Posted by: distributorcap | December 16, 2008

The Deflationary Dance Begins

Today the Bureau of Labor Statistics (BLS) announced that the inflation rate for November was negative 1.7%. In other words, the prior month saw the prices for goods and services decline from the previous period. This is the biggest drop in prices since the BLS began keeping records in 1947 and much higher than economists had predicted.

In recent months, prices for commodities have been plunging, causing a decrease in the costs of consumer goods. Energy prices dropped 17%, the most since 1957. Retailers, who have been slashing prices to generate revenue and traffic – still suffered a decline for the fifth consecutive month. Automobiles, airline tickets, other transportation modes and clothing – all down. Food and medicine were up ever so slightly.

In the coming year, consumer prices on basic goods are projected to rise just 0.7%, the lowest amount since the 1960’s. Yields on 10 year bonds (or notes) – which reflect lending levels and are related to price, interest rates etc. hit their lowest levels since 1962. Why aren’t we cheering? Aren’t lower prices good for us?

For over 35 years we have been told how awful and detrimental inflation is. In the mid 1970’s, Nixon imposed price controls when inflation began to ramp up due to skyrocketing oil prices. Carter’s handling of the two-headed hydra of double digit inflation and interest rates was a primary factor in his 1980 defeat. More recently, Alan Greenspan during his tenure at the Fed constantly harped on controlling inflation.

But the fact is deflation can actually be a lot worse and more damaging than inflation. Just talk to any Japanese businessman.

Deflation is when prices decline for a sustained period of time. Deflation means prices are declining due to less demand, less lending and less money being transacted through the economy. The Depression of the 1930’s is associated with an extended deflationary period.

What happens during deflation? With prices dropping, consumers have an incentive to delay purchases until they fall even further. This in turn reduces demand, which in turn lessens economic activity which can cause prices to fall even further. Businesses start to realize that they cannot make any money no matter how low the prices go – so they began to cut back or stop producing. With business activity plunging, investment stops. Interest rates drop in the hope of spurring economic activity. But with rates of return close to zero – or negative – all of a sudden hoarding cash becomes a better investment – the money you have now will buy more tomorrow. This is known as a deflationary spiral.

If this is where we are heading (which I think is quite obvious) – this is not good. Not only is there less money being circulated into the economy, but when prices are declining, the people who borrowed soon find out the amount they took out as a loan is more than the value of the asset(s) purchased – aka negative amortization – this is VERY bad. Let’s say you had a 0% mortgage – when home prices are declining say 5% – you are actually paying the bank back in dollars worth 5% more each year, for an asset that is worth even less – it is double death spiral for the homeowner. Add to it the fact when the debt is more than the value of underlying asset, the psychological damage is severe. For most people their home (and 401K) is their biggest asset. As people start to feel they are going broke and/or losing their life savings, fear takes over as the economic decision maker – in other words they stop spending.

When an economy (like the US) is 70% based on consumer spending – no consumer spending means no fancy lunches at Le Bernardin or $250 bottles of Dom Perignon for Wall St execs.

The same goes for businesses – why borrow to grow when the assets you use to produce and sell are going to be worth less tomorrow? Lunch at McDonald’s for the vendors.

Deflation also hurts (or rather kilils) spending. As I stated above – why buy now if you think prices will drop tomorrow? With low or zero interest rates – keeping cash looks a lot more appealing than putting it in an investment that potentially could go bust. Or in a bank that could shut their doors. This is what started the runs on the banks in the early part of the Depression. The FDIC protects your money from being lost from a defunct bank, but it does not stop it from gaining more value in a Sealy Posturepedic mattress.

Isn’t the deflationary spiral fun?

When you combine the deflationary spiral with cash hoarding you are possibly entering a new Twilight Zone – the dreaded liquidity trap. This is when the actual interest rates are zero or close to zero – and the central bank (the Fed in our case) cannot stimulate the economy by cutting interest rates any more. Since the goal of lowering interest rates is to put more money in the system (and generate activity), the Fed has to come up with other methods to inject liquidity. Injecting cash into banks is one way, but as we have seen in the past 3 months – the risk may be so high and rewards to low – that even banks won’t lend the money given to them by the Fed. No money-no credit, no credit-no buying, no buying-no jobs, no jobs-Bushvilles. You get the picture.

