Welcome to the wonderful world of deflation

by Constantine von Hoffman on October 7, 2008

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This guest post is from: Constantine von Hoffman, a veteran business journalist who writes the blog CollateralDamage.biz, a humorous look at marketing, business and his dog. If you?d like to submit a guest post drop me an email.
Like everyone else I’m relieved that gas prices are dropping. As gas prices drop so do those of a lot of other things, like food and shipping and clothes. That’s all good, right? Yeah, unless they don’t stop dropping. When that happens you have deflation and it is very bad.
Simple definition:  “A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy.”

Deflation always means hoarding because investors and buyers hold on to their money because they don’t want to invest in even the most solid of securities.  Or commodities. Like oil. Or corn, whose price dropped 6 percent Monday.  Gold is up for the moment, but I think that is more a sign of desperation and clinging to an old idea and won’t last.
Very few folks around today know what a deflation is really like. My parents lived through the last great deflation in US history, but it was 1934 and they were too young to remember it. So if you have grandparents or great-grandparents around ask them about it. But do yourself a favor. Sit down before they start to talking.
Peter Rachleff, a labor historian at Macalester College, has a description of that deflation that is chillingly familiar. “These were industries where worker productivity was quite high, but workers were not earning back a significant share of what they were producing. So workers were increasingly turning to credit as a way to acquire consumer goods – refrigerators, vacuum cleaners, radios, and automobiles – that they were producing. And the wages never caught up. And that led to goods that were repossessed that weren’t done being paid for. That led to inventories swelling and workers being laid off or work weeks being cut, and spiral downwards then from that point in 1929 to really a low point, say, in 1932-33, when about a third of the work force was out of work altogether.”
Today’s economies are at far greater risk from deflation than they were in the 1930s. Financing is now much more integral to building than it was then so capital reserves are much lower. In a deflation, companies and people stop investing and spending because prices and profits are always going down. The less they spend, the more demand dries up and the more deflation. At least we think the economies are at far greater risk. The Fed is printing money like crazy as it did not do  in the 1929-1935 period and we do not know this amount of money creation can/will/may reverse the deflation.
How do you stop a rampaging deflation? Great question. In the 1930s, the government tried to increase demand via tax cuts and increases in government spending. In an attempt to stop the deflation and reflate the government went off the gold standard and devalued the dollar by 40%, a measure not really available to the Government today. There’s still a lot of argument over how much good, if any, that did. What is definitely true is that it took the hyper-demand generated by World War II to truly erase that deflation.
Current theory argues for lowering interest rates. We are now the test case for that theory. BTW, did you know that during the Great Depression there were negative interest rates?  And that we are near negative interest rates on government paper now and for the same reasons it occurred in the early 1930s? Sweet dreams.

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    “A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. "

    But Con, don't we have stagflation?

    Definition: "Stagflation is an economic situation in which inflation and economic stagnation occur simultaneously and remain unchecked for a period of time."

    The supply of money and credit is exploding from the Fed, and while the CPI fell 0.1 in August it was preceded by a 0.8% increase in July and was still 5.4% higher than August 2007. So really prices are increasing save for energy and food while our economy tanks.

    What do you think?
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    i think that we are now seeing the prices of these things drop after a period of increase. Oil is now below $90 a barrel in response to the decrease in demand from the slowing economy. Other commodities are falling suit -- except for gold which has a talismanic status that is totally separate from any real demand or need for it in the economic system. I don't know what happens next but if the prices continue to drop in pursuit of buyers who aren't there then we have to hope they find a floor. The great risk is when they start to spiral down. Then the commodities markets are behaving with the same panic (justified or not) that we are seeing in stocks. That is when deflation hits.
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    The definition is wrong.

    While it does acknowledge money and credit supply, it ignores many areas of prices that are up (food and fuel prices are actually up on a year-over-year basis, not down. People who look at just the month-to-month numbers will necessarily be deceived as to what the long-term trend is).

    Second, there is nothing wrong with "gradual" deflation. We had it from 1800 to 1913. That is, the dollar was worth more at the end of this period than at the beginning. I guarantee you workers appreciated this. Bankers did not. During this time period the country did not lack for prosperity and attracted a massive wave of immigrants who came here to join in the prosperity and helped make the country even greater.

    What we are really witnessing now is a panic, not a straight-out deflation or inflation. Nevertheless, monetarily, I would argue we are still in inflation (and even better, stagflation), going by demand/ "zero maturity" money as a particularly important measure. This is the "money" that is accessible to regular people, and circulates in the real economy.

    Comparisons to 1929 fail on at least one key point: the US is a debtor nation now, not creditor. That means the dollar falls long-term as we cannot support our debt, and we "import" inflation -- regardless of what is happening with credit and money supply back at home.

