When the elements of deflation combine in the right order, the central bank can print a boatload of money without bringing about inflation. And we may now be watching that combination come about.
~ John Mauldin
Update: This article was featured in the Canadian Personal Finance & Investing Carnival posted at Investing Thesis. Thank you!
I’m officially back from a 2-week vacation today, although I sort of cheated and put up a new post on Friday. It’s great to be back. I’d like to thank those who filled in for me with their thoughts and insights in my absence. In the meantime, however, the financial world went on without me while I caught up on some reading. I learned a lot as a result, and I’ll be sharing some of that with you over the coming weeks.
The inflation vs. deflation debate rages on, but for now, it looks like the deflationist camp has taken the lead. In the July 24th, 2010 edition of his Thoughts from the Frontline, John Mauldin listed a number of economic elements that can interact to create deflation. I thought we might look at how many of them are currently evident in the economy, or are showing signs they might pop some of the bubbles we’ve discussed recently.
Elements of Deflation
Hydrogen and oxygen combine to form water (H2O). According to Mr. Mauldin, the following economic elements can combine to to form deflation:
1. Excess Production Capacity
Put simply, production capacity is the amount of resources available to produce the products and services we require. Right now, we have more capacity than we can use. Global capacity utilization has fallen off dramatically and has yet to recover.
2. Massive Wealth Destruction
We have certainly seen a lot of wealth destruction in the form of falling home and stock prices. Deteriorating home prices mean that consumers can no longer tap the home equity ATM to fund their purchases. Declining stock markets mean that retirement savings have been depleted, forcing many to re-examine their financial plans.
3. Decreased Final Demand
The asset side of the consumer’s balance sheet has taken a massive hit while the liability side has simultaneously multiplied. This has only recently begun to lead to Keynes’ Paradox of Thrift. Consumers are beginning to save more in an effort to right their lopsided balance sheets. That’s great, but it means they will spend less, which will be a drag on the economy. It also means that companies will have less pricing power. They can’t raise prices on products for which demand is falling.
4. Massive Deleveraging
We have recently been (and arguably still are) in the throes of a major credit crisis. As a result, consumers and businesses are trying to reduce their debt levels and banks are pulling back on lending. According to Mr. Mauldin, bank losses are over $2 trillion and rising. Many banks still hold toxic assets which have not been marked to market and are therefore worth much less than the value implied on the banks’ balance sheets, if they show up there at all.
5. Money Supply Falls While Velocity of Money Slows
The growth of the money supply globally is “close to zero”. In addition, the volume of money that central banks have pumped into the system is not moving. Banks and corporations are hoarding cash in fear of another credit crunch. As long as the velocity of money stagnates, the economy will too.
6. Falling Home Prices
The housing markets in the U.S., Europe, and Japan have fallen considerably and remain weak. “Japan has seen its real estate market fall almost 90% in some cities, and that is part of the reason they have had 20 years with no job growth, and that the nominal GDP is where it was 17 years ago.” Is it really so inconceivable to think that Western nations could be headed down the same path?
7. Reduced Government Spending
We have yet to see this in many countries so far, but there certainly is a push from the austerity camp to cease and desist with ineffective stimulus programs and concentrate on paying down debt and balancing budgets. Many states in the U.S. have been forced to cut spending as they have completely run out of money and are not able to print it like the Federal government can. If the Feds ride to the rescue with aid to the states, that certainly won’t qualify them to sit in the “reduced government spending” section.
Having said that, if governments do decide, by choice or by necessity, to curb spending, that would indeed be deflationary. One could easily argue that global government spending programs are the single largest reason the financial system did not completely melt down in 2008 – 2009. Absent that boost, many global economies could easily slip back into recession.
8. Chronic High Unemployment
This factor contributes to deflation by reducing final demand. Consumers without jobs consume less. That in turn erodes pricing power for producers and can lead to further increases in unemployment as businesses cut back on labour to match decreased demand. Chronic high unemployment is certainly evident in the U.S. and if deflation takes hold globally, it will rise in other locales as well.
So it seems that most, if not all, of these elements of deflation are either already present or showing signs of emerging in the near future. What should we do about it? According to the work of Rogoff and Reinhart, “economies are more fragile and volatile and . . . recessions are more frequent after a credit crisis. Further, spending cuts are better than tax increases at improving the health of an economy after a credit crisis.”
We have seen both fragility and volatility in the financial markets over the past couple of years. The elements of deflation are there. It remains to be seen whether or not they will meld to form a full-blown deflationary environment.
Are you seeing these elements of deflation where you live?
Will the deflation be good or bad? As a holder of debt, I would be personally inclined to say bad, but on an overall level, it would certainly be good if we required a lot less debt in our day to day living. It’s gotten ridiculous how people need to take a mortgage for 5-6x or more of their income simply to have a place to live.
As for “Excess Production Capacity”, I don’t believe there’s such a thing (lots of production means more goods for society), but there can be “Malinvested production capacity”. Prices of housing in the US was too high for too long, which drove too many resources into lumber and the like. Now all of that is sitting idle, but for good reason…
A little deflation is not a terrible thing. What economists (and central bankers) fear is a deflationary spiral, where prices just keep falling. That’s not good for anyone.
Lumber mills sitting idle are one good example of excess capacity. So are the auto plants that have been closed and are not yet being used for some other purpose.
Thanks for your comment.
Hi, another great piece by one of the sharpest people out here in the financial blogosphere.
This is an important subject, and I thought I’d offer some ideas that are off the well-worn (and worn out) path.
