Why I See Long-Term Deflation

The economy points towards deflation due to the three most fundamental laws of economics of which I am aware, plus one law of physics.

1. Human beings have unlimited capacity for desire (demand) but limited resources to indulge those desires. Translation: demand is theoretically infinite but practically limited.
2. Something is only worth what someone else is willing to pay for it; no more, no less. This price is dictated by the laws of supply and demand.
3. The law of supply and demand itself.

Physics law: Inertia is the tendency of a body to remain at rest if at rest or to remain in motion if in motion unless acted upon by an outside force.

The same can be said of inflation and deflation. Inflation continues unless acted upon by an outside force; ditto for deflation.

It cannot be debated that prices for anything and everything are falling. If you can find consumables for which prices are rising, God bless you. I cannot and so I see deflation (yes, some prices fluctuate, but in the end the trend has been a downward spiral for some time now). That is the definition of deflation: real average prices falling across the board. As far as I can see that is what we have and so, regardless of tomorrow, which cannot be known, we are in a deflationary state.

We will remain deflationary unless an outside force comes along to change the inertia of falling prices.

We are in deflation because supply far, far exceeds demand for everything (at least in the US, which is the country whose economy I am describing) and money is tight.

Even though theoretical demand is a constant at infinity, real demand (which is all that matters) is limited. At present, real demand is low because the resources needed to indulge our desires are scarce. Money is scarce because we spent too much using credit over the last five years and so have reduced access to credit. We spent tomorrow's capital. This is the largest enhancer of inflation (and of the real money supply) and so the largest potential increaser of demand, bringing tomorrow;s capital into the present: A.K.A debt/credit.

Also enhancing the lowering of demand relative to the last two to five years is the fact that people may chose to indulge or not indulge their desire whether they have the financial ability or not. This is more important right now than all but a few analysts have made clear in their pieces. If we as a nation spent 105% of disposable income one year and that dropped to 95% of income the following year (assuming income remained stable), that would have an enormous impact on, and lead to a lowering, of real demand and so a fall in prices.

So as I see it at the moment, the recent current price structure was built on both the average Americans deeper pockets of the last two to five years and their super willingness to dig into those deep pocket. Their pockets were made deeper by the policy of loose credit. The willingness to spend is proven by the fact that in two of the last five years (I think) we spent more than 100% of our income. So in the last two to five years, not only did we have more money available to us, but we also spent a higher percentage of that available money.

Today we have much less access to our future earnings due to the tightening of the credit markets and the fact that we have used up a great deal of tomorrow's capital. Also, many Americans appear to have learned their lesson regarding the dangers of credit and are becoming savers thereby spending less (perhaps A LOT less) than their available disposable income. Whatever this exact number is, the difference in our rate of spending today compared with average of the last two to five years, intuition says that it is a very large number. That large number will have placed enormous downward pressure on real demand.

So, according to the law of supply and demand, the prices in a structure which were derived from the much, much higher level of demand and consumption which arose from America’s relatively greater access to future capital and its willingness to indulge desires to a far greater extent in the last two to five years than today, will fall as they have been doing. Unless some force acts to counter these falling prices, then, moving forward, we are far more likely to see more deflation than inflation.

So while, yes, demand is still theoretically infinite, it is also limited practically. Demand is, as a matter of strict and unarguable fact, in reality, far lower in today's economy than it was two to five years ago. Since our (recent) current price structure is based on both the increased ability and willingness of people to indulge desires and so increase practical demand that existed in the past two to five years and no longer exists in the present and is unlikely to exist in the near future, demand is falling; ergo, prices are falling. Unless the inertia of deflation is affected by some outside force, demand will continue to wane and we will stay in a deflationary state.

There are two possibilities to stop deflation: increase demand or reduce supply.

That is all there is. Opine and dream all you wish, deflation will halt when more people want more of what is available or what is available ceases to satisfy demand.

Take the second first as it is easiest. Statistically speaking, we never run short of anything in the US. Once in a blue moon the supply of a stupid toy or game at Christmas or maybe a fancy car outstrips demand, but it is so rare as to be irrelevant in a statistical sense. Even in these rare case, the supply side kicks in automatically and so the supply/demand equilibrium is balanced virtually instantaneously. Right now we have cars piling up on docks, nearly a year’s worth of houses for sale, warehouse and stores full of all types of consumable and grocery markets full of food. How is it even remotely possible that the supply of anything in the US will ever fall even below normal demand levels, nevermind far enough below those levels to cause an inflationary spiral? You may see this as a possibility, but I do not.

So the only real option is an increase in demand. How? We have far less access to capital and people have far less desire to indulge their desires with what capital they do have and so convert theoretical into demand real demand. Without real demand, there cannot be anything but deflation.

Question: What mechanism will place enough capital in the average American's hands and so overcome the simultaneous pressures of lack of funds combined with an increased propensity to save, due either to shrewdness or fear, which are acting to drive demand downward?

I do not see such a force in place at present and neither do I see the possibility of such a force making itself felt in the near future.

To me it is simple. Demand was very high (it could be said, irrationally high) in the last two to five years for several reasons. Today’s demand has, also for several reasons, dropped precipitously relative to the last two to five years. The law of supply and demand dictates a fall in demand insures a fall in prices and the intensity of the fall in prices is based on the intensity of the down-swing in demand. A big fall in demand means a big fall in prices. Conspire as you will, this is a law. It functions no matter what you believe, wish to be or try to will into existence. Demand has fallen so prices should have fallen (which they have). Prices should continue to fall unless demand increases. I cannot see any obvious, rational, reality based reason for demand to rise to any great extent in the near future so we stay in a deflationary state.

