What’s So Bad About Deflation?

Jared Dillian |

When I was in junior high, my friend Scott had this Billy Crystal tape that we passed back and forth to each other. I still like Billy Crystal, but let’s just say he was truly hilarious when I was 13 back in 1987.

He had this routine about old codgers who used to tell you how hard life was in the old days.

“We had no air…” he’d say, in an old man voice. “No food. We ate wool coats and we were happy.”

Then he’d project into the future when he would be an old man, talking about what it was like in the Sixties, about Woodstock.

“We closed down the New York State Thruway, we were crazy… hippie… bastards.”

Battling Deflation at Any Cost

Today’s central banking world kind of feels like Woodstock to me. Lots of long hair, tie-dye, and perhaps a generous helping of body odor. Certainly hallucinogenics are involved.

Think about it. In the old days, as long as we could remember, the job of a central bank was to prevent inflation. Also, to promote economic growth and keep people in jobs, but they weren’t really serious about that. The only thing they were really serious about was preventing inflation—and sometimes they did a bad job anyway.

But around 1980, central banks got religious about inflation and started to do drastic things, like raising interest rates. It worked so well that every couple of years they would raise rates again. As a result, inflation went down over time, to the point where it became a negligible factor in economic decision-making, which was the whole point of the exercise.

Well, with price stability achieved, there wasn’t much left to do, but central bankers get paid too much money to sit around and stare at each other. And the one thing we learned over the last 20 years is that central bankers are only appreciated during a crisis, which is when they get to do stuff, whether it works or not.

So a new crisis was invented: deflation.

Now, you might ask why nobody thought of deflation as a threat before. There are several reasons, but principally, it hadn’t been around in a while until it reappeared in Japan.

The deflation in Japan was quite nasty. Everything was going in reverse. Not only was there deflation, but there were deflation expectations. People expected prices to go down, so they did. Wages went down, too, which sucks if you have a fixed mortgage or car payment.

In deflation, debt gets larger in real terms. But it’s great for savers. If you’ve got money in the bank earning 0% interest, but there’s 3% deflation, you’re actually doing pretty well.

This went on for years in Japan, and is still going on, although they are trying hard to get out of it.

I do find this sudden obsession with deflation peculiar. In the US, inflation has stayed positive except during the financial crisis. In Europe, it’s hovering around zero but is not really negative. There is plenty of inflation elsewhere in the world. And you can go into a spreadsheet program and see how 2% inflation compounds over time, and look at the loss of purchasing power, and you will realize that even low inflation can be quite sinister.

What’s Bad About Deflation?

But here’s the funny thing about Japan. Japan has probably had the biggest boom-bust cycle of any developed country in the modern era. The bubble was bigger than the dot-com bubble in the US in 2000, and the bear market continued for two whole decades. Plus, they’ve had years of this awful deflation, where it gets harder and harder to meet fixed debt service payments.

(Editor’s Note: We will be discussing Japan in some detail in a future issue of Bull’s Eye Investor. But don’t wait till then to join us. In the current issue, we have an in-depth analysis of why investing in airlines is the thing to do now, and a great pick of a hugely profitable airline with no debt and excellent earnings prospects. Click here to get it now.)

And yet, Japan remains one of the richest countries in the world, with a higher standard of living than just about anyone.

There are no shortages. They have plenty of food and fuel.

There have been no riots, no civil unrest.

Stocks were down 80%, but you didn’t hear anyone complaining.

So sure—deflation is annoying. And it’s not ideal. It’s not exactly price stability. But some things are worse.

So if you get too much deflation, you turn into Japan.

But if you get too much inflation, you turn into Weimar Germany, Zimbabwe, Argentina. People die in inflation.

I assure you that, given the choice, you would rather live in Japan than Argentina.

Asymmetrical Response

So the reason that central banks used to care more about inflation than deflation—and still should—is because high inflation has far worse consequences. Their approach to price stability should be asymmetrical.

Say there is 20% inflation. I need to buy some fertilizer for my lawn. I go to Lowe’s and get a bag of fertilizer, but I say to myself, “Wait, maybe I should get another one, because I’ll need it in a few months and the price will be higher. So maybe I should buy two.

“But wait—why don’t I buy all 20 bags of fertilizer sitting here, take them home, and when the price goes up, I’ll sell them to my neighbors?”

So I buy 20 bags of fertilizer and put them in my basement.

Then my neighbor goes to Lowe’s to buy fertilizer, but it’s gone, and the guy at Lowe’s tells him the jerk up the street bought it all. So now my neighbor is pretty angry at me.

There are a lot of angry people in inflation, and shortages of goods. One is related to the other.

Oddly, in deflation, everyone bands together.

Inflation Is Groovy, Man

Today, central bankers are trying to create inflation as fast as they can. It’s happening here in the US, in Europe, in Canada, now in China, even Australia.

They aren’t trying to create just a little inflation—they want above-trend inflation of 3%, 4%, maybe more. It’s like we have complete amnesia about how horrible it was in the Seventies. Nobody is asking the hard questions here. What if you succeed, but succeed too well? What if you can’t reverse it?

Just because we may be surrounded by deflationary forces doesn’t mean that QE isn’t a bad idea. Above all else, the central banks fear the “liquidity trap,” the point at which monetary policy no longer has any effect. They fear this more than anything.

I think one day, 20 or 30 years in the future, we will look back at this point in time and just shake our heads at what crazy hippie bastards we were, collectively. We will teach in freshman economics classes how we used to fight lower prices.

“Did you know there was a time,” the professor says,” when central banks were actually trying to create inflation?”

“Why would they do that?”

He shakes his head grimly. “Nobody knows.”

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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