And don’t forget, before the US economy cratered (due in large part to greed, cheating and non-regulation as well as productivity gains, outsourcing and wealth concentration and other reasons) – the low interest rates that were being set by the Fed (under Alan Greenspan) to keep the economy humming along was producing greater demand (like it was supposed to) — but it also generated a boatload of debt accumulation to purchase assets (and a lot of Chinese crap) with that demand. This was Greenspan’s upward spiral. Only he and every other economist closed their eyes for so long to the misdeeds and missteps going on – they refused to believe what goes up must come down. When the walls came tumbling down, we were left with over-capacity, over-supply, declining prices AND a ton of debt. There is no worse combination — deflation with debt. This is a death spiral better than any Russian figure skating pair could accomplish. Inflation all of a sudden is the life preserver we need.

What can be done? As many economists have stated – the only institution large and strong and credible enough to get the economy rebooted is the US government. The central bank needs to increase the money supply – and what means are left are purchase assets and/or print money. When deflation takes hold – you do not have to worry about the inflationary aspects of printing money.

Deflation is very hard to control and an even tougher cycle to break. Deflation is also not spread evenly over the economy. No one will see the prices of the NYC subway, basic foodstuffs, or worse – health care dropping – they seem to keep going up. Which of course hurts the lower and middle class even more. This is VERY VERY bad.

Japan’s problems lasted over 10 years. Everything Paulson and Bush have done thus far has not stopped deflation from beginning to taking hold. The best bet we have is that a new administration with fresh faces and ideas (including dramatic re-regulation) might be able to change Americans mindset and break the lock of fear that is allowing the economy to spiral out of control.

Please chime in if I left anything out about deflation or made any erroneous statements.


  1. The easiest way to re-inflate the money supply is for the federal government to run a deficit, print U.S. Treasuries to cover the deficit, then have the Federal Reserve to buy U.S. Treasury bonds with newly-printed dollars. In short, running a deficit is one way to print money, and why deficit spending by the U.S. government during a deflationary cycle is a *good* thing, because it’s printing money. But there are so many buyers for bonds already that the interest rate has been bid down to zero. So right now, all we’re doing is shifting investment dollars from things like capital investments, to U.S. treasuries, as part of a “flight to safety” (U.S. Treasuries are essentially *cash*). So currently we’re at the stage where people are stuffing dollar bills (or Treasuries) under their mattresses for 0% interest because they don’t see any other investment out there paying even 0%. Two things have to happen here: Jobs, and massive government spending. Preferably both at the same time, which is why Obama’s limited infrastructure spending proposal ($700B of infrastructure spending is nothing, I can spend $40B of that on just three projects here in California — high speed rail, Caltrain electrification, and BART extension to Santa Clara) is not going to help as much as that raw number says it should. We’re talking about maybe 70,000 jobs generated by that spending, when over 1,000,000 have lost their jobs over the past year. Granted, the ripple effect of that spending in the economy will create more jobs as those workers buy stuff, but reality is that most of the money will go to pay off debts run up during their period of unemployment. Most of us survive periods of unemployment today by borrowing money from our lines of credit and credit cards, since you can’t survive on the pathetic amounts offered by unemployment insurance in most of the US (I think it was $384/month when I was in Arizona — or roughly enough to buy food, but not enough for a place to live or anything). My gut feel is that we’re going to end up with a new WPA/CCC by the time this is all said and done. People need jobs. And there certainly are enough things that need doing, such as cleaning up the horrible trash dumps that are our highways today, trail-building and trail maintenance in places like Death Valley National Park, etc. The question is whether today’s Democrats have the guts to do something like that, or will instead whine and find excuses to not take a “politically risky” action (“politically risky” = “not pleasing to their wealthy campaign contributors”). _ Badtux the Economy Penguin

  2. gee, dcAp, first celebs who died too young and now this. you’re just a little ray of sunshine today!

  3. Great post, DCap, thanks for explaining all this so well. I always wondered why deflation had such a bad rep and now I understand. (I was thinking “Hey, if we have deflation, my one-third lower 401k will actually be worth more!”). Sounds like that isn’t a good thing after all…

  4. Thank you for explaining this in a way I can understand. Not that I’m happy to understand it. Ignorance can be bliss until there’s no more food to eat.

