Deflation – How It Can Exist Even As the Economy Recovers

Friday, August 13, 2010

Deflation is being presented as a force that trips up the economy. The simple reasoning: As prices fall, consumers and businesses postpone buying, thereby causing prices to fall further. Hence, a downward-spiraling cycle.

Like many of the negative forecasts we have read over the past months, this one is overly simplistic. It ignores two important, offsetting factors.

  • First – Deflation’s effects are not distributed equally throughout the economy. A good example is technology. We’ve been living with constant deflation – just wait until next year and see how much today’s prices will have dropped. Yet, it continues to be a growth area.
  • Second – Deflation also has positive drivers that can boost economic activity. These forces range from increasing “real” income to decreasing costs (of goods and capital) to making exports more price-competitive.

A good way to understand deflation’s occurrence and effects is to read a good business cycle book or two. One of my favorites is Business Cycles – Their Nature, Cause and Control by James Arthur Estey, PhD. (See information about the author and book at the end of this write-up.) Originally written in 1941 (followed by later editions), it includes a chapter, “The General Pattern of a Business Cycle,” that outlines the various stages of a cycle, both up and down. In “Revival Sets In” Estey describes the forces at work during the stage we currently are in (I have highlighted key passages):

“… the durable goods on which consumers have been coasting along are wearing out. Purchases can be delayed but become more and more urgent as time goes on. Clothes, furnishings, automobiles, and ultimately houses are wanted, and they furnish a backlog for future business activity. In industry, reserves for depreciation and obsolescence have been withheld from use under the stress of bad times and the excuse of little wear, but replacements cannot be indefinitely postponed. Even idle factories and equipment deteriorate and get out of date. So much is this so, that sudden bulges of demand may find industry scarcely equipped to take care of them. The mere presence of these potential needs weakens the forces of depression (*) and stagnation. As time passes, these needs become more insistent, likely to overcome greater and greater resistance and be responsive more readily to any favorable events.

“While this is going on, the cost-price relation tends to become more favorable. The lagging costs which pinch profits so badly at last begin to fall. The resistance of custom or law or organized groups seems gradually to weaken. Under the growing pressure of funds piled up in financial markets deprived of the ordinary commercial outlets, interest rates sink to low levels. Not only short-[term] rates but also long-[term] rates fall, with the accompanying rise in the value of first-class bonds. Long-[term] interest fixed by contract is brought down here and there by agreement, oftentimes by recapitalization or other financial reconstruction. Rents, insurance, and taxes become adjusted to the lower levels of output and prices. Wages under the harsh influence of unemployment eventually are compelled to come down, sometimes breaking rapidly to levels equivalent to the level of prices. With these direct reductions in labor cost, favorable changes in efficiency appear. The elimination of less effective labor and, possibly, the greater zeal of workmen anxious to hold their jobs tend to increase the output per [employee] and, along with the fall in wage rates, make for substantial reductions in labor cost. Indeed, it may be said that just as in expansion the general level of efficiency falls, so in depression it gradually rises. Not only the less efficient workers but also the less efficient plants and the less efficient managements are dropped, thus lowering the average cost of production.

Under the influence of all these changes, the margin of loss is reduced; in some quarters, under increase of demand and strengthening of prices, it may be replaced by profit. As this goes on, any quickening of business may readily start a substantial wave of recovery.

(*) At the time this book was written, “depression” was still used as the descriptor of the negative stage of the business cycle. Popular usage later shifted to using “recession” for all except the most severe periods.

So, where are we now? Actually, we are moving ahead as he describes. Corporate earnings are rising, business spending is up and productivity has been increasing. Interestingly, negative articles have just appeared because the increase in business spending is viewed only as catch-up (what Estey describes, above) and productivity, after rising steadily, slipped last month. Low interest rates have sparked mortgage refinancings and corporate bond issuance, each providing additional funds and/or reducing costs.

Can something go wrong? Yes, but the growth drivers don’t disappear. As Estey says,

“It is true that recovery may be delayed, despite these relatively favorable influences. Outside events of an unfavorable nature may come in to retard revival, or even to start off another and secondary depression…. The longer the revival is postponed, the more the favorable forces which we have described grow in power; and it would seem that in due time, perhaps with the aid of some “originating cause” from outside, they are bound to break through the weakening forces of depression and begin the phase of recovery.”

Don’t let the possibility of deflation put bonds into your portfolio

Remember that deflation is a risk, not a certainty. Another risk is inflation, and it remains the natural long-term result of the government’s significant “fiat money” (i.e., currency and debt) expansion. As Estey said above, all it takes is an economic strengthening (fast or slow) with increased profits to set off a “substantial wave of recovery.” And that return to normal will foster economic activity plus bank lending, building on the already large monetary base.

Ironically, this current deflation scare has set the stage for the Fed to delay adopting its inflation-fighting stance. More than ever, then, we must protect ourselves from the possibility of inflation-produced losses. The biggest ones will come from bonds with their potential double-whammy hit from purchasing power loss and interest rate rise (causing prices to decline).

So… Deflation, while a possibility, isn’t only a negative factor. It also provides some positive items for economic revival. Moreover, it is not a certain outcome – its counterpart, inflation, remains a real threat.

There is a short biography for James Arthur Estey at Purdue University’s website.

Business Cycles – Their Nature, Cause and Control (Prentice-Hall Inc., 1941) is available for reading on the HathiTrust Digital Library. The section described above starts on page 120. The book is out of print, but used copies are available at Amazon…

Amazon search for book

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