The Blessings of Deflation
Let’s say you set out on a Saturday shopping trip, drive up to the mall, and see a sign that says “50% off everything!” That’s great news, right?
Or let’s say you are in the market for a new car, and the sticker shock you experience is that cars are cheaper than they used to be. Amazing and wonderful!
Or let’s say you are paying for your daughter’s college education and find that you have set aside more money than is necessary because the price of tuition and books is lower than you expected. Glory be!
Or let’s look at it from the point of view of business. You are a manufacturer and your main expense is steel parts. After many years, even decades, of rising prices for ball bearings and other machine parts, your costs suddenly decline. The cost of replacing assets is dramatically reduced. That leaves more for investment, marketing, paying employees, and enticing investors with dividends. It is a win-win situation for everyone.
Deflation: Listening to Conventional Wisdom
So far, “deflation” seems like a glorious thing. But wait, says conventional wisdom. Consumers and businesses may benefit, sure, but what about sellers? They always desire the highest price possible for their products. If Dell had its way, every computer would cost $1 million, and they would certainly charge that if they could sell the same number of computers at this price as versus $1 thousand. By the same token, consumers want to pay exactly $0 for what they buy. It is the interplay between these two ideal worlds that yields the market price.
If businesses have been required by virtue of competitive pressure to sell at ever lower prices, how can they make a buck? By becoming more efficient. Anyone who has ever worked in a business knows that efficiency is something that businesses do when they have to. A monopolist is facing no competition (think of a government toll road) and so can charge high prices and maintain awful inefficiencies year after year. A business in a competitive environment cannot.
The computer industry itself provides the best illustration. Prices have plummeted even as sales have soared. Computer makers and retailers have profited handsomely. And this is not a unique case. The same has happened to appliances, which have gone down in price dramatically over the years even as sales have risen higher and higher. Why? Because the companies have gotten better and better at doing what they do, and have thereby been able to make profits even in the face of continual price declines.
Thus we see that there is no radical disconnect between the interest of consumers (who always want lower prices) and overall economic health. What’s good for consumers is good for everyone. You can only marvel at the many economists and commentators who try to convince the public that deflation is a very scary thing. In doing so, they enjoy the cachet associated with generating a counterintuitive conclusion, but in this case, it is simply wrong. The first intuition that bargains are a great thing is precisely the right one. In discerning economic theory, sometimes common sense turns out to be all you need.
Deflation: Money Growing More Valuable Is Bad?
And yet, many experts still say we should “worry about falling prices” because they represent a “destructive force” (according to Martin Wolk at MSNBC, for example). He explains as follows: “As prices keep going down, money grows more valuable.” So far so good!
But he goes on to say that this is actually a bad thing because it creates “an enormous disincentive for consumers and businesses to spend money. Economic activity slows, unemployment rises and demand continues to decline.” Well, but that presumes that consumers have something to gain by forever stocking up on dollars and never buying anything, which is absurd. It’s true that falling prices create incentives to save, but so long as the preference of consumers is to save instead of spend, that can only prepare the way for a future of economic growth. Consumers save for a reason, namely, to spend later.
Wolk’s next point concerns the implications of deflation for debt. Deflation makes it “far more difficult to pay back existing loans.” It’s true that loans are paid back in dollars that are more valuable than the ones borrowed. But that is part of the risk one takes when deciding to borrow in the first place. If we all had perfect foresight, our behavior would change substantially. But that is no case for pressing the pause button on economic affairs. What deflation does is provide a disincentive to borrow and an incentive to use current savings for purposes of investment. It means a reward for well-capitalized companies and individuals – a good thing all around.
Now we get to the crux of the matter: the Great Depression. The assumption is that falling prices somehow caused the economy to crumble. In fact, it was the after-effects of the boom combined with massive government intervention that caused the depression. The only silver lining in the entire period of the 1930s was precisely the falling prices that made the dollar count for more. Falling prices (a falling cost of living) are what Murray Rothbard has described as the “great advantage” of recessions. If you can imagine the Great Depression without falling prices, you have conjured up an image that is far worse than the reality.
Ask yourself whether during economic downturns, you want your money to grow or shrink in value? If your future job security is in doubt, do you want to pay more or less for goods? If your savings are meager, do you want them to have more or less purchasing power in the future? If you answer these questions rationally, you can see that deflation is wonderful for everyone, and the saving grace of a period of economic contraction. Throughout the 19th century, prices fell in periods of economic growth, which is precisely what one might expect. This is all to the good.
As Rothbard has said, “rather than a problem to be dreaded and combatted, falling prices through increased production is a wonderful long-run tendency of untrammelled capitalism. The trend of the Industrial Revolution in the West was falling prices, which spread an increased standard of living to every person; falling costs, which maintained general profitability of business; and stable monetary wage rates – which reflected steadily increasing real wages in terms of purchasing power. This is a process to be hailed and welcomed rather than to be stamped out.”
