statements like that without showing the research or backing them up somehow.

    By the way, Paul uses 'reflation' (para. #2) where he should have used 'disdeflation'. Anyone who ever took Econ. 101 studied these terms and was (presumably) tested on them. The real problem here is that Paul tries to cover too much ground in 11 paragraphs. The net effect is a litany of truisms and half truths that most of us are already familiar with. Other than that, no major disagreements, and some points are well-taken. Keep trying. How does one get to the Carnegie Hall of Econometrics? Answer: Practice, practice, practice.

  2. Apparently the only time of high inflation in recent memory has been the mid-70s. The possibility of high inflation these days just doesn't jibe historically--I'd tend to agree with the author.