Tuesday, August 25, 2009

Deflation Danger

Most of the alternative financial media has focused on inflation as the primary danger for the American economy. The reasons are obvious. The Federal Reserve has released untold amounts of U.S. dollars into the economy through its "quantitative easing" program. On top of that, China and other economies are publicly expressing doubts about the dollar and indicating that they intend to lower their holdings of U.S. dollars, which would surely put inflationary pressure on the dollar.

However, over at Reuters, writer Christopher Swann argues that deflation is still a major danger to the U.S. economy.

First, the argument that deflation is benign:

A swelling dollar can clearly be good news for shoppers as well as for those who are sitting on cash. Deflation is often a result of economic progress — productivity improvements that increase spending power. This was the friendly species of deflation caused by surging Chinese output from the 1990s onwards.

Is this the case now? No.

The current variety of deflationary pressure is far less benign. It stems not from efficiency savings but rather from weak demand. Worse still, it is accompanied by record levels of debt.

Despite frantic efforts to pay off loans, household debt is still around 130 percent of disposable income. This was precisely the combination that Irving Fisher warned about in his celebrated 1933 article on debt deflation.

Under these conditions, the rising real value of debts encourages households and businesses to sell their assets to pay down loans. As fire sales reduce asset prices — stocks and property — real net worth declines further. Output and employment decline, accelerating the slide in prices.

To add to the pain, real interest rates increase whether central bankers like it or not, discouraging borrowing and promoting even more savings.

“The more debtors pay, the more they owe,” Fisher wrote, since “the liquidation of debts cannot keep up with the fall of prices which it causes.”

Swann's argument is compelling. Consumer demand is extremely low in historical terms and appears set to go even lower. However, we can't deny the monumental inflationary pressures that also exist. Swann has hit upon an important point, however: debt is still the primary obstacle to any significant economy recovery.

But with the U.S. economy clawing its way out of recession, surely the danger has passed? Not quite. Prices are the ultimate economic straggler.

In Japan, for example, the country only started to experience falling prices roughly three years after the start of the recession in 1991. Wages didn’t start to fall until 1997. The United States could still follow Japan’s lead.

Proponents of recovery should keep this in mind. The current U.S. recession already mirrors the Japanese "lost decade" in a variety of important ways. What Japan experienced was extremely protracted. We're only one or two years into this recession, depending on perspective. Claiming we're in recovery already is extremely premature, in my opinion, and this historical example supports that perspective.

Downward pressures on prices in the United States continue to intensify, according to the latest research by Capital Economics. Core inflation may have held at a respectable 1.5 percent, but this is deceptive. U.S. goods inflation has defied gravity in part because of hefty increases in tobacco taxes over the past six months. A 28 percent increase in tobacco prices from a year ago is adding one percent to core goods inflation, according to Paul Ashworth of Capital Economics.

“Without this, core inflation would already be matching the lows reached at the end of 2003,” he says. The tobacco effect will soon fade.

Services inflation, meanwhile, has been very weak. Here the key factor has been weak rental prices, which account for about 40 percent of the total core index. Unemployment and foreclosure will continue to put relentless downward pressure on rents. Already the rental vacancy rate is at a record 10.6 percent.

Interesting. I had no idea about tobacco prices keeping up core inflation. When it comes to the rental market, supply is keeping the vacancy rate up and prices down. Homes that individuals and banks are unable to sell are being transformed into rentals until the housing market turns around. Seeing as how there are untold numbers of foreclosed homes that are purposefully being kept off the market by banks at the moment, I foresee continued downward pressure on rental prices for the time being.

Related post: Deflation or Inflation?

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