If you haven’t read my introduction to currencies you should go read that now. Really, I’ll wait. Now that you’re done, let’s talk about deflation. Most people hear the word deflation and panic because it sounds really darn scary.
Actually, deflation is neither good nor bad inherantly. The causes of deflation are the REAL problem. But I said I’d talk more about what deflation and inflation are. I decided to write two separate posts on them, starting with deflation as I believe that we are on our way into a deflationary cycle in the United States.
Supply and Demand – A Universal Truth?
I’m going to go out on a limb and guess that most of you understand the basics of supply and demand. If supply is constant, increased demand will increase prices. Decreased demand will decrease prices. If demand is constant, increased supply will decrease prices. Decreased supply will increase prices. Pretty straight forward!
Rudy’s Note: Yes, that’s simplified. No, supply or demand will generally not stay constant. The relationship is dynamic. Nonetheless, using this simplified example helps understand it!
Everyone understands that supply and demand works on goods and services we buy all the time. We see it in our daily lives on a regular basis. What many people don’t understand is that money is subject to supply and demand as well. I dabble in currency (Foreign Exchange or Forex) trading and grasping supply and demand as pertains to money is a key factor in successful forex trading. After just a short time you can look at a chart and see the powers of supply and demand at work on money just like it works on anything else.
This is important because the prices you see in the store are not only related to supply and demand for that individual item or service but also to supply and demand for money. Thus inflation and deflation are related to both types of supply and demand as they at their core relate directly to the general price index of goods and services in the economy at large.
Deflation vs Inflation
Everyone grasps what inflation is. You may know it as a cost of living increase, however. While I will have an article about inflation shortly that goes into more detail, inflation is simply a rise in price as pertains to goods and services. This is a generalized thing and is often tracked as the average cost of living increase.
Deflation is pretty much the opposite of inflation. It’s a general decrease in prices. There are a number of causes and effects of deflation which I will go into shortly. In the meantime, if you are eyeballing a $100 chain saw at Sears today, and next week it’s $80, that’s deflation. If instead it’s $120 next week, that’s inflation. Yes those numbers are unrealistic and arbitrary but you get my point.
This price reduction (aka price deflation) isn’t such a bad thing if it’s for individual goods and services, but it’s a darn bad thing when it touches the entire economy.
What causes deflation?
There are generally speaking two main causes to deflation. The first is a reduction of the supply of money or credit. Remember I talked about supply and demand working for money too? If the supply of money goes down, the VALUE of that money goes up. So even if the supply and demand for that chain saw remains the same, if the value of a dollar goes up due to lower supply, the price in dollars of that chain saw goes down. Deflated price.
Rudy’s Extra Tip: An easy rule of thumb is to recognize that in an deflationary environment your dollar will go farther the longer you hang onto it. In an inflationary environment the longer you hang onto that dollar the less it’s worth.
The other main cause of deflation is a reduction of economic expenditure. In other words, people stop spending money. Back to our supply and demand scenario, if fewer people want that chain saw the law of supply and demand forces that price down.
There is another cause of deflation that is often considered good: an increased supply of goods. If the chain saw factory has a breakthrough in efficiency and is able to make more chain saws than they normally would, then that will force the price down as well. This is often a good thing.
Rudy’s Mea Culpa: If you ask an economist they’ll tell you there are technically four causes of deflation: decreased supply of money, decreased demand for goods, increased demand of money, and increased supply of goods. I’m lumping the supply and demand changes of money together as they overall result in ‘tight money’ which means that people want more money than is available. No, I’m not an economist. I simplified on purpose! I hope you don’t mind too much.
What are the side effects of deflation?
Well, there’s one big one that might look a bit familiar. Sky rocketing unemployment numbers. If the deflationary cause is related to ‘tight money’ or a lack of economic demand for goods and services then businesses often are forced to reduce their workforce. This usually results in those now out of work folks spending significantly less. As the economy continues to contract and businesses continue to reduce their work force the problem compounds.
Add into that credit defaults, wage contraction (supply and demand works for wages too!) and even lower demand for goods and services. Resulting in more economic contraction and less free money being spent. You have the makings for an economic spiral which can lead to a major economic depression. NOT GOOD.
Woah. Going from deflation to depression?
Sorta. For a deflationary environment to broadly take over and potentially turn deflation into a depression the key factor that must historically be in place is what we call a credit bubble today. That basically means a big expansion in the amount of available credit. As the bubble gets bigger and bigger things look rosy and fantastic. Nobody expects default, lenders relax standards and lend to people who have no business with loans.
Pop goes the bubble!
When you have a credit bubble forming the signs are obvious. The cautious and smart economic thinkers will be able to see the signs clearly, but Joe Public usually doesn’t. Eventually something bad happens in the economy that sets it all off and starts the bubble popping.
Rudy’s Extra Tip: There are two kinds of credit. Self liquidating credit is something that is paid with interest in a short time. Something like a business loan, or an expansion loan, etc. This kind of loan usually adds value to the economy at large. Non self liquidating credit is your mortgage, car loan, etc. A loan that is there to acquire an asset or to speculate. Basically anything that isn’t tied to direct production of a good or service. When non self liquidating credit forms a bubble and pops, then deflation is FAR worse. Sound familiar?
The result of this economic death spiral is a recession or depression, formally known as an economic contraction. Bad news, Batman.
So what happens next?
The central bank steps in and adds more money to the economy. This must be done in an intelligent fashion though, which is the key problem. You can’t fire off a big stimulus package and increase government spending because that generally doesn’t hit the economy very well. On the other hand, sending out a stimulus check doesn’t work either because people will just hang onto it because they need it for debt or are worried about spending it. In any case, it doesn’t do much for the economy. It does start causing inflation though.
The key here is to direct that money towards productive uses. Underwriting self liquidating credit for example is a good one. Focus on enabling people to generate real value and production for the economy. Eventually if you inject enough money in the right way the spiral ends and things pick up.
Rudy’s Tip: If you have personal debt, get out as soon as you can. Deflation hurts particularly bad when you have personal debt. At very least get out of debt that carries variable interest rates.
The problem is that people often don’t do this the right way. Enter hyperinflation which I’ll talk about later this week.
See the parallels?
I’m guessing at this point I don’t have to lay it out for you. In this country we are in a deflationary spiral now which was caused by the credit bubble (NON self liquidating) popping. Resulting in high unemployment, credit defaults, and the vicious circle. We now have printing presses running overtime flooding the market with dollars. And we’re selling more and more government debt. Neither of which is doing anything at all to right the ship.
Right now cash is king. The problem is that this will eventually end and we’ll see inflation kick back in. I fear it will be a hyperinflationary environment. Yikes.