  5. NY Gov. Paterson announced his budget today and it is so ripe with new fees and taxes that I predict a mass exodus of people leaving.It often takes just one more push until people say, “enough.”Jim graduated from Nursing school yesterday and we certainly have the option to buy a house here and put down roots but, the property taxes, the weather and other taxes and fees, are so staggeringly high that we’ve decided to leave.I understand New York is desperate to raise revenue but, new taxes on haircuts, soda, and the elimination of the Star property tax exemption? Property taxes in New York are already science fiction. $5,000 and $6,000 on a lousy, 3 bedroom ranch house worth $139,000? No thanks.

  6. Sounds like you agree with the theory that things will get worse before they get better ~ re the economy.

  7. Yeah, today I mentioned deflation too. It seems only way too likely.Regards,Tengrain

  8. They worried about inflation because they didn’t want labor to demand more. Now we are all fucked. Lovely. Hope it doesn’t take 10 years to get out of this. Thanks for the informative post, DCap.

  9. I just skip the front page and go directly to the comics page… it seems to work better that way. I think Bush might do that too.

  10. What’s left to say. I feel like I just read a very decipherable Economics 101 textbook. Well done. Thanks for the splash of reality.

  11. No, this was great stuff, far better than any of the econ classes I was drafted to teach ;=>One word to add to the mix after thirty years or so — "stagflation".Enjoyed the comments, too.So get out there and buy something new right now, Americans!

  12. I think you’re a bit too clear in your explanations, dcap. It doesn’t sound so bad when I can’t understand it.

  13. As you know I’m in the casino business and I’ve been very worried for awhile about the effect the economy would have on my income. For some reason we are just a busy as ever. Economist have always noticed an increase in gambling in tough times but I thought this time would be different. Not so. I guess a 25 dollar blackjack is something that doesn’t depreciate.I’ll keep you posted on how things go down here.Peace.Matt

  14. Thanks for the illuminating, if depressing, explanation of this stuff. We’re screwed, aren’t we?

  15. There are some industries that have survived long periods of deflation, most notably electronics and related gadgets. A new cool gadget shows up, and if it catches the public imagination, its sales are always moderated by people who know the price is going to be lower six months later. Usually, prices find some steady state, but that happens when the product is no longer cutting edge and has becomes a “must-have” object, the way people now feel about cell phones and flat screen TVs.While I used to be an early adapter, I got over it. I do not own a flat screen TV and my cell phone was bought to help test a game for friend, and never sees the outside of my sock drawer.And, oh yeah. ALL YOU KIDS GET OFF MY LAWN!

  16. I skipped Econ. 101 since I was an English Lit major. So now I know a bit more, and thanks for that, but I’ve been seeing the deflation for awhile now. I’m hanging on to what little cash I have. I only spend on absolute essentials like food, meds, and property tax. The house is falling down around my shoulders, but I can’t afford the needed repairs. Odd that this year property taxes went up in my bit of urban SLC, but the house itself was devalued. I’m predicting a big increase in a black market economy. We have to survive some way. Great post. Thanks for the nicely explained bad news.

  17. The one real danger sign is the amount of the federal deficit as a percentage of the GDP. Japan’s deficit at the time of their deflationary spiral was approx. 33% of GDP. If we start moving the needle that high, then we’re in for a very long night. If we’re able to grow our GDP faster than the deficit then we’ll come out of it much sooner. Another problem the Japanese business community had was something called “Keiretsu” whereby a group of companies that united not only by their parent company but also owning shares of each other. In other words these Japanese companies created an entire ENRON based financial economic model. The good news is that we haven’t done this type of thing. Yes things suck, but we certainly have many more advantages than Japan had at that time.

  18. I was amazed to receive a letter from the state informing us that the health care insurance premiums that were announced in June for 2009 have been rescinded. I have to admit, I have been putting off major purchases at home and work, even though I know “let someone else” spend to revive the economy is a horrible idea.

  19. Do you have copy writer for so good articles? If so please give me contacts, because this really rocks! 🙂

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