Deflation: Nothing to Fear
I am an occasional reader of Business Week, and each time I pick it up and read James C. Cooper's "Business Outlook" column, I find myself frustrated. With that said, let me lay out my argument against Cooper's "A Real Risk of Deflation," in the November 10th, 2008 edition of Business Week.
I feel I should point out that Mr. Cooper has a small internet footprint and a brief Google search reveals a dearth of information on the man, and nothing official. I will however assume him to be educated and qualified insofar as the established business and economic press is concerned. This is of import here as I believe Mr. Cooper employs arguments that ring throughout the economic establishment. I will endeavor to show that these supposed axioms are little more than mercantilist self-interest.
I will first let Mr. Cooper speak for himself:
Deflation is an economic disease caused by a sustained drop in overall demand and falling prices that forces business to cut prices ever deeper.
Mr. Cooper likens deflation to an economic ill of the most terminal variety. He goes on to blame this contagion for a real increase in the cost of credit, which he posits is "the opposite of what monetary policy needs to do to combat falling demand." The real cost of credit does increase in the event of deflation. This however would increase the return to would-be creditors. This increase in profit would bring more credit to the market, the lack of which, supposedly, is the monkey on the back of the flailing economy.
Mr. Cooper is confused at the most fundamental level as to the definition of deflation. Since deflation is just part of the continuum of the money supply, i.e., a falling money supply, it cannot be treated separately from inflation. To quote Milton Friedman, "Inflation is always and everywhere a monetary phenomenon" (A Monetary History of the United States 1867–1960). This is to say that inflation (or deflation) is not the result of a change in prices, but rather a change in the supply of money. The broad sustained change in prices is a result of a change in the money supply. It is the real inflationary mechanism that Mr. Cooper alludes to when he talks about "what monetary policy needs to do."
It is this misunderstanding between disease and symptom that seems to be the genesis of Mr. Cooper's incorrect conclusions. It is nearly impossible for a broad sustained drop in prices to occur while the federal government is bringing about one socialist policy after another, spending on the public's credit to no good end and wildly expanding the money supply. Then, how, you may ask, can we see the current sharp depression in so many prices? Does this not refute the tie between money supply and the inflationary continuum? Let us examine the graph to the right, taken from Mr. Cooper's article, but, I should point out, not directly mentioned in the text. From the data, it would appear that commodity prices were on a steady climb and have undergone a massive collapse.
There is a very different conclusion buried in the data that must be considered. Based on information made available on Commodity Research Bureau's website, here is a broader view of commodity prices:
While considering the broader context of the recent decline, I will do Mr. Cooper's allusive data one favor and I will ignore the Nixon Shock of late 1971. For this reason I will use the peak of 249.9 at the end of July 1974 as my baseline.
From this point to the end of January 2006, there was a 25% increase in commodity prices. Over this 31.5 year period, this is an annualized rate of 0.8%. In the 2.4 year period between the end of January 2006 and the peak at the end of June 2008, there was an annualized rate of increase of 22%! This is hardly consistent with the preceding three decades and is not a reasonable rate of growth. If we look at the annualized growth rate between the end of July 1974 and the end of October 2008, after the fall in prices, the growth rate is a much more modest 1.1%. Based on the historical average this "corrected" growth is approaching the normal market variation.
This correction is a drop in demand, rather than a contraction of the money supply, but in the same way an overinflated balloon must pop, the demand was never sustainable from the outset. Much of the demand in commodities as well as other assets was based on the pyramid-scheme belief that another buyer, hungrier than the last, was just around the corner. As with all such schemes, someone finally decides they are done with the game, and the downward spiral begins. If the scheme was built on credit or margin, the fall is all the more precipitous.
Mr. Cooper's suggested baseline of the past few years was a heyday for business due to the free flow of credit, and thereby monetary expansion.
Businesses who received these credit-created dollars are the first in line at the monetary-expansion spigot, and the ones to feel its maximum benefit. Their employees, creditors, and vendors receive an already-inflated, credit-created dollar, and, as each dollar moves its way through the system, its lack of value becomes apparent as the realization sets in that dollars are more numerous. Despite the predictions offered by Mr. Cooper that the 5.5% inflation of July 2008 will be "close to zero by early" 2009, such a thing seems extraordinarily unlikely if viewed in the broader context of history, as opposed to the excess of the last few years.
Mr. Cooper goes on to point out that it is not just commodities that are falling in price. A 40% drop in the Wilshire 5000 and a 20% drop in the S&P Case-Shiller Home Price Index from their respective peaks "are part of a broad deleveraging by financial firms and households." Mr. Cooper goes further: "this forced casting off of debt is fueling the sale of homes, stocks, and other securities at fire-sale prices while shutting off new lending in a self-reinforcing spiral that destroys wealth and depresses demand."
Mr. Cooper's assertion that a reduction in debt is fueling sell-offs is enigmatic at a minimum. A reduction in debt would seem to give the consumer and businessman greater room to increase demand based on savings (real wealth) or room for additional credit. This does not match reality because these consumers and businessman have overstretched their credit capacity and their gambles ("investments") have not paid off, leaving them to sell their now greatly devalued assets to cover their debts. Mr. Cooper is under the painfully common misconception that the ability to acquire is the ability to afford. Credit is not wealth: it is at best someone else's wealth. At worst, credit is purely fabricated currency.
You would not suggest giving a teen who has just maxed out their first credit card more credit so they could somehow spend their way out of the financial hole they have made, nor will this approach work for a business or a nation. The delusion and mysticism that is called upon by the business and economic establishment have obscured the fact that the economic realities of your own homes are not fundamentally different from those of a business or nation. If you are unable to pay your debts, you are insolvent. In some cases, credit can help you bridge a "low" time. If, however, this credit only increases debt you still cannot afford, then the inevitable has merely been postponed.
The same mistakes that were made during the Great Depression are being made now. The call to prop up prices will grow to a din as the self-interests of businesses push themselves on the Federal Reserve and Treasury. This desire for price controls is no different from the mercantilist policies of colonial Britain, which forced the British populace to pay the higher prices of British producers, to the boon of the businesses and the pain of the populace. Talk of today's "illiquid" assets is just a resistance by the owners of those assets to sell them at the market-clearing price. I assure you, I'll buy a mortgage for one dollar!
The business and economics establishment will soon call for a new New Deal, and all the socialist policies of FDR will be dusted off and respun to the unwitting public, and the years that follow will be ones of pain, high prices, and a real fall in the standard of living.
As long as our central government has the ability to dole out these favors, there will be special interests lining up to receive them. James C. Cooper has no reason to doubt the value of his opinions to a businesscentric audience. This does not, however, make his views any more just or valid. In so long as these mouthpieces for special interests maintain a stranglehold on mass media, we will all pay the unfortunate price.