Some Thoughts on Deflation

Posted By on July 24, 2010

By John Mauldin
July 24, 2010

 

The Elements of Deflation

Just as every school child knows that water is formed by the two elements of hydrogen and oxygen in a very simple combination we all know as H2O, so deflation has its own elements of composition. Let’s look at some of them (in no particular order).

First, there is excess production capacity. It is hard to have pricing power when your competition also has more capacity than he wants, so he prices his product as low as he can to make a profit, but also to get the sale. The world is awash in excess capacity now. Eventually we either grow the economy to utilize that capacity or it will be taken offline through bankruptcy, a reduction in capacity (as when businesses lay off employees), or businesses simply exiting their industries.

I could load the rest of the letter with charts showing how low world capacity utilization is, but let’s just take one graph, from the US. Notice that capacity utilization is roughly in an area that we associate with the bottom of past recessions (with one exception).

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Deflation is also associated with massive wealth destruction. The credit crisis certainly provided that element. Home prices have dropped in many nations all over the world, with some exceptions, like Canada and Australia. Trillions of dollars of “wealth” has evaporated, no longer available for use. Likewise, the bear market in equities in the developed world has wiped out trillions of dollars in valuation, resulting in rising savings rates as consumers, especially those close to a wanted retirement, try to repair their leaking balance sheets.

And while increased saving is good for an individual, it calls into play Keynes’ Paradox of Thrift. That is, while it is good for one person to save, when everyone does it, it decreases consumer spending. And decreased consumer spending (or decreased final demand, in economic terms) means less pricing power for companies and is yet another element of deflation.

Yet another element of deflation is the massive deleveraging that comes with a major credit crisis. Not only are consumers and businesses reducing their debt, banks are reducing their lending. Bank losses (at the last count I saw) are over $2 trillion and rising.

As an aside, the European bank stress tests were a joke. They assumed no sovereign debt default. Evidently the thought of Greece not paying its debt is just not in the realm of their thinking. There were other deficiencies as well, but that is the most glaring. European banks are still a concern unless the ECB goes ahead and buys all that sovereign debt from the banks, getting it off their balance sheets.

When the money supply is falling in tandem with a slowing velocity of money, that brings up serious deflationary issues. I have dealt with that in recent months, so I won’t bring it up again, but it is a significant element of deflation. And it is not just the US. Global real broad money growth is close to zero. Deflationary pressures are the norm in the developed world (except for Britain, where inflation is the issue).

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Falling home prices and a weak housing market are one more element of deflation. This is happening not just in the US, but also much of Europe is suffering a real estate crisis. Japan has seen its real estate market fall almost 90% in some cities, and that is part of the reason they have had 20 years with no job growth, and that the nominal GDP is where it was 17 years ago.

In the short run, reducing government spending (in the US at local, state, and federal levels) is deflationary in the short run. Martin Wolfe, in the Financial Times, wrote the following last week (arguing that that the move to “fiscal austerity” is ill-advised):

“We can see two huge threats in front of us. The first is the failure to recognize the strength of the deflationary pressures …  The danger that premature fiscal and monetary tightening will end up tipping the world economy back into recession is not small, even if the largest emerging countries should be well able to protect themselves. The second threat is failure to secure the medium-term structural shifts in fiscal positions, in management of the financial sector and in export-dependency, that are needed if a sustained and healthy global recovery is to occur.”

Finally, high and chronic unemployment is deflationary. It reduces final demand as people simply don’t have the money to buy things.

Deflation that comes from increased productivity is desirable. In the late 1800’s the US went through an almost 30-year period of deflation that saw massive improvements in agriculture (the McCormick reaper, etc.) and the ability of producers to get their products to markets through railroads. In fact, too many railroads were built and a number of the companies that built them collapsed. Just as we experienced with the fiber-optic cable build-out, there was soon too much railroad capacity, and freight prices fell. That was bad for the shareholders but good for consumers. It was a time of great economic growth.

But deflation that comes from a lack of pricing power and lower final demand is not good. It hurts the incomes of both employer and employee, and discourages entrepreneurs from increasing their production capacity, and thus employment.

That is why it will be important to watch the CPI numbers even more closely in the coming months. The trend, as noted above, is for lower inflation. If that continues, the Fed will act. I did a summary of Bernanke’s 2002 speech on deflation a few weeks ago. For those who didn’t read it, here is the link.

If the US gets into outright deflation, I expect the Fed to react by increasing their assets and by outright monetization, buying treasuries from insurance and other companies, as putting more money into banks when they are not lending does not seem to be helpful as far as deflation is concerned. More mortgages? Corporate debt? Moving out the yield curve? All are options the Fed will consider. We need to be paying attention.

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