Defining Deflation

Deflation, in my humble opinion, can be defined in one of two ways - either as a decrease in the price paid for goods and services or a decrease in the money supply. At this point in time, I believe that we are, without a doubt, seeing both.

There can be very little debate about the decline of asset, service and goods pricing. Charts of any asset class, with the exception of US Treasury bonds, all look like they have walked off of a cliff. The price of consumer goods is falling rapidly across the price spectrum as retailers from Wal-Mart (WMT) to Barney's of New York offer increasing levels of discount pricing. Durable goods prices are falling as both new and used automobiles, airplanes and other goods are no longer in sufficient demand due to economic and credit market conditions. The Baltic Dry Index has taken an unprecedented tumble.

When analyzing money supply, the picture becomes a bit more murky. While unprecedented amounts of liquidity have been injected into world financial markets by the Federal Reserve, European Central Bank, the Bank of England and other central banks, the flow of credit to corporate, institutional and private clients has decreased significantly. While I am not an expert in money supply statistics, I do firmly believe that a reduction in credit availability in a credit driven global economy should firmly constitute a reduction in money supply and therefore meet the definition of deflation.

Comments

[wyvern:]

While I do believe that the prices of many big ticket consumer goods are dropping, it would seem to have more to do with the immediate lack of funds with which to make the purchases and not necessarily a case for outright deflation. As consumer credit begins to dry up over the next year this trend will continue for the forseeable future. (short term) As regards to the overall deflation of the currencies of the world your conclusion would most likely be accurate during normal monetary policy however what will most likely become apparent next year is that the central banks of the world have gone on a mad inflation frenzy whose effects have not yet begun to manifest themselves as of yet. You have the drying up of consumer credit and inflation of world currencies, couple that with a global recession that will last for at least another year and you begin to have some serious issues.

2008 Dec 07 07:29 AM

[investor88:]

Phillip has written a good concise article and in my view has shown clear thinking on the important subject of deflation. Everybody is saying deflation but on the hand confused by all the central bank injection of this and that, bailing out this and that, stimulating with this and that, cut rates left right and center, in ever greater intensity; so they say deflation but all these dramatic central moves are inflationary, they get confused.

Not Phillip- he sees deflation clear and simple because credit is tight. Tight credit means deflation never mind all the central bank massive printing, bailing, stimulating and much more. I think Phillip has contributed an important insight here.

2008 Dec 07 08:00 AM

[labkoger:]

"Charts of any asset class, with the exception of US Treasury bonds, all look like they have walked off of a cliff. "

Actually this comment is syntactically & semantically intact but in the inverse further supports his argument ; the point is NOT that bond prices are high , rather that bond yields which track the inflation rate are asymptotically approaching ZERO ...... deflation !

2008 Dec 07 09:05 AM

[leh:]

Sorry, but I don't see ANY deflation in many of the big-ticket items that most affect American consumers, namely health care, education, insurance, property taxes, and car repairs. Why are these types of essential every day costs always ignored when the topic of deflation is brought up?

So it costs only $30 to fill my tank now instead of $60, and I can get a sweet deal on that flat-screen TV at Best Buy. Big friggin deal. I still have all those other crushing monthly bills to pay, so will have to pass on the TV and will continue to drive as little as possible. Until economists start addressing the true costs of living, arguments such as the one posited here remain hollow and irrelevant IMO.

2008 Dec 07 09:25 AM

[Philip Gvinter:]

Actually to be fair property and liability insurance rates are extremely cheap and have come down in price. Healthcare and health insurance however continue to rise in price. However, when we discuss the cost of healthcare we do have to take into account the new technologies and procedures which at least partially drive up the cost. As for education that is a very fair point. It will be interesting to see what happens over the coming 9 to 18 month period regarding educational costs, especially in light of the reduction in the availability of private student loans.

2008 Dec 07 10:02 AM

[Philip Gvinter:]

I do not disagree that the central banks are attempting to fight deflation by using every inflationary tool in their arsenal. Despite their best efforts however deflation is beginning to accelerate rather than decelerate. It is no longer just durable goods which are suffering from a lack of consumer credit and corporate confidence. Even cheaper items like clothing or portable electronic devices are suffering. It is also not just consumer credit but corporate credit which has been nearly cut off. My main point is that money supply should not be calculated at the banking level but rather at the borrower level regardless of whether the borrower is a business, individual or institution. With a reduction of credit to all of these classes of borrowers the real money supply has in my opinion clearly shrunk.

