The Independent Market Observer

1/10/13 – Inflation Part 2: Deflation Becomes the Problem

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jan 10, 2013 12:05:52 PM

and tagged Fiscal Cliff

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In part 1 of this post, I talked about what inflation is and how a moderate level has actually been good for the economy over the past couple of decades. That changed in 2008. Asset prices, particularly in housing, had inflated to an unsustainable level. The inflation measure the Federal Reserve (Fed) had been watching was based more on consumer consumption prices and less on asset prices. The asset price inflation got out of control and eventually collapsed. Because much of the financial system at that time was exposed to those asset prices, a financial crisis ensued.

We talked about how a small level of inflation appears to create wealth, as values increase while debt remains the same. When an economic shock like the financial crisis hits, however, the process goes into reverse. Incomes go down; asset values, such as home prices, go down; and demand goes down. Debt, however, remains the same, which exacerbates the impact.

In 2008, even as the values of many assets collapsed, debts owed against those assets remained at the same level. Debtors were stuck, and in order to pay off those loans, they sold what they could, not what they wanted to, which resulted in further price declines in other assets in a continuous downward spiral. Asset prices had inflated, but they were now deflating.

At the same time, companies cut costs wherever they could in order to free up cash to pay those debts. Business demand dropped, as did consumer demand as jobs and wages disappeared. Banks called in credit lines, canceled existing loans, and generally did their best to destroy as much purchasing power as they could.

Just as on the up cycle, when more dollars for the same amount of goods resulted in higher prices, fewer dollars resulted in lower prices, resulting in the risk of deflation.

Unlike inflation, which encourages people to spend now because their money will be worth less later, deflation encourages people not to spend, as their money will buy more later. Deflation also results in decreasing asset values, even as debt remains constant, and continuously destroys wealth—unlike inflation. The risk of deflation is that it results in a self-sustaining downward spiral, which is very difficult to break.

The Fed knows how to fix inflation: discourage spending and decrease demand by increasing the cost of money, known as interest rates. We have been through several of these cycles, and the mechanisms are well understood. Inflation is a problem with a solution.

No one knows how to fix deflation. Because the incentive is not to spend, and wealth is being destroyed, there is no simple solution. Cutting interest rates, making money cheaper, is the obvious answer, but as we have seen, that has not worked here in the U.S.—and it has not worked for the past 20 years in Japan either. The problem is likened to “pushing on a string.”

Because inflation has positive side effects at low levels, and because deflation is destructive and very difficult to fix, the Fed has been deliberately attempting to create inflation and avoid deflation. So far, they have not really succeeded, but the question is whether they will eventually and what that will mean if they do. The question is on everyone’s minds right now.

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