Deflation

In the December 2014 quarter, the New Zealand CPI feel by 0.2 percent, mostly as the result of declining fuel prices.

Now everyone is talking about deflation, but this misses the point.

• Houses prices are up 5 percent in the last year.
• Rents have risen sharply.
• They price of farmland has been booming.
• Share prices are at record levels
• Local authority rates continue their upward drive.
• Insurance premiums continue to increase.
• All monetary aggregates from M1 to M4 are increasing.

We are a long way from deflation.

Deflation can be a problem if assets prices fall sharply, as the people who have borrowed against them have to sell them at fire sale prices. This further reduces the demand for assets, which depresses prices further. The combination of declining asset prices and high levels of debt can be a toxic combination. However, there is no sign that this is happening in New Zealand.

Yet.

Deflation

According to Ambrose Evans-Pritchard at the Telegraph, the Swedish Riskbank is worried about deflation.

Sweden has become the first country in northern Europe to slide into serious deflation, prompting a blistering attack on the Riksbank’s monetary policies by the world’s leading deflation expert.

Swedish consumer prices fell 0.4pc in March from a year earlier, catching the authorities by surprise and leading to calls for immediate action to avert a Japanese-style trap.

Lars Svensson, the Riksbank’s former deputy governor, explained that this falling prices are a problem, because they cause debt burdens to ratchet up in real terms. Swedish household debt is 170pc of disposable income

This is a bit rich. Creeping inflation has hurt savers for years, slowly wiping out the value of their hard earned savings. Now a 0.4 percent fall in pirces hurts bgorrowers, and the central banks get worried. It is clear whose side they are on.

Central banks have been rewarding borrowers and punishing savers forever. This contributed to weak risk assessments which contributed to the Global Financial Crisis.

Central Banks fear deflation. The most common argument is that if prices are falling people will stop buying and wait till prices get lower. This does not make sense. Technology prices have been falling for years, but people have not stopped buying.

Chis Casey explains the flaws in this fear in his article called Deflating the Deflation Myth.

In addition, the American economic experience during the nineteenth century is even more telling. Twice, while experiencing sustained and significant economic growth, the American economy “endured” deflationary periods of 50 percent.

This during a period of “sustained and significant economic growth”. But just think of all those poor consumers, having to make the best of constantly falling everyday low prices.

Deflation benefits consumers, because it increases their ability to buy things, without an increase in wages. The inflation of the last few decades has robbed consumers of reduction in prices that should have come through technology gains. These have been captured by people in debt.

Central banks believe deflation leads to depressions. Casey quotes a study completed by several Federal Reserve economists who found:

... the only episode in which we find evidence of a link between deflation and depression is the Great Depression (1929-34). We find virtually no evidence of such a link in any other period. ... What is striking is that nearly 90% of the episodes with deflation did not have depression. In a broad historical context, beyond the Great Depression, the notion that deflation and depression are linked virtually disappears.

Peter Schiff

Peter Schiff predicted the collapse of the housing bubble when most economists thought the new world had come. He is now concerned about the impact of the government pumping the supply of money.

For now the inflationary tide is being held back by the countervailing pressures of bursting asset bubbles in real estate and stocks, forced liquidations in commodities, and troubled retailers slashing prices to unload excess inventory. But when the dust settles, trillions of new dollars will remain, chasing a diminished supply of goods. We will be left with 1970s-style stagflation, only with a much sharper contraction and significantly higher inflation.

Falling Prices (6) - Investment Strategy

If inflation stopped completely and prices began to decline slowly, investment strategies would also have to change dramatically. Buying an asset and just waiting for the capital gain would no longer be a feasible strategy. That would be a good thing for the economy, as investors would shift to assets that are actually productive.

Investment decisions would require real wisdom and prudence. Ownership of a house would not be viable unless it could be let out for a rental that covered all expenses and any decline in price. Most investors would have to switch to investments that produce something real and valuable.

Inflation has disrupted investment patterns in a very negative way. One of the reasons is that real incomes in the western world have not grown as much as we would like is that most savings (and massive imported savings) have been ploughed into residential dwellings. The problem is that residential dwellings do a produce a return that benefits the economy in turns of jobs and output.

If inflation disappeared, investment would flow into assets that are productive and produce goods and services that people are willing to purchase. Declining asset prices would push investors into more productive investments, which would be good for the economy. More productive investment would benefit society be increasing employment and wealth.