Law: A statement of fact, deduced from observation, to the effect that a particular natural or scientific phenomenon always occurs if certain conditions are present.

I see three basic errors in arguments for inflation.

Many arguments leave out supply and demand altogether. This law is the bedrock of economics. If someone does not wish to indulge demand, then all of the money in the world cannot raise the price of one single thing one single dollar.

That leads to the second problem and many very highly placed economists make this mistake. This mistake is the notion that somehow demand is static. Demand is constantly fluctuating, which is why prices in a truly open market also constantly fluctuate.

The third mistake is psychological in nature. It is what caught many people up in the Madoff thing. People simply believe what they want to believe. One example: one person noted that a devalued dollar = inflation. If this is a law instead of a congruency, then if the dollar is tanking as it is (it went from 1.22CHF to 1.06CHF in three days); then why is the price of oil not skyrocketing? Because this idea stated above in the equation is a fallacy. It is not a fallacy because it is strictly untrue. It is fallacious because it is overridden by the law of supply and demand.

All I can see is deflation at present and do not see in the future a mechanism or force that will alter the inertia of deflation. I note that people who see or want to see inflation points to maybes, possibilities and probabilities, whereas people who argue for deflation are able to point to hard facts.

I hate cliches, but what I see is a perfect storm of falling demand. Everything in economics is screaming that demand is falling and when demand falls prices fall, there is nothing that can mitigate the effects of the law of supply and demand. Ergo, deflation.

As with most things, what is being argued is actually the matter of time. Inflation will most certainly recur, but when? Six months?....12 months?.........Two to five years?.....A decade or more?.... I say we will see years of falling prices.

Comments

[Scott1:]

in real terms, true, demand is falling, so prices should fall under a system of fixed money supply. But if the money supply increases dramatically (acknowledging velocity of money issues, of course) , prices can nonetheless rise. The authorities are intent on increasing the money supply and thus creating inflation in order to bailout the banks and the homeowners (this will make the banks profitable allowing them to play the yield curve and lower the real debt load on homeowners, because their salaries and eventually their house values will rise relative to their debts, which are mainly fixed).

Most developing countries have probably spent half or more of the last fifty years in inflationary periods, even when in real terms their economies were often shrinking. Zimbabwe, anyone? If Zimbabwe and many other developing economy know how to create perpetual inflation, despite often shrinking economies, why should the US have a problem doing so?

There is no trick to creating inflation, the myth that it is difficult seems to be perpetuating through the memosphere because people don't understand basic economics. There is no limit to the money supply under a fiat monetary systems, if the authorities increase the money supply by sending out checks or buying up assets (which amounts to the same thing) using monetization (ie issuing new money out of thin air) prices would eventually rise, and the changeover can happen quite suddenly.

There really is no trick to this, yes demand is falling relative to supply, so prices must fall in real terms, but if we double the amount of money outstanding or triple it or more, then prices will rise again, same laws of economics apply. If there are more units of currency outstanding, then each good and service in the economy is worth that much less in terms of currency outstanding.

The government can create an infinite supply of money, there is no technical limit, if the government only has the will they can always create inflation by sending out checks or buying up assets. See Bernanke "Deflation, making sure it doesn't happen here"

2008 Dec 23 07:24 AM

[investor88:]

World governments led by the US are fighting deflation. During this period of turmoil, economies and financial markets will also be in turmoil. A difficult period ahead, but deflation is having the upper hand now.

2008 Dec 23 07:52 AM

[prudentinve...:]

Excellent and lucid article. I agree with all your arguments, except that I believe the conclusion is deflation in real terms, not nominal terms. In real terms, deflation will win, and we shall consume less. In nominal terms, however, the vast supply of liquidity being dumped by the world's central banks are likely to produce inflation, so we shall pay more in dollars while actually consuming less.

2008 Dec 23 08:14 AM

[patio:]

Demand has a strong pyschological element, as consumers distinguish want from need. I am upper middle-class, in Austin where the local economy has hardly felt so much as a ripple- housing actually up for the year, unemployment well below US average, etc.
Our household has undegone a seachange in attitude, and furthermore we like it. We like the discipline of a strict budget, we've decided we have everything we need, and even shop for groceries with a very discerning eye and coupons. Everyone I know likewise- there is palpable fear, and we have no idea how people less fortunate are making it.
Demand destruction is complete, IMO, and since Americans have purchased forward so much "stuff" in the last decade, I see no way it comes back. If I got a check in the mail, it goes to debt reduction or savings. And I have a job.
Banks are hoarding, companies are hoarding, and people are hoarding. Unless the government can force spending, forget inflation.


On Dec 23 07:24 AM Scott1 wrote:

> in real terms, true, demand is falling, so prices should fall under
> a system of fixed money supply. But if the money supply increases
> dramatically (acknowledging velocity of money issues, of course)
> , prices can nonetheless rise. The authorities are intent on increasing
> the money supply and thus creating inflation in order to bailout
> the banks and the homeowners (this will make the banks profitable
> allowing them to play the yield curve and lower the real debt load
> on homeowners, because their salaries and eventually their house
> values will rise relative to their debts, which are mainly fixed).
>
>
> Most developing countries have probably spent half or more of the
> last fifty years in inflationary periods, even when in real terms
> their economies were often shrinking. Zimbabwe, anyone? If Zimbabwe
> and many other developing economy know how to create perpetual inflation,
> despite often shrinking economies, why should the US have a problem
> doing so?
>
> There is no trick to creating inflation, the myth that it is difficult
> seems to be perpetuating through the memosphere because people don't
> understand basic economics. There is no limit to the money supply
> under a fiat monetary systems, if the authorities increase the money
> supply by sending out checks or buying up assets (which amounts to
> the same thing) using monetization (ie issuing new money out of thin
> air) prices would eventually rise, and the changeover can happen
> quite suddenly.
>
> There really is no trick to this, yes demand is falling relative
> to supply, so prices must fall in real terms, but if we double the
> amount of money outstanding or triple it or more, then prices will
> rise again, same laws of economics apply. If there are more units
> of currency outstanding, then each good and service in the economy
> is worth that much less in terms of currency outstanding.
>
> The government can create an infinite supply of money, there is no
> technical limit, if the government only has the will they can always
> create inflation by sending out checks or buying up assets. See Bernanke
> "Deflation, making sure it doesn't happen here"

