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Deflation Made Easy?


Talk of inflation one day and deflation the next. It is enough to make people's heads spin. The Fed is doing their part, to confuse that is. It is amazing to me when I talk to brokers and others who should know better that they are as mystified as anyone else as to what is actually going on.

Deflation is the hoarding of cash (money, credit, or anything else you can spend) by consumers or from another perspective, the lack of supply of cash if a government is constricting money supply. Just look at Japan which had (has?) deflation: the people there were (are?) afraid (for whatever reason) to spend their money. Deflation is met with a rising savings rate.

The U.S. does not (obviously) have any of these problems yet. Our consumers spend freely. Our government supplies freely. Other governments lend to us freely (at least for now). Our savings rate is negligible (pathetic). This is a "deflationary set-up".

A symptom of deflation is falling prices. People don't spend their money so prices in nominal terms do not rise. This is simple supply and demand (economics is simplified if you think of everything in this way).

Right now prices in the U.S. are not going down; they are going up, especially in commodity prices. The real problem right now is global overcapacity as other economies around the world have created it with years of free credit (fiat currencies) and high debt. Capacity utilization in the U.S. has hovered around a low 75% (it was 85% in the 90's) and only now gotten to 77% through this whole expansion.

What we really have right now because of this overcapacity is the inability for corporations to pass on increasing costs to consumers; they have a lack of pricing power. This is why it "feels" like deflation.

Sure U.S. companies are making money now, but that is only because we have been running a negative real interest rate policy for the longest period in history. Given the amount of stimulus, this is not impressive at all, and in fact, a little scary in my mind. We have been swimming downstream for a long time. Do you notice how tough it seems to be to make the turn?

The Fed has been astute in their ability to confuse because the only way to keep our heads above water is to print more and more money. So they talk about deflation from time to time. If they have to lower rates again (or try to) you will hear them talk about it again.

Someone asked me where the tipping point is, where and when do prices begin to drop and we enter into a deflationary spiral. I don't have the answer to that: it depends on the propensity for consumers to take on more and more debt.

As the government creates freer credit in an attempt to get consumers to spend more, which generates income, which is used to eventually pay down debt, the government first creates more debt. If the consumer is willing to take on this new debt, the economy is able to generate more income and eventually that debt and more is paid off. That is how it is supposed to work.

But suppose the consumer reaches a point where they are unwilling to take on more debt. Then this cycle breaks down. It takes more and more new debt to generate a dollar of income (I have talked about the fact that it takes three times as much new debt to generate income than it did fifteen years ago).

Consumers begin to hoard cash, the savings rate increases (perversely the last thing the Fed wants to see) and the velocity of money slows down.

The ever increasing supply of money is offset by this decline in the velocity of money. As income falls people actually start to sell assets to pay down debt; they have no choice. Asset prices begin to fall and real deflation begins. I believe (but it is more feel than anything) that we have been teetering at this point for some time.

As this cycle worsens the government will respond by printing more and more dollars (making credit easier and easier), but this won't help because the velocity of money will continue to fall. At the bottom of a deflationary cycle there is likely to be hyper-inflation as the "government begins to drop cash from helicopters".

Gold actually does very well in a "deflationary" environment: people will hoard gold just like they hoard cash. At the end of deflation there is likely to be hyper-inflation as the supply of money becomes irrationally high. The problem is that people don't spend the cash on investment, but rather on non-durable goods like food. Gold does especially well in an environment where all governments freely print currencies.

So when the Fed flip flops between talking about inflation and deflation, it is likely because they are frustrated that the economy is just not responding the way it should to easier credit.

But perhaps the economy is responding rationally. A cycle of ever increasing debt and credit and no end in sight to overcapacity at some point reduces the velocity of money (an increasing savings rate).

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