Wednesday, January 14, 2009

A Few Thoughts on Deflation

Inflation is familiar to most of us. Inflation tends to occur when the economy is growing. People demand things faster than the market can produce them. To some extent, production capacity grows; but to some extent, smart sellers keep supply a bit tight so they can justify charging more. If you really want the thing, and can't get it at your preferred price, you may be willing to pay a somewhat higher price. Deflation is less familiar. Deflation tends to occur when the economy is not growing or is actually shrinking. People don't demand so much in this case. Sellers still have to pay their bills, so they don't have much choice but to cut prices, in a bid to keep some dollars coming in the door. Now, unlike in an inflationary scenario, there's more stuff than anyone wants to buy; and in the "worst" case, people just plain lose interest in buying. It's really the opposite of the shop-'til-you-drop mindset of the inflationary situation; it's people who realize it makes sense to mind their money carefully, not waste it -- and hold off buying that thing for a little longer, because prices keep dropping. The inflationary scenario is good for people who have enough money but not enough stuff. The economy is growing, the money is there, not much to worry about, so just buy whatever you want (relatively speaking). It doesn't work for everyone, of course -- there are lots and lots of very poor people in this scenario -- but it works for enough people to set a general tone or expectation for what is economically normal or average. When that goes away, as is now happening, it feels like things are no longer normal. The deflationary scenario is good for people who have enough stuff but not enough money. They weren't really feeling a desperate need to acquire more crap right now, so it's OK to postpone purchases while prices drop; and they become more aware that jobs are endangered (because the economy is slowing down), such that they may not be able to get money when they really need it, sometime in the future. When growth continues, it encourages continued consumption. When it continues for long enough, the notion of saving and being cautious can seem quaint. People who learned hard lessons from the Great Depression were sometimes too fearful to take bold risks that could have really paid off financially in, say, the 1960s. But eventually those people passed from the scene -- retiring, dying, being muscled aside by their numerous Baby Boom progeny -- and their restraining hand was loosened. We went from fear of risks to payoffs for wise risks to acceptance of all kinds of risks. It would have been nice if we Boomers could have bottled some of that advice our parents were handing us in the 1960s and kept it, like a vintage wine, to be opened in the 1980s, when the Reagan Administration began dismantling Depression-era regulatory safeguards. So debt became normal -- not only for credit card users, but for financial institutions and government. They fed us tons of debt, in mortgages and cash advances and student loans and military adventures. Debt continues to be the answer, this late in the day, as government tries to employ FDR's Depression-era spending as an antidote to deflation. People in power want to return to "normalcy" -- that is, to an inflationary economy. They have not yet made the transition to realizing that consumers are broke, indebted, and scared. If you gave each American consumer $100,000 right now, there is a good chance that half of it (if not all of it) would go into savings, hiring a bankruptcy attorney, catching up on some bills, and otherwise trying to undo the personal exposure created by the inflationary years. That sort of behavior is not going to recreate a growth economy. It could lay the foundation for a solid, savings-based economy in coming decades, except for that debt problem. Unlike the 1930s, the amounts of individual, corporate, and governmental debt are simply beyond anything that a deflationary economy can pay off. Debts taken out with an expectation of an income of $60,000 look very different when that income drops to $25,000, or below, and many people will be unable to avoid that kind of drop as we continue to transition to a world in which American workers compete against Asian and robotic workers. The U.S. government can continue to spend borrowed money, as long as people continue to be willing to lend to it. There are recent signs that China may finally be starting to back off from that, though, and in any event they should do so if repayment becomes more doubtful. The present impression appears to be that today's deficit spending enhances tomorrow's inflation. So if the lending from China and elsewhere did get consumers spending again, it would be counterproductive for those investors in the sense that they would have helped to arrange a return to a growth economy with, it appears, some potential for high inflation -- which would erode the real value of their investments. In other words, they would have loaned us $1 billion (or whatever), and that would have helped a bit to get things going again, but now that $1 billion would have lost maybe 10% of its value because the dollars with which it is repaid are able to buy less than before. Given the rate at which the U.S. government is now spending money, it appears the next step will be for the spigot to be partly closed. If Obama stumbles and/or if the economy continues to unravel, confidence in the federal ability to repay borrowed money will decline, and the government will have to pay higher interest rates. Other borrowers will have to pay even higher rates if they are to stay competitive with the "safe" rate of interest being offered by investors in U.S. Treasury securities. This will make it harder for the economy to stay in a growth mode, because loans to companies will become more expensive. This all happened because we developed a financial system that was too complexly interwoven for anyone to understand or fix. And that happened because transparency and other regulated behaviors were shut down. The go-go economy that developed under such circumstances is not likely to be replicated under the more restrictive regulations that will be emerging in the coming year or two. The "Roaring Twenties" were a legend even into the 1960s. It increasingly appears that the twin bubbles of the dot-com era and the housing frenzy will stand out, for decades to come, as historically remarkable phenomena. I suspect that what Obama *will* say, in his inaugural address, is that we all need to hope and pitch in and make things better again -- and that what he *should* say is that we may very well be at the start of a second Great Depression, and the remedy is to take a lot of bitter medicine immediately if we don't want it to drag on for years. The bad financial instruments have to be mopped up, regulations must return, a calming social safety net needs to be put in place, financial blood must flow in the streets, and then he will have credibility. They will say he wasn't trying to make it look better than it is; he was just no-nonsense. We need a 5.5-month time-out for bad behavior, with the goal of making this July 4 a heartfelt rededication to a fiscally solid, sensible economy and government. That, I think, is the sort of thing that would make a sufficiently strong impression on where we are and where we are going. One part of that bitter medicine is to accept that retailing has changed. We can get there the fast way, maybe, or we can get there the slow way. The slow way may involve some years of getting used to the sight of boarded-up stores, to the point where old movie scenes of busy downtown business districts look strange and even unrealistic. Slowly, the stores will be converted or bulldozed, malls will become skating rinks and indoor jogging tracks, or in other ways the whole face of the retail world will change -- and that new world will seem normal.