Federal Reserve, Live and Learn

Deflation 101

Deflation is a lot like these party balloons…only the balloons are your house. Well, kind of. If the air inside them was money (equity), then it would be your house. Not to worry, though; your domicile will not begin imploding as markets deflate.

balloon

A great question about deflation was sent my way and I’ve decided to share it with the community:

Why is deflation so “feared” by the media/politicians? Isn’t it the natural reaction when an overheated market’s bubble bursts and there is a significant reduction in prices to consumers. It appears this is happening in everything from electronics to gas to housing, etc. Isn’t this actually “good” because it gets prices set in a better position in the markets. I understand it is painful for the companies that now have to adjust their business models for the new reality in markets and also to employees that feel the effect with reduced income and unemployment. The employees will then have an opportunity to become employed by firms who are successful in structuring to the proper business models. Also other firms will enter new markets as firms fail.

All of this is painful in the short term but seem to me to be healthy in the long-run.

What say you?

SwiftEconomics.com Response:

I think you have the right idea here. Technically the “long-run” is defined by a period of time greater than one year. There is no cap on the long-run. No matter the economic situation, it could be said that it will be sunshine and lollipops in the long-run…2 years, 5 years or 20 years down the line. Other components to the “long-run” include a period where all costs are variable. This means a firm has the ability to enter or exit any industry and wipe clean all fixed costs of land, labor, factories and other capital goods as economic conditions change. The long-run allows for firms to adjust and remain competitive.

With the right mix of circumstances, deflation could be good for an individual. If a person still has their job, the same level of pay, and doesn’t hold assets such as housing and stocks, all of the sudden their real income improves without an adverse effect on their net worth (if assets such as housing and stocks fall in value so, too, does a person’s net worth who owns them).

Most economists would tell you “disinflation” is significantly better than “deflation.” Disinflation is a reduction in the rate of inflation. For example, the consumer price index goes from 3% in the first quarter to 1.5% in the second, but prices are still increasing. This gets back into monetary policy. The Fed likes small and gradual moves of inflation and the current system allows this by steadily increasing the money supply. Inflation is what creates “wealth” for most of the economy, especially consumers who own nest egg houses, classic cars and the like. Anti-monetarists argue that this is phony wealth and simply creates a money bubble (food for thought: Warren Buffet said he thinks the next bubble will be in the dollar). The short-run pain feared by economists, the media and politicians are the millions of jobs lost due to the slowing of markets and reduction in prices. If real estate prices never go up (and go down in many cases) and a potential tenant’s income doesn’t, how many banks will give out commercial loans to build new projects? And if these are the same banks who are hoarding bailout money to weather their sinking balance sheets, how much money have they made available for lending? Yeah, gas is as cheap as it’s been since March 2005, but Americans are still driving 5-10% less year to date.

What you describe is most effective in pure capitalism where capital was designed to find its way into profitable industries and soundly managed firms with products and services people demanded. Creative destruction killed off poorly ran companies and uncompetitive or irrelevant industries. We definitely don’t have that. The Big 3 automakers want a bridge loan because economic times are difficult. They believe they are the foundation of American manufacturing, just about ready to turn the corner and too important to fail. They should fail. I’m supposed to be impressed because they have a fossil fuel-burning engine SUV that gets 24 mpg in the city and 30 on the highway. Wow. Even if their cars were on par with their Japanese and Korean competitors, they’ve been so underwhelming in comparison for so long that it would take years to overcome the perception gap.

Deflation is the response to contagions and ultimately brings prices down to their equilibrium. The housing supply is far too great. Houses have to come down in value. This returns markets to a sensible and real valuation but it also puts people out on the streets in the short-run and increases bankruptcy. Bankruptcy sure makes it hard for consumers to buy $35,000 cars off GM, Ford and Chrysler lots.

In the long-run, even the Detroit Lions are a playoff team.

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