2008 Dec 23 08:21 AM

[Alan von Al...:]

Inertia is called momentum in market language, strictly psychological, not a principle or factor that can be or ought to be overcome by action. Most of the time momentum is silly. Some of it is program trading. Contributes to and exaggerates the random walk. Strictly short term noise.

You said: "unlimited capacity for desire (demand)" which is a fallacy. Demand is cash or credit you are willing to trade for something else. The notion of reducing supply is truly bizarre. It would bump prices higher, making demand (purchasing power) weaker. Granted, supply of certain goods and services will contract as businesses fail -- autos, retail, loan brokers, alt energy, paper, mining. But this is a process of consolidation that we should expect in a recession, an ordinary aspect of the business cycle. Nothing to get excited about, unless government tries to put a trillion dollar penny in the fuse box and debase the currency.

2008 Dec 23 08:41 AM

[gooter:]

i have a difficult time seeing how a population raised to spend will suddenly change their behavior. short-term, yes but long-term i cannot envision the US as a nation of savers. the dna in americans doesn't include frugality or long-term thinking. we will regroup, assume the govt. has got things going, and assume our historic method of operation. sad but true. inflation is inevitable with the freshly printed dollars wallpapering our nation and available for nothing.

2008 Dec 23 08:48 AM

[De Graaf:]

John,

You set out a very good article today, in which I agree fully except a remark on the following statement. You said;

"The third mistake is psychological in nature. It is what caught many people up in the Madoff thing. People simply believe what they want to believe. One example: one person noted that a devalued dollar = inflation. If this is a law instead of a congruency, then if the dollar is tanking as it is (it went from 1.22CHF to 1.06CHF in three days); then why is the price of oil not skyrocketing? Because this idea stated above in the equation is a fallacy. It is not a fallacy because it is strictly untrue. It is fallacious because it is overridden by the law of supply and demand."

In above quotation, you make the same mistake the 'static' economists make and that is; demand is falling, that includes oil.
So when you consider the dollar weakening against the Swiss Franc (despite the economic factors in Switzerland driving the SFranc) you abondon the possibility of inflation by concluding that oil didn't rise in effect. I think this is to short around the corner.
Oil is falling because of oversupply, in effect caused by overconsumption with bad credit, which is (fortunately) halted. Oil isn't static either! And due to the fact that oil still trades around $40 a barrel, instigates a reasonable amount of inflation, as it could be trading around 20 - 25 dollars a barrel by now.

FED policies have minor effect battling deflation out of the economy, although causing some inflation as part of the equation. Look at the money supply. It only increased a min. 10 percent. Deflation is among us, I agree.

I fully agree with your analysis that this is going to be a very large period of contracting prices, just by the fact that the American consumer is stopped. The're probably waking up and saving until 2020 until they head along another path of spending.

Good article.

ps; Commenter 'Prudentinvestor' above has the same vision as me. Good comment. Nominal (FED) dollars cause inflation while demand is falling, so prices drop slightly or remain the same, but demand is gone. In real terms, whe are facing monetary deflation.

brgds.

2008 Dec 23 09:05 AM

[swisswiss:]

A fundamental so big that it's overlooked--the number of abortions since 1973 totals 49,551,703. And over 20% of that number would be at childbearing age today. While nothing says that depopulation causes deflation, the absence of vigorous population growth is an aggravating factor. The exciting conclusion: the long play is in Brazil.

2008 Dec 23 09:12 AM

[Dr.Jackpot:]

Energy seeks a lower level. It's downhill the moment you are born. You shoot up like a roman candle but you are dieing at the same time you are growing up. God was the only one to figure out how to make energy seek a HIGHER level and in an instant the universe was born. Work on it. I'll buy a hundred shares.

2008 Dec 23 09:21 AM

[Briggsy:]

Destruction of wealth and the absence of future prospects to acquire wealth are both deflationary and self-perpetuating.

2008 Dec 23 11:45 AM

[Rob Viglione:]

@Scott, best point made. Asset prices are undeniably falling, but at some point the crash will temper and we'll have to face incredible increases in money supply and unmanageable piles of debt. This will likely be the dominant factor in the long-term inflation-deflation battle.

Best case in point is to learn from Zimbabwe/Rhodesia.