There’s nothing wrong with deflation. Deflation is simply the market for goods and services trying to re-establish some sort of rational pricing for itself. That is nothing to fear.
Falling prices also doesn’t hurt economic performance. In fact, falling prices are a good thing, which we’ve been fortunate to experience through most of our nation’s history. We need it for the next boom.
Deflation increases our standard of living, while inflation erodes it. Isn’t this obvious? Do you want to pay more or less for your house or your car?
It’s inflation that’s the scourge. Inflation eats away at the value of you capitol, and causes people, looking for relief from the erosion of their buying power, to risk their money by speculating in financial markets. This is not a healthy thing (though Wall Street, and those in it’s pockets, would like you to think otherwise.)
The only reason people think of deflation as the boogyman is because some misguided economists (like out past and present Fed chairmen, and others) say it is. Why would you listen to these guys? These are the same people who said there was no bubble in the first place. And now they want to do everything possible to re-inflate it. That’s like trying to put out the fire in your kitchen by throwing gasoline on it. Silly.
Deflation must and will occur. It could have happened quickly, and been done, but, noooooo. Now, thanks to some monumental meddling by the government and the Fed, it will be probably be long and slow, like Japan.
As Pete Seeger wrote so many years ago: When will they ever learn?
I love your fire in the kitchen analogy! I’ve often said that you can’t solve a debt crisis with more debt and throwing gasoline on a fire is a good metaphor for that. I agree that Greenspan and company made some serious mistakes by allowing asset inflation and deregulation to get out of hand and preventing the free market from correcting imbalances as it should.
I also agree that we are at serious risk of a Japanese-style contraction. I hope I’m wrong on that, as it would prove devastating to the legions of investors who have listened to the long-only, long-always crowd over the past few years. Can you imagine what would happen if the S&P 500 went down 70% and stayed there for 20 years as the Nikkei has done?
Thanks very much for your comments!
Yes, those massive, prolonged deflationary periods are certainly the bigger concern. One thing that particularly sucks is that the asset classes drop in tandem, and decline in one can precipitate further declines in others.
It sounds like you believe we are really on the verge. What do you think is the biggest threat that could push us over the edge?
Looking at the futures this morning, it feels like we’re on the verge, but we’ve kicked this can down the road for many years now, and there’s nothing to say that central banks couldn’t come in with some “rescue” package that scares the shorts and provides a temporary boost to the markets. The options for rescue, however, are pretty thin now as most of them have already been spent with nothing to show for it but more debt.
I wouldn’t presume to know when or if this Japanese scenario might unfold, but there are enough warning flags out there that I don’t want my money at risk if it does. If it doesn’t happen, I’ve made a little in my savings account and maybe lost out on some dividend payments or capital gains. If it does happen, I’ve sheltered our savings and got a lot of dry powder to use later. In the meantime all of our extra savings is going to pay down the mortgage.
Thanks for stopping by!
Nice article! I agree that a little deflation is okay. The trouble is, as Shawn alluded to, once the ball starts heading downhill, it is often tough to stop it. Banks greatly reduce the amount of money they lend – which keeps businesses from expanding. Layoffs ensue and unemployment increases. People refuse to spend money – or risk investing it – because prices will be lower next month and besides, they can earn more by keeping it in a shoe box under the bed.
It is a very slippery slope. People need to be careful what they wish for.
All the best,
Len
Len Penzo dot Com
Thanks Len. Since most of this information came from John Mauldin, I’ll paraphrase him again: I’ve often heard him recount a conversation he had with Paul McCulley of Pimco in which John asked if Paul wasn’t a bit worried about inflation with the way the Fed was pursuing quantitative easing. McCulley replied: “You better hope they can cause some inflation.”
I have also reduced my stock holdings in anticipation of a quick drop in the markets. GICs help me get a good night’s sleep!
I like GICs too. They don’t have the capital risk that a bond fund has. I wonder what type of equity holdings you are maintaining? Are you keeping pretty diversified, or do you have a focus on defensive names and dividend-payers?
I’ve been thinking about taking up a small position in utilities on the next downdraft. So far, I’m considering Emera, Canadian Utilities or Fortis. In pipelines, I’m looking at TransCanada vs. Enbridge.
Any thoughts or recommendations are welcome!
It’s interesting reading how deflation seems to be so feared. While not a good thing, it’s the only healthy way back from a giant inflationary bubble, like we experienced.
Austrian economics tells us that deflation is nothing to be feared, and that the idea of a disastrous inflationary spiral is a myth. I know this isn’t the prevailing viewpoint, however, you have to admit that the non-Austrians have a pretty lousy record of predicting things
)
A few years ago there was a study that seems to corroborate the Austrian idea. It’s very interesting, and you might want to take a look.
http://mises.org/daily/1583
The danger is that the government/Fed inflates the money supply at such a rapid rate that we’re never able to garner the benefits of the deflationary cycle. That will be the worst of all worlds, and seems to be where we’re going.
Thanks for a fun discussion.
Marc
Thanks for the link Marc. I’ll check it out. I only have a basic understanding of the Austrian school, but I do know that Paul Krugman isn’t a member.
The Keynesians (like Krugman) have been in charge for quite a while now and have been warning that if we don’t continue to spend we will have another Great Depression. It’s funny because it seems to me that if we do continue to spend money we don’t have, we’ll have a depression anyway. If we had only allowed normal recessions to proceed as they should, we might not be in this pickle.
This has been an interesting discussion, hasn’t it? Thanks to all of you for participating!