Tuesday, May 22, 2012

Beware the deflationary forces at work in the worldwide economy

I'm not an economist by training, but that won't keep me from advancing a hypothesis or two about the worldwide economy.

My main thesis is that there are signifcant deflationary forces at work today (mostly new in the last six months), which could have unexpected consequences in the months ahead.

Not all parts of any economy are deflationary. Some are inflationary. But it's important to recognize what the deflationary forces are.

Deflation is (colloquially, at least) a situation in which too little money is chasing too many goods. Ultimately this leads to a surplus of goods and lowered prices on them, with a corresponding strengthening of currencies.

One of the great examples of deflation cited in textbooks is the deflation that occurred from the period of 1870 to 1900 as the dramatic productivity gains of the Industrial Revolution (combined with relatively modest increases is wages) resulted in cheap goods with few buyers. I think we are living a replay of this situation today. Gains in computing power (with Moore's law) combined with the application of technology to production (resulting in historic high productivity), combined with the devaluing of ordinary items of consumption via competition on the Internet (e.g., Amazon), combined with declining earning power (in real terms) for most workers, has led to a phantom deflationary economy that runs in parallel with an inflationary economy. 

The evidence for deflation, today, comes from many sources.

1. Petroleum has been declining in price (significantly) recently.

2. Natural gas (a feedstock for plastics, as well as an energy source) is at historic low prices.

3. Base metals (steel, aluminum, copper, etc.) are sinking in price.

4. Precious metals have been on a downtrend since February 2012.

5. Soft commodities (e.g., agriculturals) have been on a steady decline since February.

6. There is a glut of unsold real estate in the U.S., depressing prices. In China, home prices have declined 15% or more in the past year.

Cash hoarding is known to be deflationary, and we have seen plenty of that, not only on the part of banks, but also the very wealthy, who have not been spending the majority of their cash (neither to create jobs, nor invest).

Participation in the stock market by individual investors has shrunk markedly over the past two years.

Unemployment has the effect of decreasing consumer spending. In the U.S., real unemployment (including the discouraged, and those who have left the workforce) is running around 15%. These are people who are barely spending any money.

The rate of new family formation (in the U.S.) is down substantially. This puts downward pressure on the housing market and leads to less spending, generally.

U.S. corporations are carrying record amounts of cash on their books. This is a form of cash hoarding.

Banks are not making as many loans as they used to. Again, cash hoarding.

Government austerity programs are aimed at cutting government spending, which is a form of cash conservation (hoarding).

Lately, because of the banking crisis in Europe, there has been a run on the U.S. dollar, increasing its relative value. This is delflationary in the sense that dollar-denominated assets are now dropping in price.

The short-term effects of deflation are positive for businesses whose margins are dramatically affected by raw-supply costs. If aluminum, steel, and rubber are cheap, car makers can enjoy increased margins. If restaurants see the cost of food go down, this means margins increase.

Longer-term, the effects of deflation are not so salutary. Inventories pile up. Consumers who are hoarding cash (or don't have much cash to begin with) will stop buying big-ticket items (houses, cars) and inventories of those items will increase.

Also, consumers will be less likely to buy items on credit, because if you take a loan out to buy a high-ticket item, you are promising to pay in future dollars that are worth more than current dollars. In essence, you are paying more for an item than the interest rate would indicate.

The Internet has been a huge deflationary influence. Think of all the items on Amazon that have been cut in price to a fraction of pre-Internet pricing. Multiply that by all the other companies on the Web who have been able to "eliminate the middleman," bringing you goods at historic low prices.

Where it gets complicated is in separating out deflationary aspects of the economy from inflationary aspects. This is no longer largely a goods-based economy. It's a service-based economy, more and more. And services are not going down in price. The prime example of this is health care costs. In the U.S., health care costs are one of the fastest rising cost centers in the economy. The same is true of the cost of higher education. Colleges have been increasing their tuition rates much faster than the overall rate of inflation.

Bottom line, not all aspects of the economy are experiencing deflation. Some aspects are experiencing significant inflation. Thus, the Consumer Price Index is positive, still. But it may not be, for long.

What does it all mean? You can probably expect that housing prices will stay low (given the huge amount of unsold inventory). Also, you can expect to buy a new car at a much lower price later this year than right now. The U.S. is on track to produce 15 million new vehicles in 2012, which is more than a 10 percent increase over last year. This will lead to a glut of unsold vehicles come late fall. If you're in the market for a new car, you'd be well advised to wait until late in the year to purchase a new car. Dealers will be overstocked and anxious to cut deals.

Ironically, this may be one of the best times in history for governments to print more money and boost inflation. Rather than encouraging austerity, governments should be spending more on social programs and paying for them with printed money that will be worth less in the future than now.

And the stock market? That's a complicated question. If there's a flight to the dollar, the dollar will increase in value and everything dollar-denominated (including U.S. stock prices) will inevitably go down, unless the Fed acts to increase the money supply. But to do that, they would practically be forced to charge negative interest rates to banks. That's never happened before.

The banking crisis in Europe is putting new focus on all these questions. Every Greek (and Spanish and Italian and Irish) citizen knows instinctively that cash is king. Local currencies could be devalued severely in any country that leaves the Eurozone.

Time to prepare for deflation. Not inflation. It requires quite a mind-shift. Are you thinking about it now?

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