On Dec 23 07:24 AM Scott1 wrote:

> in real terms, true, demand is falling, so prices should fall under
> a system of fixed money supply. But if the money supply increases
> dramatically (acknowledging velocity of money issues, of course)
> , prices can nonetheless rise. The authorities are intent on increasing
> the money supply and thus creating inflation in order to bailout
> the banks and the homeowners (this will make the banks profitable
> allowing them to play the yield curve and lower the real debt load
> on homeowners, because their salaries and eventually their house
> values will rise relative to their debts, which are mainly fixed).
>
>
> Most developing countries have probably spent half or more of the
> last fifty years in inflationary periods, even when in real terms
> their economies were often shrinking. Zimbabwe, anyone? If Zimbabwe
> and many other developing economy know how to create perpetual inflation,
> despite often shrinking economies, why should the US have a problem
> doing so?
>
> There is no trick to creating inflation, the myth that it is difficult
> seems to be perpetuating through the memosphere because people don't
> understand basic economics. There is no limit to the money supply
> under a fiat monetary systems, if the authorities increase the money
> supply by sending out checks or buying up assets (which amounts to
> the same thing) using monetization (ie issuing new money out of thin
> air) prices would eventually rise, and the changeover can happen
> quite suddenly.
>
> There really is no trick to this, yes demand is falling relative
> to supply, so prices must fall in real terms, but if we double the
> amount of money outstanding or triple it or more, then prices will
> rise again, same laws of economics apply. If there are more units
> of currency outstanding, then each good and service in the economy
> is worth that much less in terms of currency outstanding.
>
> The government can create an infinite supply of money, there is no
> technical limit, if the government only has the will they can always
> create inflation by sending out checks or buying up assets. See
> Bernanke "Deflation, making sure it doesn't happen here"

2008 Dec 23 01:02 PM

[The Good Ne...:]

Deflation is bad for the economy only if prices fall significanly below what it takes to produce the products measured by the deflation index.

But today what is really occuring is not widespread price declines, but a huge fall in the cost of energy. And oil prices continue to fall. Not because it costs more to produce oil, but because speculation drove the price up and now down. Oil itself was produced over millions of years. The refining costs have not changed appreciably in the past year, only the price of the raw material oil.

For most of the year, high energy prices have caused consumer prices to soar, reaching a 17-year high in July. But energy prices have fallen about 70% since then.

What is extremely noteworthy is that most of the other prices in the core of the price index have remained steady. This is double good news.

Significantly lowered energy prices have helped every American with their monthly (if not weekly) budget.

The cost of living is way down (primarily because of oil). The risks of deflation are very slim.

What more could we ask for the holidays?

I've written a short article on that at:

mast-economy.blogspot....
or at seeking alpha at:
seekingalpha.com/artic...

The Good News Economist

2008 Dec 23 01:02 PM

[secmaven:]

Over supply of "everything" on out into the future assumes that the rest of the world is going to keep shipping their goods and services to us for our money. That money is created by the Treasury selling bonds to investors or the Fed. The bonds are backed up by the future ability of the Treasury to collect taxes and right now the tax base due to rising unemployment and falling investment values is shrinking as fast as our national debt is increasing. What this tells me is that the dollar will be toast sooner rather than later and the flow of goods from abroad traded in exchange for those dollars will dry up. There can be no long term deflation in this scenario.

2008 Dec 23 01:06 PM

[carey_jim:]

Also, everything tends to return to the mean and it is arguable that America, which is the economic engine of the world, has been partying since World War II with only a few coffee break recessions.

I don't think we Americans will ever pay much attention to sages such as Henry David Thoreau or Walt Whitman, not to mention the teachings of the Gospels, but there is every reason to think that we've reached an extreme of frenetic economic activity that must tend back towards a mean between these two extremes.

After all, money is vitally important so that we have a roof over our heads, have plenty of healthy and tasty food and have transportation to get to where we want to go.

But after the economic basics, life starts, and life consists of all those things that the Christmas season is supposed to remind us of, which boil down to wise living together.

Merry Christmas and a Happy New Year!

2008 Dec 23 01:19 PM

[Jimbo:]

I like prudentinvestor's analysis. The only thing he left out is the word: "stagflation", which is ,unfortunately, the worst of both worlds. It seems like almost all grocery items we purchase in the stores are higher. The local electric utility has won a 25% increase in its' base rate ,effective January 1. I believe the price of motor fuel is going back up in the coming year because actual production costs, for many producers, are higher than current market prices and producers will simply shut down. The bottom line: The standard of living for most of us will fall for some time.

2008 Dec 23 03:58 PM

[John Lounsbury:]

John Evans - - -

You have written a provocative article. My bottom line is that you see an extended period of deflation. You have not made a clear attempt to define how this might end, but (see item 2. below) you clearly think it might, and possibly soon. However, the bulk of your arguments are supporting persistent deflation.

The comment stream thus far makes some good points. I would like to add some more, specifcally analyzing some of your statements.

1. "We are in deflation because supply far, far exceeds demand for everything (at least in the US, which is the country whose economy I am describing) and money is tight."

I agree that the U.S. is still the land of plenty and there are serious over- supply areas in things central to our economy: houses, automobiles and consumer electronics come to mind. But there still are not over-supply issues in such areas as pharmaceuticals, medical services, wide-band services some post-construction services for home-owners. Local plumbers, electricians and mechanical tradesmen are charging more than a year ago in this area (North Carolina). In my experience there are still price increases in the other areas I mentioned, as well. Also, my wife tells me that the cost of groceries is continuing to rise. All these observations relate to my comment 3. below.

2. "As with most things, what is being argued is actually the matter of time. Inflation will most certainly recur, but when? Six months?....12 months?.........Two to five years?.....A decade or more?.... I say we will see years of falling prices."

This is the big question and that is your opinion. I believe your conclusion is valid only if we have a deflationary spiral (the momentum you discussed). Such a condition would likely result in The Great Depression II or, even worse, The Greatest Depression. The attempt to avoid this outcome is the purpose all the money being printed to retire the debt off which we have been partying.

3. "That is the definition of deflation: real average prices falling across the board. As far as I can see that is what we have and so, regardless of tomorrow, which cannot be known, we are in a deflationary state."

I disagree with your statement that we have "real average prices falling across the board". See 1., above. This could come to pass, but we are not there yet. If it does come to pass, Fed and government monetary policies will have failed. The result would be as described in 2., above.

