The Risk Of Deflation

When I was still a stockbroker in 2001 and early 2002, I used to warn some of our clients about the risks of deflation. Couldn't warn them all because most didn't understand, didn't care, or just didn't want to listen. But for those that wanted to hear me out, it was always a good conversation.

At the time, I was one of the few people (particularly in my company) that was even discussing deflation as a real possibility. Most economists and brokers just looked at it as some abstract theory or maybe that thing that Japan was dealing with. But the prevailing opinion was that the US would never suffer the wraths of deflation. Rule #1 to working in the financial industry: nothing is absolute.

So now, many of "experts" are now talking about the threat presented by deflation. They're all waxing concerned and expressing their grave fears for the economy, when in reality they are only concerned about their own personal economy.

It's already too late to take action to prevent a deflationary cycle if it's about to begin. To prevent deflation, spending would have to be encouraged. To encourage spending, interest rates would have to come down even more (tax cuts would also work, but in sufficient quantity, they may be a political non-starter). But a cut in interest rates takes at least 9 months, and usually more than a year, to filter through the economy to have an effect on spending. If the "experts" are now noticing the threat of deflation, we probably don't have a year.

So what is deflation and why is it so bad for the economy?

Deflation defined is a reduction in prices. If that's the case why is it so bad?

Individual price reductions are usually ok. They don't really make a whole lot of difference in the grand scheme of things and they generally don't change buying habits. The threat of deflation is that it affects the entire economy. As prices fall across the board, spending for all non-essential items basically stops.

Why? In a deflationary cycle, a dollar tomorrow is worth more than a dollar today, so they logical pressure is to save your money so that it goes further. If you can buy a refrigerator and a microwave tomorrow for the price of a refrigerator today, unless you absolutely have to have a new refrigerator why would you go out and buy one now? A widespread sense of deflation will basically halt spending in its tracks.

And once the spending stops it becomes very difficult to restart. Look at Japan as an example. Japan entered a deflationary cycle, spending stopped, interest rates were cut to basically 0, and yet they still can't break the cycle. More and more it is looking like Japan is going to have to engage in tax cuts and some massive, massive deficit spending simultaneously in order to resuscitate their economy. They have to create inflation in order to break the cycle of deflation.

They just have to use care to not overdo it and to create a cycle of hyperinflation. Trying to control an economy the size of Japan's with the tools available is like trying to hang a picture with a sledgehammer.

It just proves that no matter how economically "sophisticated" we get, we still can't wipe out the cyclical nature of the economy. There will always be ups and downs in every facet of the economy.

The balancing act required to keep an economy on course is incredibly delicate. From the end of the depression until the start of the bubble in the '90s we managed to keep things relatively in check. We never strayed too far from the long-term trend line. During the bubble years, things got out of whack and now we are paying the piper for our excesses.

When you hear the "experts" talking about keeping inflation under control, bear in mind that some inflation is good. A little inflation encourages us to spend our money now or to invest it in moneymakers so that it grows faster than it loses value. In other words, a little inflation encourages us to grow the economy. Deflation encourages us to shrink the economy.

A little inflation now and then is a good thing.