Falling Prices (5) - Houses Too

Inflation makes investment easy, people can buy assets, do nothing, and watch them slowly increase in price. The benefit comes at the expense of people on fixed incomes, as inflation robs them of their wealth. Of course, inflation does not affect all assets evenly. Some assets increase price more quickly than others, and housing has done better than most other asset types. People have brought dwellings and watched their wealth increase, as inflation pushed up the value of their homes.

Our long experience of house rising in price is actually an illusion. The reality is that houses age and suffer from wear and tear over time. Therefore to be a good indication for economic decision making, the price of dwellings should decline slowly to reflect that reality. In ten years time, my house will be ten years older, so its price should be less than it is now. If inflation were eliminated, residential dwellings would gradually decline slowly in price year by year, reflecting the fact that they are getting older and less modern. A thirty year old house would be worth less than a two year old house.

Unfortunately, people have become so used to inflation that the thought of their home not increasing in value over time is quite disturbing. The reality is that most capital goods decline in price over time. Manufacturing plant and equipment can be almost worthless when it has reached the end of its useful life. Nevertheless, business people are happy to buy plant and equipment knowing that its resale value will decline over time, because they can use it to produce goods that can be sold for a return that will compensate them for the depreciation in value of their assets.

In the same way, we have no problem with buying a car that will be worth less next year than it is this year, because the transport services that the car provides are worth more to us than the decline in price and the cost of maintenance.

The reason that we would be disturbed by a decline in the price of houses is that we tend to think of a home purchase as an investment. This is incorrect thinking. In the absence of inflation, the purchase of a home is consumption expenditure. The person buying a home consumes all the shelter services that it provides. The purchase price is actually an up-front payment for a very long-term stream of services. (Some of the shelter services that are not used up may be sold when the owner is ready to move on)

The only way to turn the purchase of a dwelling into an investment that produces a return is to rent it out to some willing to pay for the shelter services. In addition to providing a steam of income, the rent would compensate for any decline in price.

If there were no inflation, people would have to stop seeing their home as an asset that will increase in value over time. People would only buy a house to live in, if they valued the shelter services it could provide more than the decline in price and the cost of any maintenance.

Falling Prices (4) - Normal

Very few people realised that deflation should be normal. If governments did not inflate their currency, price inflation would not drop to zero. In a country where the monetary policy is neutral, the price level would gradual fall over time. A few prices might increase in response to shifts in demand, but the prices of most goods and services would fall, as new technology and economies of scale reduce the costs of production.

Declining prices are a powerful economic mechanism, because the benefits flow to everyone in the economy. People on fixed incomes benefit, because the things they have to buy get cheaper. Those who are weak and powerless benefit, because they can purchase more with what they have. Inflation benefits the few, who can work the system and know how to use debt to speculate in property. Falling prices benefit everyone.

One of the best ways to help the poor is to eliminate inflation. Even if price inflation is only three percent per year, poor people will be worse off unless they can increase their income by that amount. Poor people generally do not have sufficient political or market power to negotiate that kind of increase in their incomes, so inflation harms their situation. On the other hand, declining prices benefit the poor without any need for negotiation.

Over the last few years, cheap imports of electronics and clothing from China have been so pervasive that the level of consumer prices has generally declined slowly. This should have turned into a downward flood that brought increased prosperity to everyone, but unfortunately governments continued to inflate their currencies throughout the period. The world thinks that inflation has been low over the last few years, but that is wrong, because prices would have been falling much more, if governments had not been manipulating the money supply.

When economies of scale and technological advances should be reducing prices, even zero price inflation is harmful. Over the last decade, people on fixed incomes have been robbed of the benefits that would have come their way, by governments that have stopped prices from falling. This inflation has eased the pain of those who are heavily in debt. Inflation punished those on fixed incomes and benefits and benefits those in debt. Gradual deflation would benefit everyone, especially the poor.

Falling Prices (3) - Inflation is Good?

We have had inflation for so long, that people have begun to assume that inflation is good. For example, house prices are now so high, that home owners are only able to cope with the huge debt needed to buy a house, because the endemic inflation has reduced the burden of their mortgages. Over the last decade, inflation has made it possible for home owners to cope with really high debt levels, because rising house prices increase the equity of people with mortgages.

Governments are usually huge debtors. In the modern world, most governments have enormous public debt. They love inflation because even at low rates, it gradually erodes the burden of the outstanding debt. The declining value of debt, allows the government to increase debt further. Politicians like debt, because it allows them to spend money, without having to raise taxes.