4. "At present, real demand is low because the resources needed to indulge our desires are scarce. Money is scarce because we spent too much using credit over the last five years and so have reduced access to credit. We spent tomorrow's capital."

I have been criticized by some for making the same argument, but I still think you are right. In my opinion, the new money being printed is replacing the money already spent. The inflation problem arises when new money exceeds that needed to remove the bad debt. I fear that may be sooner than you anticipate.

5. "How is it even remotely possible that the supply of anything in the US will ever fall even below normal demand levels, nevermind far enough below those levels to cause an inflationary spiral? You may see this as a possibility, but I do not."

I can not only see this as a possibility, but I have lived through such episodes in my lifetime. Post WW II saw a serious supply shortage driven inflationary period. This could happen again if new technology emerges (energy technology, for example) and demand exceeds supply until the technology becomes more mature. The 1970's saw another inflationary period driven by energy supply issues.

6. "Question: What mechanism will place enough capital in the average American's hands and so overcome the simultaneous pressures of lack of funds combined with an increased propensity to save, due either to shrewdness or fear, which are acting to drive demand downward?

I do not see such a force in place at present and neither do I see the possibility of such a force making itself felt in the near future."

The problem is not the "source of enough capital". The source of capital is already hard at work: the printing press. The temporary problem is the velocity of that capital. It is being captured on bank balance sheets and will continue to stay there until the need subsides for added reserves to cushion future additional defaults from the collapsing debt pyramid. Then the problem will quickly become the "source of too much capital" and the risk is that velocity will explode.

You do not define near future, but I would limit near future to no more than 12-24 months. If the low velocity dam does not break, allowing all this new money to flow into the streets, within 2 years, your vision of persistent deflation and my spectre of deep depression become much more likely.

The trick to successfully navigate this period is to print just enough new money to monetize the debt (the money spent) without over-shooting into hyper-inflation. I don't think the exact amount needed can be known and the Fed will err on the side of more than enough new money, because the structural damage to our society is greater if they err on the side of too little.

7. "The third mistake is psychological in nature. It is what caught many people up in the Madoff thing. People simply believe what they want to believe. One example: one person noted that a devalued dollar = inflation. If this is a law instead of a congruency, then if the dollar is tanking as it is (it went from 1.22CHF to 1.06CHF in three days); then why is the price of oil not skyrocketing?"

Don't make the mistake of mixing micro observations with macro trends. Your observation is valid. However, the only way that such a trend could go on for a long time, say a year, would be that (a) the dollar ceased to be the primary exchange currency or (b) we were in a depressionary spiral and demand was dropping faster than the dollar was devaluing. I am not anticipating either.

8. "I hate cliches, but what I see is a perfect storm of falling demand. Everything in economics is screaming that demand is falling and when demand falls prices fall, there is nothing that can mitigate the effects of the law of supply and demand. Ergo, deflation."

I believe you observation is correct. We can debate the duration of this effect. From my previous comments you can see that I think the duration is limited and that if I am wrong, we will enter the "Dark Ages" of the 21st century.

Mr. Evans, presenting writers such as you is one of the important services that Seeking Alpha provides. Debatable positions allow a broad range opinion to come forward. That's what makes Seeking Alpha much more than just a news blog.

Keep on writing!

2008 Dec 23 04:12 PM

[Jeff:]

The main question to our economic future concerns American consumers ability to continue to spend. I like your comment on my basic question below.

Your Question: What mechanism will place enough capital in the average American's hands and so overcome the simultaneous pressures of lack of funds combined with an increased propensity to save, due either to shrewdness or fear, which are acting to drive demand downward?

I do not see such a force in place at present and neither do I see the possibility of such a force making itself felt in the near future.

My Question:
My whole adult life I have been told that consumers represent 70% of our GDP.

In 2002 Alan Greenspan side stepped our current crisis by providing consumers with new cash, "using the only viable asset class to escape the tech bubble collapse", by inflating the housing market with a sustained 1% Fed Rate.

No one has addressed just how this 70% group will now obtain new cash. Into what asset class will new money be injected, and what collateral will be used to obtain these monies, when every major consumer asset class is collapsing at the same time.

Not from Housing: down 38% to 45% and still falling
Not from stocks: down 40%
Not from income: flat at best
Not from jobs: 2.1 million lost so far, and many more to come
Not from savings: 0% savings rate
Not from credit cards: C.C. company's are raising rates and decreasing limits
Not from increased State assistance: 41 states need federal bail outs just to survive
Not from historic low mortgage rates: the consumers who need it, can't qualify

So short of dropping money from helicopters, Please, anyone explain to me how new money's will reach these folks, and if 70% is the true number, how can we possibly avoid a deep, deep, depression like contraction, without consumers leading the way to ever higher spending?

2008 Dec 23 08:04 PM

[MSE:]

The last 100 years have shown that global asset markets go through long periods of increasing or decreasing valuations. Increasing valuations are fueled by above average availability of credit, leading to increases in credit driven demand, increased velocity of money and eventually, asset inflation.

You see it in the roaring 20's, the 50-60's and the 80-90's. by 2000, stocks had reached the highest PE in recorded history (asset bubble) then those dollars leave and flow into real estate and commodities creating two more asset bubbles.

But once the credit driven asset demand has created a global asset bubble (all asset classes are priced at the upper end of their historic range), asset price inflation falls under it's own weight. This is where I agree with the article, deflation inertia will cause assets to find equilibrium... the answer to deflation is lower prices and it will take longer than most pundits believe.




