It’s Deflation Not Inflation We Should Be Worried AboutSubmitted by Guidant Planning on July 28th, 2010
As economic troubles cascade from the largest corporate entity down to the single individual, people are quick to confront the well known dangers like inflation. However, an old threat is creeping out of the pages of our history books and re-inserting itself into the economic fabric of America: It is deflation. Lately, many articles have been written about the economy’s next foe, deflation. The recent cover story on The Economist makes it more or less official – Deflation, not inflation is now the greatest concern for the world economy. Over the past year prices have declined the world over, both in the producer’s price level and the consumer price index, enough that members of the Federal Reserve openly voiced concerns about deflation at their last meeting.
Let me paint a picture where prices of all goods and services just keep spiraling down. Your weekly grocery bill drops from $100 a week to $90 week, to $80 a week, the price for gasoline is only $1.50 a gallon, your accountant, lawyer, advisor, hair dresser (everyone) gladly lowers their prices 15-20%, just to keep your business. Sounds pretty good? There’s more. Vacations and trips you spent thousands for in previous years are now 30-40% less, the new Lexus you purchased last year cost $15,000 less for the exact same model. The value for your home reverses in price back to the 1980s. All of your worldly possessions are reduced by 15-30% across the board. That’s not all; employers cut employees salary (Not working? How about family, friends’ neighbors?) or fires them to reduce costs. Businesses respond to the current time, if prices are declining they will reduce output and employment. Why would any business invest in making something to sell if the price they get for it will drop? It get’s worst; consumers will hold back on buying for the same reason. The result is a downward spiral that can bring about a depression in a worst case scenario. Situations like these are already happening.
Individuals, businesses and cities (government) are scrambling to deal with deficits, unemployment and declining revenue. The knee-jerk reaction has been to jettison expenses; walk away from mortgages, close manufacturing plants, and fire employees. Let’s take a look at Maywood, CA as an example. They plan to disband (sounds like fire to me) all their employees. That’s right all, they plan to outsource all of the city’s functions. The point here is that this is a microcosm of deflation. The city must match its revenues (sales tax, property tax, fines, etc.) with its expenses to run the city. Cities are having to cut payments to their employees (disband, furlough, etc.) to bring the cost in line with the revenue. The result is lower pay which can be in the form of less income, less benefits, or both, it doesn’t matter. What does matter is that the employees are forced to accept lower compensation for the same functions performed previously. Of course they can quit, but with unemployment north of 10% that would be a big risk. On a larger scale, what will happen to the economy when the collective spending of all employees is reduced?
To date, none of these price declines have resembled the massive deflation that occurred during the Great Depression, but the fact that deflation has reared its ugly head is a concern. In fact, the 1930’s was the last time Americans experienced deflation, so let’s brush-up on that topic since it’s been 80 years since the last occurrence. Webster’s dictionary defines deflation as “a contraction in the volume of available money or credit that results in a general decline in prices.” Historically, inflation has been the economy’s enemy which the Federal Reserve has been continually battling with to ensure it doesn’t get out of hand. One of the biggest worries among economist is that fighting deflation is much tougher than dealing with inflation. The Federal Reserve charged with setting monetary policy has only three tools in its bag of tricks to deal with the US Financial system and economy; open market operations, the discount rate, and reserve requirement. The primary tool of the Fed is Open Market Operations where Federal Funds Rate is set and US Treasury and federal agency securities are purchased and sold. The current rate which is already near 0% (for almost 18 months) has had little effect to spur economic activity. One of the biggest problems is that banks are hoarding too much cash. Banks are required to keep a certain amount of cash for reserve requirements, but right now collectively banks have roughly $1 trillion in excess reserves. The primary driver is that banks are worried about the economy and the ability of borrowers to repay their loans. To further compound this problem the Fed pays banks 0.25% for the excess capital deposited at the Fed Reserve. Last year to discourage this type of hoarding the Swedish Central bank establish a negative interest rate on excess reserves, charging banks to keep excess cash. Some are encouraging our central bank to do the same.
Many economists argue the problem isn’t the lack of willingness of banks to lend, but the lack of demand for capital to invest in a weak economy. How many businesses are seeking capital to invest to expand production, hire new employees and create new products?
The consensus is the Fed will do everything in its power to avert deflation. That would probably mean printing money with abandon and finding ways to get it into the hands of businesses and consumers if banks can’t or won’t. Would a massive new stimulus plan, printing press binge cause significant inflation? Yes, that’s the point, the central bank would rather have inflation than deflation.
By Allen Yee