Deflation: Deflationary Recessions
If we must have recessions, make them deflationary recessions. What’s far worse is the phenomenon of the inflationary recession that Keynesians are always trying to foist upon us. For the same reason that deflation is a good thing, rising prices during a recession are the worst possible thing, because they provide a disincentive to save and invest for the future. They encourage present consumption and thereby gut the capital base necessary for future growth. They prolong suffering in every way.
Thus can we see that the widely-approved prescription to prevent deflation, namely inflation, is the worst possible path. But this is precisely what the Fed has endorsed as a matter of policy. It is hardly surprising that the central planners managing our lives would adopt the exact policy that will make us so much worse off.
Fortunately, the free market contains mechanisms that can work around attempts by the Fed to inflate. It could be that the banks have a hard time foisting new money on people and instead work to protect their balance sheets. Businesses too, stung by economic contraction, might avoid going further into debt, no matter how cheaply they may be able to borrow. In this case, prices could fall whether the Fed wants them to or not.
In economics, it is a good rule that what is good for individuals and families is also good for the economy. Everyone wants a bargain, which is to say a low price. Sadly, in our present age of inflation, lower prices mostly affect specific products and sectors. May the joy we take in falling prices for electronics be expanded to anything and everything we buy. Let the commentators fret and worry about what their fallacious macroeconomic models tell them. The rest of us can sit back and watch our standard of living rise and rise.
Sadly, I doubt we will see any deflation. Even based on the last ten years of data, overall price increases are still the norm.
In fact, since 1913 and the founding of the Fed, the dollar has lost 95 percent of its value. It is far more likely that this robbery will continue rather than for our lost purchasing power to be restored to its rightful owners: you and me.
for The Daily Reckoning
July 15, 2003
What can we tell you about this market that you don’t already know, dear reader?
U.S. bonds are so expensive; it is as if investors thought they were a no-lose proposition. So confident are they in the dollar, they are willing to lend at yields not seen since the Eisenhower administration.
There was a time, your editor recalls it, when investors thought lending to the government was a no-win situation. U.S. Treasury bonds were called “certificates of guaranteed confiscation” – an insight that might have come 20 years too early. Back then, inflation flared up so brightly, investors thought they would be consumed by it. The CPI was already rising at double-digit rates and investors saw no relief in sight. Had they looked around, they might have seen the towering figure of Paul Volcker with a cigar in his mouth and a firehose in his hands.
Now, by contrast, after 20 years of falling inflation, they see no danger. They should look around; now, instead of the firefighter Volcker, we have the pyromaniac Greenspan on the job, with a pack of matches! In the latest 3-week period, $100 billion has been added to M3. Greenspan adds dry tinder faster than anyone ever did…to a world stacked high with it already.
U.S. stocks, meanwhile, are almost as expensive as ever. The hundred largest Nasdaq companies are once again in the Land of Wishful Thinking. Putting them all together, they sell for 40 times the P/Es recorded at bear market lows. What could justify such prices?
But the Arizona Republic reports that even the tech sector, where most of those Nasdaq firms reside, is expected to shift more of its work overseas. It is one thing to export jobs from declining industries, but losing jobs from the nation’s leading growth industries has to provoke a fret or two.
Fretting is our business here at the Daily Reckoning. We fret that the present echo-bubble in the Nasdaq is going to end badly, like the last one. We fret that bonds are near a top – and about to be ruined by a conflagration of falling dollar and/or rising inflation. We fret that somewhere, somehow, sometime, someone is going to have to pay for all this debt Americans so happily built up. And we fret that the U.S. economy has been weakened by too much credit…too many dollars…too little savings…and too much foreign competition, at much lower labor rates, which our own free- spending ways have helped create.
Of course, many readers mistake this fretting for pessimism. But if we seem pessimistic, at least we have a saving grace: we are insincere about it. Sincere pessimism is a curse and a bore. Our pessimism is merely superficial, like too much make-up on a pretty girl. Hose us down and we are as fetching as any other market kibitzer.
Deep down, as we try to explain, we are profoundly optimistic.
Yes, the world is going to Hell in a handcart – but that is where it deserves to go. And were people not to get what they have coming, it would be a far, far darker world than the gloomy place we see.
Over to Eric Fry, our very cheerful, optimistic man-on-the- scene in Manhattan:
Eric Fry in New York…
– Will the indefatigable Mr. Market ever break a sweat? Will he ever pause to catch his breath? Or will he just keep racing tirelessly higher…until he races off a cliff?
– Yesterday, the fit and trim financial marvel scaled to new multi-month highs. The Nasdaq Composite rallied 1.2% to 1,755 – a fresh 15-month high. The Dow climbed 57 points to 9,177. What’s more, six of the Dow’s 30 components breached 52-week highs, including Intel, Citigroup, American Express and J.P. Morgan Chase.
