Deflation And Stupidity

When Bloomberg’s financial and business writers and opinion columnists start a fear and loathing campaign against deflation one must wonder who is fronting the money for such obvious propaganda against critical thought.  The horrors of lower prices for everything looms over troubled businesses.  Imagine that you, as the consumer, are happy with lower prices but you want even better bargains.  So you put off buying that widget a little longer in the belief that the price will become lower.  There are two assumptions made by such a claim.  The first is that the consumer will delay all purchases and two that every business will sell below cost.  Now if you believe those two assumptions are true I’ve got a bridge in New York to sell you.  First, very few consumers are going to go on a diet while waiting for the price of porterhouse steak to drop to a dollar a pound.  People will buy the necessities as they need them.  Non necessary purchases may be put on hold as happens when unemployment concerns hit the budget.  Second, selling below cost is illegal, doesn’t pay the bills, and would lead to bankruptcy.  A business cannot operate at a loss for long and still stay in operation.

But why is there deflation, that is, the reduction of prices for goods and services?  Well, one very good reason is that the demand is less.  You see, supply and demand work together to find a common price and quantity that will clear the market.  By the term clear the market we mean that the equilibrium has been restored to both price and supply.  This discovery process is not quite so cut and dried.  In fact, it gets a little messy.  Some consumers may get a bargain and some may not, but usually the average consumer pays the average price.  So how does deflation normally come about in an economy?  Usually through inflation.  That is, goods and services become inflated for too long.  This may take decades to make into the possible deflation change in an economy.  And if you remember, inflation is caused by the expansion of credit.  Now why credit and not just money?  Because credit is the same as money.  Under investment usually is the cause for under production.  One of the reasons for under investment is the expansion of credit.  If business A produces widgets at the rate of 100 per day and Bank B provides an expansion of credit to consumers that allows the consumption of 110 widgets a day, business A is under producing widgets by ten each day leading to an increase in price, or inflation in the price of widgets.  This increase in price means that the competition for purchasing widgets is among those who can afford the now higher price one of those widgets.

Business A has one of two choices; it can keep prices higher or it can expand its production to produce more widgets.  If it wants to expand its capacity then it needs more capital and more capital means that money must be borrowed or gotten from somewhere.  If the general public is experiencing an increase in credit then business A will have to borrow at higher rates which means that it may not be able to produce enough widgets on demand.  The other economic activity that will happen is that as more individuals are hired to produce more widgets wages will tend to increase.  As demand increases in one area due to an increase in credit it fuels an increase in demand in other areas, thus increasing demand in general and causing similar problems in the general economy.  The other culprit to inflation is an increase in government spending for goods and services.  This is why government spending, particularly when fueled by deficit spending (the government issues its own line of credit, if you like) is very deadly to an economy as it crowds out both the credit markets and the market for goods and services.

All of this expansion of economic activity tends to cause bubbles.  The price of private housing will tend to rise, commercial real estate will increase in price. the price of labor will rise disproportionately, the cost of raw materials and intermediate goods will rise.  In short, the economy booms through inflation to levels that cannot be permanently maintained.  As the credit expansion is exhausted we start to see the contractions in consumption.  Recessions occur because demand has miscalculated the supply of goods and services.  Generally it is a matter of several industries over producing their goods and services and thus the only way to restore equilibrium to those markets is that they stop over production.  It takes some time to allow the economy to reallocate goods and services to that equilibrium point.  When a government attempts to interfere with that process it usually does the wrong things at the wrong time.  If too many commercial buildings are built it may try to assist in the sale of such new construction by lowering mortgage rates or by giving financial incentives to buy these extra units of real estate.  But when too much credit has been extended to the economy at large it does the really stupid act of trying to inject more money into that economy to bolster the consumption of goods and services.  The problem to having produced too many apples for sale is not to encourage the consumers to gorge themselves by buying and consuming more apples but by letting some of the crop of apples to rot and go unsold.  True, the price of apples may reach lower levels but this is necessary if that equilibrium point is to be reached.  And if the public has run out of credit and cannot afford to buy more than the necessities of life with the cash they have on hand then there will be a general reset as to prices.  There will be other dislocations to the market.  Employment will drop.  Unions will greatly resist any attempt to force their members wages lower but this only puts off the problem as businesses are forced to find ways of doing with fewer union employees.  Thus we start to see a rising trend towards not only more automation but more robotic manufacture.  Right now the construction unions are among the highest paid group of employees.  There is a company that makes robotic controlled construction equipment such as bulldozers and earth movers that can eliminate heavy equipment operators.  This is part of that general price/cost reset.  In a depression, which the world has not seen since the 1930’s we will see far more reductions in wages across the board.  Even unions will be hard hit as we will see more attempts to use non union labor.

So we are coming to a point in the world economic climate where the movement of production to cheaper economies means that wages will decline.  True, not all necessary labor can be outsourced, but changes can be made that will break the grip of expensive union labor.  Also lack of work for craft union work will result in price competition.  We are going to see far more responses to these artificial barriers to equilibrium in the markets.  Deflation is only a problem when government tries to interfere in the markets and unintentionally corrupts the markets in unintended ways.  During the thirties the dairy farmers complained that they could not produce milk at low prices.  So the state and federal governments decided to place price supports on the price of dairy products.  They also controlled production and thus we saw millions of children denied milk due to high prices while millions of gallons of milk were dumped to keep those high prices.  Deflation, when allowed to work, is not the end of the world, it is the reordering of it in a way that works.  But when we let politicians and bankers interfere with that reordering then we can expect more trouble down the road.

But for the politician, inflated prices means inflated wages and inflated costs.  Because the taxes are levied on a percentage basis and usually have a floor defined by some poverty level.  If there is a drop in prices, wages, and costs there is a corresponding drop in tax revenue and that artificial floor will allow those with lower incomes to keep more of their income.  If an individual use to make $100,000 a year and the poverty level is $50,000 a year, then in a depression where his wage drops along with all other prices, he benefits to closer to the poverty level his new wage becomes.  Deflation is a two edged sword and it is beneficial when it reduces the disparity between rich and poor.  But it is not some awful fate worse than death that so many financial pundits decry.

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