2008 Dec 07 10:49 AM

[ghassan karam:]

It might be true that individuals are entitled to their point of view but it is equally true that a "publisher" has the responsibility that readers are not subjected to inane explanations of important and complex issues.
You have done your readers a great disservice by allowing such meaningless gibberish to be presented as thoughtful and reasoned commentary. Why oh why do people insist on writing about something that they know nothing about???
Would it be rude to suggest that it is clear that Mr. Gvinter has no idea what the term money supply means.

2008 Dec 07 10:57 AM

[scootie2008:]

Thought experiment:


Assume the USD is "gold" and all other currencies are backed by it... Now look at the economic indicators and see how much sense they make.

2008 Dec 07 11:03 AM

[carey_jim:]

What I've said before on this forum, and many others have said before me, is that governments cannot always control economic forces such as inflation and deflation.

It is clear, however, that modern governments have learned to live happily with inflation because inflation makes payment of debt easier.

Most of the governments who were involved with World War I didn't want war OR inflation but they got both.

What governments want and what they are forced to live with are clearly two different things.

Inflationary and deflationary forces are at war with each in the contemporary world and it isn't clear which will dominate. What seems clear is that once either one predominates over the other, it will tend to perpetuate itself.

Since there are enormous investment consequences, the inflation/deflation debate will be heated and distorted by self-interest.

2008 Dec 07 11:18 AM

[Philip Gvinter:]

I believe that it would be rude to suggest that my disagreement with the calculations of money supply inherently imply a lack of understanding of the term money supply. Money supply is a statistical measure meant to show the total amount of money circulating in the economy. I feel that the statistics can be misleading because there exists a tremendous amount of discretion in determining how any securitized debt plays into the formulas. Combined with variable reserve requirements placed on financial institutions who hold securitized debt bought with borrowed funds and reserved against with customer deposits can skew the real amount of money flowing through the economy. In short I feel that real money supply is an extremely important component of the economy but that the current methods used for calculating it are highly flawed and extremely inaccurate.

2008 Dec 07 12:29 PM

[Rob Viglione:]

Keep an eye on the monetary aggregates, particularly M2 (fed compiled) and M3 (no longer fed compiled). Unfortunately, the Fed stopped publishing M3 statistics, but a good source I've found is:

www.shadowstats.com/

You can see a sharp drop in M3, but it is still well above reasonable expectations of deflation...it's around 7% annual growth right now. Admittedly, I'm not sure how the last couple months have treated the aggregate, but there is still enough slack to keep from worrying just yet.

At some point when asset prices cease crumbling, money velocity should pick up and then we'll be left with an excess money creation issue. I fully doubt central banks will be capable of absorbing excess liquidity.

2008 Dec 07 03:56 PM

[ghassan karam:]

Your attempt to defend your lack of understanding of what is money supply proves the accuracy of the initial accusation. It appears that you have no idea of what is meant by money supply or what are its components. It would be so much better not to pass judgment , especially on relatively serious forums, on things that you do not understand clearly.


On Dec 07 12:29 PM pgvinter wrote:

> I believe that it would be rude to suggest that my disagreement with
> the calculations of money supply inherently imply a lack of understanding
> of the term money supply. Money supply is a statistical measure meant
> to show the total amount of money circulating in the economy. I feel
> that the statistics can be misleading because there exists a tremendous
> amount of discretion in determining how any securitized debt plays
> into the formulas. Combined with variable reserve requirements placed
> on financial institutions who hold securitized debt bought with borrowed
> funds and reserved against with customer deposits can skew the real
> amount of money flowing through the economy. In short I feel that
> real money supply is an extremely important component of the economy
> but that the current methods used for calculating it are highly flawed
> and extremely inaccurate.