– Curiously, Wall Street’s most severely earnings- challenged companies continue to lead the way. “The monster stock rally that has been underway for nine months is starting to take on a familiar look – maybe too familiar,” the Wall Street journal observes. “In a flashback to the days of Internet mania, stocks in money-losing companies again are doing better than those of profitable companies…Of 1,500 large, medium and small stocks tracked by Standard & Poor’s, the 195 that lost money over the past year are up 101% on average since October 9, while the 1,305 that made money are up an average of 42%…The entire Nasdaq 100 Index, which groups 100 of the biggest Nasdaq stocks, now sells for more than 240 times its companies’ earnings for the past year, according to market-research firm Byrini Associates. It trades for 38 times forecasts for its companies’ earnings next year.”
– Helpfully, the English language furnishes a word that aptly describes the stock market’s recent trading action. The word is “speculation.” The bullish contingent on Wall Street – which includes just about everyone – might scoff at the notion that speculation is driving share prices higher. But how else could one describe a stock market rally that propels the market’s least worthy stocks to triple-digit gains?
– “Sure, the Nasdaq 100 is selling for 240 times earnings,” the bulls would admit, “but that’s because the market is ‘looking forward’ to a robust earnings recovery.”
– We doubt that the market ever looks forward…or backwards or sideways. And we doubt it can anticipate the future any more reliably than a slice of rye toast. But just for kicks, let’s imagine that the market does gaze into the future and that it does know the unknowable well before any mere mortal can ascertain it. How far into the future can the market see? One day? One month? One year?
– If we did believe in the market’s ability to peer into the future, we might be comfortable with the notion that it could “see” into August or September. And on a clear day, perhaps, that the market could make out the faint financial profile of 2004. But a market selling for more than 200 times earnings is not merely peeking into next year, it must be looking ahead to the next decade. At 240 times earnings, the Nasdaq 100 is not clairvoyant; it’s delusional.
– Yesterday, the legions of speculating stock-buyers received a bit of hopeful news: a couple of big banks – Citigroup and Bank of America – earned more money last quarter than most folks, thanks to robust consumer lending. Citigroup’s earnings from consumer lending jumped 18% as its mortgage originations doubled to $23.5 billion. At Bank of America, the bank made a record $40 billion in new mortgage loans. Credit card income increased 23% to $762 million.
– Thanks to the lowest interest rates since the 1950s, financial companies from coast to coast have been enjoying boom-time conditions. Citigroup and Bank of America are merely two high-profile examples. Many of the lesser lights in the consumer-finance constellation are also basking in the warm glow of low interest rates.
– Unfortunately, the falling interest rate trend that enabled Citigroup and BAC to post some shareholder-pleasing earnings has been reversing with a vengeance. Yesterday, the 10-year Treasury note plummeted once again to drive its yield from 3.63% to 3.72%. That’s a quite a distance from the 3.08% yield it hit in early June.
– The new rising rate trend is driving a stake through the heart of the mortgage-refi boom – a phenomenon that has single-handedly supported the consumer spending that has single-handedly supported the U.S. economy. Mortgage originations have been tumbling for four straight weeks.
– As the refi boom dies, what new fuel will power the massive, consumer-dependent U.S. economy?
Bill Bonner, back in Paris…
*** Your editor’s 82-year old mother is a real optimist. Taking the train down to the country on Saturday, she got out her passport in case she was asked to prove that she was entitled to a Senior Discount.
*** Addison is back on the job. The French government decided that it was in the best interest of La Patrie for his wife to spend 6 days resting up at the hospital following the birth of his son, August.
Government knows best, of course…on both sides of the Atlantic. But on this side, people get much more rest. Your editor took yesterday off; he always stops his work to honor those who lose their heads in a moment of hysteria. For the headless aristocrats of the French Revolution, it may have been a far, far better place they went to than the one they left behind, but they were probably in no more hurry to get there than the rest of us.
*** America is, as everyone knows, the best place in the world to live…except for the food, the weather, the architecture, the traffic, and so on…
It is the richest country in the world, depending on how you measure it. And now that socialist materialism has triumphed everywhere, money is what seems to make the planet turn.
We note that Californians produce $26,570 of GDP per capita. Here in France, the total is just $22,700. But when you divide these totals by the number of hours worked, a strange thing happens; it is the French who begin to look wealthy.
The average salaryman in Frogland works only about 1500 hours per year. In America, the latest total we’ve seen is 1862. Unless we did the math wrong, the average Frenchman is more productive than the average Californian, by nearly a dollar an hour.
*** Speaking of the weather… Paris has become dreadfully hot. The temperature is supposed to shoot up to 100 today. — advertisement — It’s up 534% in the last 7 years, including 119%+ gains in the last 12 months alone. Yet chances are your broker doesn’t know about it.
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