On Dec 23 04:12 PM John Lounsbury wrote:

> John Evans - - -
>
> You have written a provocative article. My bottom line is that you
> see an extended period of deflation. You have not made a clear attempt
> to define how this might end, but (see item 2. below) you clearly
> think it might, and possibly soon. However, the bulk of your arguments
> are supporting persistent deflation.
>
> The comment stream thus far makes some good points. I would like
> to add some more, specifcally analyzing some of your statements.

>
>
> 1. "We are in deflation because supply far, far exceeds demand for
> everything (at least in the US, which is the country whose economy
> I am describing) and money is tight."
>
> I agree that the U.S. is still the land of plenty and there are serious
> over- supply areas in things central to our economy: houses, automobiles
> and consumer electronics come to mind. But there still are not over-supply
> issues in such areas as pharmaceuticals, medical services, wide-band
> services some post-construction services for home-owners. Local
> plumbers, electricians and mechanical tradesmen are charging more
> than a year ago in this area (North Carolina). In my experience
> there are still price increases in the other areas I mentioned, as
> well. Also, my wife tells me that the cost of groceries is continuing
> to rise. All these observations relate to my comment 3. below.

>
>
> 2. "As with most things, what is being argued is actually the matter
> of time. Inflation will most certainly recur, but when? Six months?....12
> months?.........Two to five years?.....A decade or more?.... I say
> we will see years of falling prices."
>
> This is the big question and that is your opinion. I believe your
> conclusion is valid only if we have a deflationary spiral (the momentum
> you discussed). Such a condition would likely result in The Great
> Depression II or, even worse, The Greatest Depression. The attempt
> to avoid this outcome is the purpose all the money being printed
> to retire the debt off which we have been partying.
>
> 3. "That is the definition of deflation: real average prices falling
> across the board. As far as I can see that is what we have and so,
> regardless of tomorrow, which cannot be known, we are in a deflationary
> state."
>
> I disagree with your statement that we have "real average prices
> falling across the board". See 1., above. This could come to pass,
> but we are not there yet. If it does come to pass, Fed and government
> monetary policies will have failed. The result would be as described
> in 2., above.
>
> 4. "At present, real demand is low because the resources needed
> to indulge our desires are scarce. Money is scarce because we spent
> too much using credit over the last five years and so have reduced
> access to credit. We spent tomorrow's capital."
>
> I have been criticized by some for making the same argument, but
> I still think you are right. In my opinion, the new money being
> printed is replacing the money already spent. The inflation problem
> arises when new money exceeds that needed to remove the bad debt.
> I fear that may be sooner than you anticipate.
>
> 5. "How is it even remotely possible that the supply of anything
> in the US will ever fall even below normal demand levels, nevermind
> far enough below those levels to cause an inflationary spiral? You
> may see this as a possibility, but I do not."
>
> I can not only see this as a possibility, but I have lived through
> such episodes in my lifetime. Post WW II saw a serious supply shortage
> driven inflationary period. This could happen again if new technology
> emerges (energy technology, for example) and demand exceeds supply
> until the technology becomes more mature. The 1970's saw another
> inflationary period driven by energy supply issues.
>
> 6. "Question: What mechanism will place enough capital in the average
> American's hands and so overcome the simultaneous pressures of lack
> of funds combined with an increased propensity to save, due either
> to shrewdness or fear, which are acting to drive demand downward?

>
>
> I do not see such a force in place at present and neither do I see
> the possibility of such a force making itself felt in the near future."

>
>
> The problem is not the "source of enough capital". The source of
> capital is already hard at work: the printing press. The temporary
> problem is the velocity of that capital. It is being captured on
> bank balance sheets and will continue to stay there until the need
> subsides for added reserves to cushion future additional defaults
> from the collapsing debt pyramid. Then the problem will quickly
> become the "source of too much capital" and the risk is that velocity
> will explode.
>
> You do not define near future, but I would limit near future to no
> more than 12-24 months. If the low velocity dam does not break,
> allowing all this new money to flow into the streets, within 2 years,
> your vision of persistent deflation and my spectre of deep depression
> become much more likely.
>
> The trick to successfully navigate this period is to print just enough
> new money to monetize the debt (the money spent) without over-shooting
> into hyper-inflation. I don't think the exact amount needed can
> be known and the Fed will err on the side of more than enough new
> money, because the structural damage to our society is greater if
> they err on the side of too little.
>
> 7. "The third mistake is psychological in nature. It is what caught
> many people up in the Madoff thing. People simply believe what they
> want to believe. One example: one person noted that a devalued dollar
> = inflation. If this is a law instead of a congruency, then if the
> dollar is tanking as it is (it went from 1.22CHF to 1.06CHF in three
> days); then why is the price of oil not skyrocketing?"
>
> Don't make the mistake of mixing micro observations with macro trends.
> Your observation is valid. However, the only way that such a trend
> could go on for a long time, say a year, would be that (a) the dollar
> ceased to be the primary exchange currency or (b) we were in a depressionary
> spiral and demand was dropping faster than the dollar was devaluing.
> I am not anticipating either.
>
> 8. "I hate cliches, but what I see is a perfect storm of falling
> demand. Everything in economics is screaming that demand is falling
> and when demand falls prices fall, there is nothing that can mitigate
> the effects of the law of supply and demand. Ergo, deflation."

>
>
> I believe you observation is correct. We can debate the duration
> of this effect. From my previous comments you can see that I think
> the duration is limited and that if I am wrong, we will enter the
> "Dark Ages" of the 21st century.
>
> Mr. Evans, presenting writers such as you is one of the important
> services that Seeking Alpha provides. Debatable positions allow
> a broad range opinion to come forward. That's what makes Seeking
> Alpha much more than just a news blog.
>
> Keep on writing!
>
>
>
>
>

2008 Dec 23 08:17 PM

[carey_jim:]

I'll give a very simplistic example just to try put economics itself in perspective.