2008 Dec 07 04:53 PM

[Philip Gvinter:]

I would appreciate actual constructive criticism of the points made rather than a blanket rejection with absolutely no alternative point. It is this kind of behavior that takes value away from a forum such as seeking alpha. My point is that the money supply statistics no longer accurately represent real amount of money available in either the US economy. The increased use of securitization and the variable reserve requirements imposed on lending institutions which are effected as much by the ratings of assets held as by deposit volume has taken many of the actual sources of money out of the transactions which compose the data points used for calculating real money supply. I am very interested in hearing a counter point to this contention but do not think that simply saying "you don't know what you are talking about" and putting previously posted information in quotation marks suffices to offer a counterpoint.

2008 Dec 07 05:17 PM

[ghassan karam:]

So which of the components ot either M1, M2 or M3 do you feel is not being reported accurately?


On Dec 07 05:17 PM pgvinter wrote:

> I would appreciate actual constructive criticism of the points made
> rather than a blanket rejection with absolutely no alternative point.
> It is this kind of behavior that takes value away from a forum such
> as seeking alpha. My point is that the money supply statistics no
> longer accurately represent real amount of money available in either
> the US economy. The increased use of securitization and the variable
> reserve requirements imposed on lending institutions which are effected
> as much by the ratings of assets held as by deposit volume has taken
> many of the actual sources of money out of the transactions which
> compose the data points used for calculating real money supply. I
> am very interested in hearing a counter point to this contention
> but do not think that simply saying "you don't know what you are
> talking about" and putting previously posted information in quotation
> marks suffices to offer a counterpoint.

2008 Dec 07 06:44 PM

[Philip Gvinter:]

I believe that M3 is no longer being published by the Fed. also believe that our entire system of money supply statistics is no longer an accurate representation of the actual "money supply." Every country uses a slightly different formula for determining money supply. For example the EU uses securities with maturities of up to two years as part of money supply. My point is that the use of securitization has opened new sources of funding both domestic and foreign in origin within the US financial system. When securitized loans made up a relatively small portion of total credit extended the M1, M2 and M3 statistics accounted for a majority of the capital available to be deployed within the financial system. As securitized debt began to be sold off in ever greater proportion to the assets held on bank balance sheets and secured by deposits or repo agreements which are part of the traditional money supply statistics the accuracy of the current M1, M2 and M3 began to represent a smaller portion of actual money supply as it exists within the system. In short I believe that a new measure of money supply must be added to the existing M1 and M2 and that M3 should be brought back as an official measure.

2008 Dec 07 07:32 PM

[ghassan karam:]

The Fed stopped reporting M3 as of March 23, 2006 but there is nothing to prevent you from computing it since all the missing aggregates for all the additional variables can be computed individually. It is one thing to hypothesize that the GDP is no longer as closely correlated to a monetary aggregate but it is a completely different thing to just make the absurd statement that deflation is correlated to a decrease in money supply. (Go and tell that to the Japanese!!!!).

2008 Dec 07 08:01 PM

[Philip Gvinter:]

Be careful what you call absurd. Don't want to take my word for it try wikipedia or investopedia.

From en.wikipedia.org/wiki/...)

Deflation in economics is a persistent decrease in the general price level[1] of goods and services - a negative inflation rate. When the inflation rate slows down (decreases, but remains positive), this is known as disinflation.
Inflation destroys real value in money. Deflation creates real value in money. Alternatively, the term deflation was used by the classical economists to refer to a decrease in the money supply and credit; some economists, including many Austrian school economists, still use the word in this sense. The two meanings are closely related, since a decrease in the money supply is likely to cause a decrease in the price level.

From www.investopedia.com/t...

A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression.

Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. To counter deflation, the Federal Reserve (the Fed) can use monetary policy to increase the money supply and deliberately induce rising prices, causing inflation. Rising prices provide an essential lubricant for any sustained recovery because businesses increase profits and take some of the depressive pressures off wages and debtors of every kind.


That certainly seems to make my point of a combination of reduction of prices as well as reductions in M3 (www.shadowstats.com/al... (2nd chart) seem to mean deflation. I also still stand behind the point that the true aggregate amount of money rotating through our economy is no longer accurately reflected by M3 as M3 does not include significant funding sources which fluctuate and have significant equally effects on the availability of capital for non government purposes.

2008 Dec 07 09:33 PM