Wikinvest Wire

Deflation worries from coast to coast

Sunday, November 02, 2008

They are awfully worried about deflation these days - from coast to coast. Both the New York Times and the Los Angeles Times have run stories in recent days warning about the danger of falling prices:

Ominously, the world's most popular doomsayer, Nouriel Roubini, is quoted in both.

It's as if the whole world is about to fall into some sort of a deflation vortex where we will all be transported back into a black-and-white 1930s breadline if prices fall.

Maybe we will. From the left coast, Tom Petruno writes:
Investors are constantly reminded to think about inflation when making decisions about their money.

Now there's a new wrinkle: the possibility of deflation. We've already had severe deflation -- falling prices -- in housing, stocks and commodities this year.

The question is whether that could spill into prices of goods and services across the board, as well as into wages, as the economy worsens.
Declining inflation is good for the economy, and consumers, in the long run. And in some businesses, such as tech, prices are always falling.

But if the CPI were to go negative for an extended period, that would signal that a potentially dangerous deflation had kicked in. It would suggest that demand was so weak that companies were slashing prices to a level that would gut their earnings, in turn fueling massive layoffs and wage cuts.

Could it happen?

Tom Higgins, chief economist at investment firm Payden & Rygel in L.A., isn't predicting a drop in the CPI in 2009. But he believes the risk of outright deflation is higher today than it was in 2002-03, the last time there was serious talk about a broad-based decline in prices taking hold.

Because the double whammy of falling home values and plummeting stock prices over the last year has sharply eroded many people's net worth, "I'd be much more worried about deflation today than in 2003," Higgins said.
It never ceases to amaze me how so many writers and economists place so much emphasis on the government's dubious consumer price index, extrapolating from that severely flawed representation of prices to predict all sorts of possible futures.

As noted here many times before, if you put home prices back in the inflation measure instead of the nefarious "owners' equivalent rent", you could argue that we've had deflation even with soaring energy prices for the better part of the last year.
IMAGESubstituting a severely flawed and much maligned proxy for the biggest single component of the consumer price index will surely come to be recognized as one of the worst transgressions by economists in the post-war era.

It reduces talk of CPI "deflation" to something that is almost nonsensical, but the talk continues nonetheless.

In the New York Times, Peter Goodman notes:
As dozens of countries slip deeper into financial distress, a new threat may be gathering force within the American economy — the prospect that goods will pile up waiting for buyers and prices will fall, suffocating fresh investment and worsening joblessness for months or even years.

The word for this is deflation, or declining prices, a term that gives economists chills.

Deflation accompanied the Depression of the 1930s. Persistently falling prices also were at the heart of Japan’s so-called lost decade after the catastrophic collapse of its real estate bubble at the end of the 1980s — a period in which some experts now find parallels to the American predicament.
Through much of the 1990s, prices for property and many goods kept falling in Japan. As layoffs increased and purchasing power declined, prices fell lower still, in a downward spiral of diminishing fortunes. Some fear the American economy could be sinking toward a similar fate, if a recession is deep and prolonged, as consumers lose spending power just as much of Europe, Asia and Latin America succumb to a slowdown.

“That’s a meaningful risk at this point,” said Nouriel Roubini, an economist at New York University’s Stern School of Business, who forecast the financial crisis well in advance and has been warning of deflation for months. “We could get into a vicious circle of deepening malaise.”

Most economists — Mr. Roubini and Mr. Barbera included — say American policy makers have tools to avert the sort of deflationary black hole that captured Japan. Deflation fears last broke out in the United States in 2003, but the Federal Reserve defeated the menace with low interest rates that kept the economy growing. This time, the Fed is again being aggressive, dropping its target rate to 1 percent this week. And the government’s various bailout plans have also pumped money into the economy.

“If you print enough money, you can create inflation,” said Kenneth S. Rogoff, a former chief economist at the International Monetary Fund and now a professor at Harvard.
Dr. Rogoff's thesis is now being put to the test.

They say that "persistently falling prices" were at the heart of the worst economic contractions of the last century, but is that really true?

Isn't it interesting to note that all prior bouts of feared or realized deflation came after the bursting of massive asset bubbles - the U.S. in the 1930s, Japan in the 1990s, the U.S. again in 2003, and the entire world today?