Consider the situation of an orchard of ripe apples and a farmer who has no money to pay workers, and banks have no money to lend.

The farmer has two options. One is to let the apples rot on the trees and the other is to promise to pay workers AFTER they have picked the apples and after they have been sold.

The basic units of economics here are trust that people will pay for apples in the future and trust in some kind of government authority that can enforce a contract drawn up by the farmer.

Money itself developed out of similar basic foundational units of economics such as faith that everyone will accept money as payment and that a trusted government (our representatives) will have the sole authority to print money and the ability to stop counterfeiters.

Trade breaks down when the underlying basic foundational units of economics fail. This happens during and after revolutions and wars usually, and occasionally during financial panics.

The German problem of hyperinflation, for example, was not a problem of money supply, except nominally. What actually happened was that the victors of World War I and especially France, placed enormous reparations payments on Germany that Germany could not pay. Naturally Germany printed paper money to pay but the amount of money demanded was absurdly high and so hyperinflation became inevitable. But if you reduce the problem of German hyperinflation to one of money supply, you are missing the point. A gun was being held to Germany's head and they were forced by real military authorities to pay money they didn't have.

America still has the same wealth it had at the beginning of 2008. All the houses, buildings, bridges, factories and other capital goods are still here.

Nothing has really changed except the collective perception that we, as a nation are doing too many things that are wrong and that we can't (or shouldn't) continue doing those things. Stock market and real estate speculation are the two most prominent.

But there are many others too.

The War in Iraq and Afghanistan.
The destruction of the environment.
A crumbling infrastructure.
Dwindling natural resources.
The failed legal system.
The failed medical system.
Illegal immigration.
The fast food nation and obesity.
The drug problem and I'm not just speaking of illegal drugs.
Divorce and the dysfunctional family.

I could go on, obviously.

To reduce the problem to one symptom, that money is no longer available to solve so many problems is to forget that no one is holding a gun over our heads to fight in Iraq and Afghanistan or to produce more real estate, light trucks and fast food.

The concept of money supply and credit rest on deeper foundational economic units which, after all is said and done, rest on the eternal verities we call virtue.

If America can't rediscover its best values, all the money on earth wont get us out of our mess and we'll be reduced to selling apples on street corners again as the only economical way to get those apples off the trees.



On Dec 23 08:04 PM Jeff wrote:

> The main question to our economic future concerns American consumers
> ability to continue to spend. I like your comment on my basic question
> below.
>
> Your Question: What mechanism will place enough capital in the average
> American's hands and so overcome the simultaneous pressures of lack
> of funds combined with an increased propensity to save, due either
> to shrewdness or fear, which are acting to drive demand downward?

>
>
> I do not see such a force in place at present and neither do I see
> the possibility of such a force making itself felt in the near future.

>
>
> My Question:
> My whole adult life I have been told that consumers represent 70%
> of our GDP.
>
> In 2002 Alan Greenspan side stepped our current crisis by providing
> consumers with new cash, "using the only viable asset class to escape
> the tech bubble collapse", by inflating the housing market with a
> sustained 1% Fed Rate.
>
> No one has addressed just how this 70% group will now obtain new
> cash. Into what asset class will new money be injected, and what
> collateral will be used to obtain these monies, when every major
> consumer asset class is collapsing at the same time.
>
> Not from Housing: down 38% to 45% and still falling
> Not from stocks: down 40%
> Not from income: flat at best
> Not from jobs: 2.1 million lost so far, and many more to come

>
> Not from savings: 0% savings rate
> Not from credit cards: C.C. company's are raising rates and decreasing
> limits
> Not from increased State assistance: 41 states need federal bail
> outs just to survive
> Not from historic low mortgage rates: the consumers who need it,
> can't qualify
>
> So short of dropping money from helicopters, Please, anyone explain
> to me how new money's will reach these folks, and if 70% is the true
> number, how can we possibly avoid a deep, deep, depression like contraction,
> without consumers leading the way to ever higher spending?
>

2008 Dec 24 12:09 AM

[X-15:]

Supply and Demand

If a house drops in price to a point it becomes affordable doesn't that create demand when purchased?

If demand for oil drops from 89 million barrels a day to only 75 million barrels a day isn't that still a requirement that needs to be fulfilled? And isn't that a demand that has a diminished supply ongoing?

Are 6 + billion people going away?

2008 Dec 24 01:02 AM

[yamo:]

I think you wrote a very inteligent article but I don`t agree with you, first of all you should not make an analisis in only in a few months basis, because before that, everything was going up for years and some of the things very much, like oil or so, second you cannot isolate the USA from the rest of the world and again a lot of the deflation also is coming because the US dollar is gaining strength compared to other currencies, and that was a change prior to the deflation period we are living at, inflation in the world is emerging in some products like energy, medications or interests in credit cards is skyrocketing in some countries. Inertia is applied to objects and we are in living system which is always changing and growing and internal and external forces act on it, so I say again US is not isolated from the world and the same forces that acted to make the dollar more strong can act on it, the other way around, you will say this is not happening right now, but is like a terminal disease that will happen inevitable. Other thing the law of supply and demand is also applied to the money, the goverment is supplying alot of dollars and that will happen on all the bailouts that are coming ( the inertia law will work here in fact, because they said they will do so), and since the supply of dollars has been very high and will be very much higher that will end on inflation or hiper-inflation. We must keep in mind that hiper-inflation and deflation are events where all the products are distorted compared to their real value and usually both things happen at the same time, and we should look at the products that are every day living like food, energy, medications or so.