    These conditions did not exist at the same time in the US until now, so comparisons to the Panic of 1873 or the Great Depression are missing a key element.

    A cynic might even suggest that the dollar has only rallied of late because arrangements have been put in place to allow foreigners to "launder" bad debt back into the US (some but not all of which was originated here), where the US authorities will then monetize it. This implies that the recent dollar rally will be coupled with a fall that is just as bad.
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    Eric Janszen also comments on this topic:

    http://www.itulip.com/forums/showthread.php?p=5...

    Also I should point out we are in negative real interest rates right now, which is inflationary. It is tough to keep commodities down with that kind of backdrop (yes, demand for commodities will fall, but supply also falls as production is cut back due to cost and financing pressures).

    I tend to agree more with Morgan on this issue. The long term trend for the real economy is stagflation. What I mean by "real economy" -- If we called every credit market or stock market decline a "deflation", would that really mean anything? Not really , because which market are you talking about? Further, what of people who aren't participating in these asset markets at all? For those that own no house and for whom expenses are more important than stock prices (or who own no stocks), this all doesn't feel very "deflationary" to them.

    Maybe we can agree that its 1930s for the bankers (and those with a lot of home equity), and 1970s for everyone else!
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    Your points are all valid and very well made. My only comment about them (and it is a small one) is that given the nature of deflation by the time year-to-year numbers are adjusted and appraised the deflation may already be well under way. As I said, this is a minor point and one that doesn't change the strength of your argument. I think deflation is a possible scenario not a guaranteed one. I certainly hope that you are right and I am wrong. For the record, I had the Cubs vs. the Angels in the World Series. I am beginning to suspect that it's not going to work out that way. ;)
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    Constantine,

    You make an error here that seems common in most analysis of the market corrections happening today. You assume deflation is a bad thing. It isn't. As a matter of fact, mild deflation, in the absence of government intervention, is the natural state of any economy. A stable currency implies just that. The amount of currency in circulation stays relatively unchanged while the amount of goods and services chased by said currency increase leading to a mild, but noticeable, deflation in asset prices as well as goods and services as the competition for the currency heats up. The type of deflation that the US experienced in the 1930's and today was specifically caused by the government's attempt to avoid the simple laws of supply and demand by creating more and more currency out of thin air in an effort to target the rate of inflation. Devaluation of the currency was caused by increasing levels of debt encouraged by the central bank(s) through the use of artificially low interest rates (would you loan money for 1% interest?)and by the government through overspending and overborrowing. This has led to unsustainable debt levels and misallocation of resources that must by liquidated. Demand for currency has increased, leading to deflating "asset" prices due to the fact that governements, companies, and individuals SPENT TOO MUCH AND THE BILLS ARE COMING DUE! It is that simple. Period. End of story. The longer government and central bank officials try to drag out or avoid the correction, the more painful it will be in the long run. This is not an issue of a "panic" causing "asset" values to fall below their fair value. This is an issue of "asset" values falling TO their fair value in terms of a highly demanded currency. The "rampaging deflation" should not be stopped. Instead, it should be allowed to happen as quickly as possible so the economy can get back on sound footing with lower spending, higher savings, and cash strong "fortress" companies (like Berkshire Hathaway) ready to move the US forward. Unfortunately, that is not what Congress and the Central Bank have decided to do. They have decided to create a hyperinflationary scenario in order to ateempt to avoid falling stock and house prices. It is likely these efforts will fail, the extra "liquidity" will get driven into commodities, purchases of real goods will accelerate and there will be food, fuel, and metals shortages on a worldwide basis. We will face, on a worldwide basis, the crack-up boom, as described by Ludwig von Mises, as paper currencies around the world get destroyed in an effort to capture as many physical natural resources as possible. It is likely we will see stagnant salaries, stagnant paper asset prices, stagnant housing prices, and skyrocketing physical asset prices (and costs of living). I hope to all the gods I'm wrong, because this will lead to resource wars in an effort to control oil fields, fresh water sources, uranium mines, gold stockpiles, productive farmland, etc, etc, etc, but, with the current crop of world "leaders," I don't see how it can be avoided.
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    All, this is my metaphor regarding the accuracy of "modern" economics.

    I guy by the name of Copernicus came of with a model of how the universe revolves around the Earth - this about the same state of development economic thoery is in.

    In geocentric models the spheres were most commonly arranged outwards from the centre in this order: the sphere of the Moon, the sphere of Mercury, the sphere of Venus, the sphere of the Sun, the sphere of Mars, the sphere of Jupiter, the sphere of Saturn, the starry firmament, and sometimes one or two additional spheres.
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    My 87 year old mother was a teenager. All she remembers is her father- who was a Newark, nj firefighter, got paid every other week. One week the firefighters were paid, the next week the police were paid. 2 weeks work, 1 week pay.
 

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