Deflation is not to be feared - bursting asset bubbles are.


This week's cartoon from The Economist:
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little larry sellers said...

I really don't understand these deflation concerns at all unless they are some sort of propaganda attempt to make people feel safe with cash. We've managed to create trillions of dollars out of thin air, everybody is getting bailed out with massive cash injections and we have a Federal Reserve and government that think the printing press is the answer to every problem. I've heard recent quotes of the entire credit and housing crunch costing something in the neighborhood of 55 trillion USD.

I mean, doesn't that strike anyone as just a little inflationary? The only way out of this debt is to print the money to pay for it, especially since foreigners are finally realizing we haven't the slightest desire or ability to pay back the debt we already owe them.

And once the dollar loses its role as reserve currency... I don't even want to think about that. It will be, as the joke goes, getting Weimar in here.

barnaby33 said...

The trick with beleiving in an inflationary bout is not that you think the govt won't try to print, but that it will FAIL to do so successfully. Printing by itself isn't inflationary, you've got to get that money out into the economy. What the Fed is suffering from right now is a classic liquidity trap. It lowers interst rates but banks hoard cash, hence its primary money transmission mechanism is broken.

The only way to fix that is to restore transparency, also known as trust, to the system. The problem is that has all sorts of unpleasant corollary effects. These are exactly what the Fed has fought a viciously socialist rear guard action to stop.

barnaby33 said...

Oops I meant deflationary bout, d'oh.

douglas tuttle said...

On the other hand world net worth has dropped $29T during this crisis, so far. The US has "printed" about $2T, Europe about the same and kick in another $2T for everyone else.

That's a total of $6T. Actually a lot of that it is borrowed against reserves abd savings, so wasn't printed per se.

When we compare that to $29T of losses, we need to remember many of those losses were fictional; i.e., taken against unrealized or non-monetized gains.

Regardless, we are destroying it faster than we're printing it, which his why people are talking about deflation. Once this decline has abated, however, what will all that money go looking for?

Anonymous said...

Dr. Hamilton pretty much put this one to rest, in my opinion:

little woman said...

we've had massive asset price inflation for the past 5+ years. what's wrong with deflation correcting that?

Anonymous said...

"Once this decline has abated, however, what will all that money go looking for?"

This thumping of everything against dollar and yen is going to create shortages in things with real supply deficits - likely food and energy first. That is where the new money will go to - huge new carry trade. I think it is higly probable that Asian dollar reserves will be spent on huge public works projects very soon. If so, we are in the midst of the mother of all commodity whipsaw trades.

Tom said...

Remember that Japan had interest rates below 1%. Once the government intervened in the banking industry there, the economy improved significantly. That's why they have been the lest effected by recent woes. I found some good information on this at

Mathlete said...

Just remember your Depression history. Hoover refused to let wages fall. FDR continued the policy and added farm goods, among other things...recall the dumping of milk into rivers to prop up prices. The problem wasn't that prices fell, it was that some prices fell and others were propped up by the government, creating massive supply/demand imbalances. Let all prices fall and this problem is eliminated.

Sing Expat said...

It is appalling that the media, politicians, and even economists have come to accept price inflation as normal. God save us from declining prices! So instead, we get rising prices and stagnant real wages, leading sheeple to seek wealth through speculative bubbles instead of production.

I, and many others, are happy to see deflation. I have been a prudent saver. Now I will be able to acquire assets like a house and cars for less than last year. And with any luck, other consumer items will fall in price.

Basic economics tells us that increased production should lower the cost of goods and services. So, why is deflation bad!

Suck it, inflationistas!

Anonymous said...

Inflationistas aren't cheering for loss of value. Most of us are just confident in the government's ability to devalue currency.

Evan said...

I'm with Sing, if you hold no debt and hold cash, there's nothing wrong with deflation. About damn time prices besides gasoline start falling. I'm irritated that everybody's so happy when gasoline falls in price, but nothing else does. I don't eat gas for dinner, I eat food which I realize takes gas to make but I don't see food prices dropping 25% across the board in 3 months like gas did.

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