2008 Dec 24 02:16 AM

[John Evans:]

Thank you all for the lucid, intelligent and well considered comments. I learned something from every single one.

To respond to the majority of inflation-ites I can say 2 things.

First: this is basically an argument of time. I noted that. Inflation will certainly return, it is only a matter of time. The question is "how long?". Will inflation return in the short term, 3-6 months or the very long term of 2 to 10 years, or something in between? I say the longer term.

The second is that more persuasive of the inflation-ites seem to be relying almost solely on the increase in the money supply as the basis for a shorter term wait for the return of inflation. To respond, the housing slump is going on 2 years with a full 6-9 months of it under the aegis of the bailout mentality. Why? Because demand is falling and so prices are falling and so people are waiting to see the bottom. If this occurs across the board, for whatever reason and I believe it will, then demand will continue downward and so prices will necessarily follow.

We will see what we will see and that reality is the bottom line.

PS: To the deflation-ites, I never imagined so many demand siders existed. I previously believed I was alone in a world of supply siders.

2008 Dec 24 02:31 PM

[Daniel B:]

It is completely stupid to just arbitrarily apply a law of physics to a complex human system that doesnt obey the laws of physics.

And even when using it you have screwed up the analogy. Deflation/inflation are rates of change. In physics, if something is changing a force is acting upon it. So your "base case" if one will, of deflation continuing until a force acts, is just flawed. Inertia, in your stupid analogy, would keep prices stable, not moving. Something has to change for prices to change, no?

People who arbitrarily apply models from hard sciences to human systems have no business writing about complex topics. Why not just start a hedge fund and call it long-term capital?

2008 Dec 24 11:10 PM

[Kunst:]

Welcome, Daniel B. I hope your second post is more insightful than your first.

2008 Dec 24 11:52 PM

[Alan von Al...:]

Eeek! It's a Kunst attack! Run for your lives!

I agree with Daniel B, which I discussed previously in this thread, but I want to inject another thought here. (Remember to vote thumbs down early and often on whatever I say. The planet is in terrible danger. Don't take any chances. Kunst knows what's best. Turn off your car and walk.)

The great problem with rising taxes and falling commodity prices is that marginal players are going to go bust. As it stands right now, new build shipping and offshore construction projects are suspended or cancelled. Onshore domestic wells are being shut in. Bakken foolishness is over, as well as Canadian tar sands that never made any sense to begin with. It's possible that Chevron and Conoco could fail, depending on what happens next in Africa. Pedevesa, Pemex, and Petrobras are negative cash flow zombies, living hand to mouth on subsidies and hot air. Saudi Aramco is producing more water than oil. Russia is a bad joke, despite slap-happy expropriation of BP, Shell and Exxon assets.

The point is that supply will crash. It doesn't matter whether crude sells at or below production cost in 2009 because "short term" is a 10-year horizon in the oil business. Last time we went through a crash, mergers wiped out a whole generation of experienced rig hands and geologists who knew how to correlate well logs.

End of lecture. Deflation is not a macro story. Reflation won't fix it.

2008 Dec 25 01:32 AM

[John Evans:]

To Mr Daniel B.

Thank my freind. I use my real name and you? Yes I know you. What do we have , millions against one and themillions will be crushed? Yes I think so. Tell all your freinds I said, "hi" and happy Hanukkah.

2008 Dec 25 03:54 AM

[scotty1560:]

Long painful stagflation...walks like a duck, looks like a duck..

Hungry for snapper or grouper? Not many left in the gulf, so we pay more.
Filling up the Grand Cherokee? Let's see where oil is 2-3 years out.
Bottle of "Evian" water?....precious water is running low...
Running your sprinklers? mmm...my water bill just doubled again. Consumption tax? VAT tax? what will UNCLE's next desperate gimmick be? Taking a trip? Consolidated airlines mean much higher prices.

Now the bad news..my retirement assets?
My properties..dead..sure I hope I don't need to sell for 7-10 years
My stocks...dead..I'd rather not be forced to look at the statement.
My "maple leaf" coins...dead imo..fun for a couple of years though.
"real" assets slowly decline or just flat line for years..

supply and demand 101: diminishing "cheap" resources and ever increasing "humans". Corporate America, Governments, churches....consumers wanted...not concerned with long term effects...walks like a duck, looks like a duck...stagflation.

Convert all Americans to financial services and healthcare?...takes care of all our problems?....we don't need oil, water, manufacturing, steel?...Asia will solve the world problems?..foreign exchange rates?...let's complicate the tax code some more?...100 year mortgages will solve our problems?...Let's double the write off for primary and vacation homes, that should do it? 3% fixed rates for mortgages..don't forget about jumbos?

Much higher taxation directly or indirectly..much higher cost of living..
one final squeeze out of "mom and pop" middle class America.
Gotta keep growing the government and pay those visionary CEO's.

Worldwide governments always have plan "D", create a war if needed.
Iran-Israel? Russia Georgia? Iran-US? pols need to get re-elected.
What really happened at "Easter Island"? resource depletion?
No "cheap" resources = no growth. Everything else = short term gimmicks

Time for us Americans to get "real" and learn to live off lower expectations..

2008 Dec 26 12:56 PM

[Daniel B:]

John I don't understand your comments. Don't worry about clearing them up, I don't really care too much.

On topic, do you really think it appropriate to take models from well defined low-variable environments where humans can't affect the rules themselves and apply them to complex multi-thousand if not multi-million variable environments where the very understanding of the environment by various players changes that environment?

Do you think it will give useful results?

Jan 05 01:30 PM