Many people now believe that a little inflation is a good thing, but it reality inflation is a two-edged sword. It might reward those who are in debt, but it punishes savers. The value of savings is eroded by inflation. Even if inflation is between two and three percent, which most government see as a noble goal, the value of a responsible person’s savings will be halved in fifteen years. In thirty years, the saving will be worthless. Any phenomena that hurts saving and rewards debt is dangerous for an economy.

God’s blessing falls on lenders and not on borrowers.

For the LORD your God will bless you as he has promised, and you will lend to many nations but will borrow from none. You will rule over many nations but none will rule over you (Deut 15:6).

Borrowing is sometimes necessary, but is dangerous because it removes freedom.

The rich rule over the poor, and the borrower is servant to the lender (Prov 22:7).

Inflation blesses debtors and harms lenders. God works the other way round. Being free from the need to borrow is a fruit of his blessing.

You will lend to many nations but will borrow from none. The LORD will make you the head, not the tail. If you pay attention to the commands of the LORD your God that I give you this day and carefully follow them, you will always be at the top, never at the bottom (Deut 28:12,13).

Inflation fights with against God’s blessing.

Falling Prices (2) - Borrowers Punished?

The other concern of the columnists is that deflation punishes borrowers.

A prolonged period of deflation can have a pernicious affect on an economy. The other main reason why deflation can cause so many problems is that it serves to make debt more expensive. Here's why. If you borrow £1,000 at the start of the year to pay for a new sofa, the cost of the loan does not change throughout the year. It remains at £1,000. But the sofa is falling in price. So at the end of the year – when you are still paying back the loan – you have ended up taking out £1,000 to pay for a sofa now worth just £900 or £800. Think of it as negative equity on a grand scale, spreading itself into every corner of consumer credit. Of course, in theory there are some winners: savers (Harry Wallop, Daily Telegraph).

The curse of deflation is that it increases the burden of debts. Incomes fall: debts stay the same. This way lies suffocation…. The great credit bubble of the last 20 years has pushed debt levels in Britain, the US and other Western societies to unprecedented highs… Our sensitivity to debt deflation is therefore greater (Ambrose Evans Pritchard, Daily Telegraph).

This is twisted thinking. The curse of debt has been replaced by the curse of deflation. Evil is good. The lie is truth.

The commentators dislike deflation, because it rewards those who save and punishes those who borrow. Falling prices redistribute wealth – the wrong way (for the columnists). Savings appreciate, which is good for those who have saved. Income is transferred from those in debt to those who have saved. Income is transferred from borrowers and speculators to those who have been responsible. In the strange modern world of debt and leverage this is seen as bad.

Falling Prices (1) - Postponed Spending

Asset prices and commodity prices are falling rapidly as the impact of the global credit crunch permeates the world economy. Newspaper columnists are now starting to warn of the dangers of deflation. The first concern is that consumers defer their spending when prices fall.

Deflation has other insidious traits. It causes shoppers to hold back. They wait for lower prices. Once this psychology gains a grip, it can gradually set off a self-feeding spiral that is hard to stop (Ambrose Evans Pritchard Daily Telegraph).

It encourages people to defer spending, as they wait for prices to fall further. This in turn forces down the price – as retailers slash prices in a vain attempt to attract shoppers. As retailers cut prices, so too do manufacturers, who then have less money to invest in new technology, equipment and, crucially, staff.

Wages then start to fall – psychologically very damaging for consumers, even those that keep their jobs. As they fret about less money in their pockets and their job prospects, they further postpone spending, starting the deflationary spiral once again (Harry Wallop, Daily Telegraph).

These statements are nonsense. Falling prices do not stop consumer spending. Computer prices have been falling for the last twenty years, but spending on computers never stopped. Although prices of most consumer electronics have fallen dramatically over the last decade, sales have increased significantly. The reason is that when prices of things fall, more people can afford to buy them, so sales increase.

The benefit of falling prices is that consumers can buy things when it suits them. During inflation, people rush into purchases before they can afford them, because they are scared that the price will go up. They will often get into debt, trying to beat rising prices. Inflation forces people to make purchases at the wrong time.

Falling prices eliminate this problem. People are not put under unnecessary pressure to buy. They can save for something they need knowing that price increases will not push it beyond their reach. People are free to buy large items when the time is right for them. Falling prices increase freedom.

The related benefit of falling prices is that people get access to better quality goods. By waiting a little longer, they can get a later model, at the same price. This makes them better off.