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Joe Barbieri has Bachelors' degrees in both Civil Engineering and Commerce from the University of Toronto. He has worked in the Financial Services field for over 13 years, with over 10 years on the institutional side of the business. He has covered positions from Fund Accounting to Investment... More
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  • What If Deflation Comes To Pass? 0 comments
    Jun 12, 2014 11:30 AM

    The global bond market has surpassed 100 trillion dollars, (2) and the ECB has reduced interest rates into negative territory. (3) What is the common motivation behind these decisions? They are all being done to reduce the threat of deflation. Is this justified?

    What is deflation? It is when the amount of dollars is fewer relative to the goods that they can buy. The inflation situation is the opposite: The amount of dollars is higher relative to the goods that they can buy. Deflation is like going to a supermarket and seeing prices going down continuously, or opening your bills and watching the costs decline each year. The fears around deflation are that the real value of debts will rise, recessions will be lengthened and there can be a deflationary spiral, where production of goods ceases because it is not worth it for companies to provide goods for continually less profit. On a consumer level, it could cause hoarding of cash because it would go up in value over time, whereas inflation is encouraging people to spend or invest cash because if it sits around, it loses value. (1) Another variation of deflation is when interest rates and production get so low that nobody will want to borrow money. This is because it will not be possible to produce goods and pay the loans back. Assuming credit fuels the economy, there would be economic gridlock.

    What if deflation were a reality? This means that people would be getting a raise each year because the dollars they receive would buy more goods instead of fewer goods. The value of debt would go up, but the value of savings in currency would also go up. The value of physical goods secured against this debt would go down in value in relative terms, which means more people will be walking away from loans. Real estate prices would be going down slowly each year instead of rising. Since cash value is going up, savings ratios would be much higher than they are today. Credit would not fuel the economy because it would be too expensive - and cash would replace it based on what it could buy. The circulation of money would slow down considerably because people would not want to part with currency unless it was for a good reason. Cash would be treated as a store of wealth, which is the status that gold has had for most of history.

    What has changed about the deflation theory? When the deflationary ideas were created, there were limits as to how much cash can circulate in an economy because money was physical. This is not true today as most transactions are done electronically, and money can be issued instantly in any quantity desired. Look at the bailouts and multiple QE episodes for proof of this. As for the deflationary spiral, it is not clear whether this outcome still applies. Corporate profits and production of goods are very high. (4)(5) If these products can be converted into currency, they will continue to be produced. The other elephant in the room is technology. Labour used to be the largest cost of producing goods since most things were made by hand and that took a lot of effort. Now, technology has decreased the demand for labour, materials are more scarce due to overconsumption, and shipping has become a large cost of production due to globalization. This technology combined with cash that is readily created would make deflation a great opportunity if it was perceived correctly.

    If you believe that circulation of money is what drives the economy, deflation may be the greatest threat to economic survival. If you believe that value creation is what should be emphasized regardless of what the currency is, then deflation is not relevant if the economy provides what people need to thrive. It may be time to reassess which mode of thinking should be focused upon, and whether all of this market manipulation is worth the cost.

    Sources:

    1) http://en.wikipedia.org/wiki/Deflation

    2) http://www.bloomberg.com/news/2014-06-01/the-unstoppable-100-trillion-bond-market-renders-models-useless.html

    3) http://www.bloomberg.com/news/2014-05-30/draghi-gets-ready-to-go-negative-as-inflation-sinks.html

    4) https://www.google.ca/search?q=Corporate+Profits+Statistics&tbm=isch&tbo=u&source=univ&sa=X&ei=1weWU8f-CoGUyASS-YKQBw&ved=0CDQQsAQ&biw=1360&bih=631

    5) http://www.oecd.org/trade/its/2539563.pdf

    Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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