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Jon Talton

Analysis and commentary on economic news, trends and issues, with an emphasis on Seattle and the Northwest.

July 9, 2010 at 10:00 AM

Deflation — there, I said it. Here’s why we should be concerned

As any econ geek can tell you, deflation is a “sustained fall in the general price level.” Now, stay with me and don’t flee to the hockey news. Beyond that, definition is a very destructive force that causes the value of goods, services and assets to fall and keep falling. It’s not a relative thing, such as a pullback in the rate of inflation (that was the disinflation we saw in parts of the 1990s). Deflation just keeps on coming.

Most Americans alive today have no memory of the deflation in the 1930s. The only upside was to make money more valuable, if you could get it. But it was devastating for job creation, capital formation, just keeping a business going, world trade and anyone who lived dependent on investments. Deflation was the engine of the Depression. Our distant memory — and obsessive fear among policy-makers — is inflation. But not too long ago few people in the market had any memory of the difficult pre-1984 investing environment. They thought the bull would run forever.

Deflation is back as a fear, and not only among bears such as Robert Prechter, who has been forecasting this for years. It tallies more than 6 million entries on Google. Nouriel Roubini has been warning for a couple of years of “stagdeflation.” As the Eurozone struggles with its banking and debt crisis, it must reassure the world that deflation won’t happen. Commentators even argue about “good” and “bad” deflation.

Deflation is almost always bad. First, it destroys wealth (and not only that held by the rich, as any homeowner or person living on a fixed-income can attest). Second, once it becomes ingrained in people’s expectations and the many subtle drivers of market forces, it is very hard to defeat. Third, it creates great uncertainty for business, especially for a generation of managers with no experience with the conservatism needed to navigate such a calamity. And finally, it makes growth almost impossible, and that means sustained high unemployment. Thus, while some will tell you to protect yourself against deflation by getting into cash, don’t think this is a cure-all. Major deflation hurts nearly everyone.

As Fed Chairman, Ben Bernanke has been very careful to avoid the “D” word. And yet much of the central bank’s policies, especially a quick move to near-zero interest rates and massive monetary expansion, have been aimed at avoiding just that. Bernanke, the Depression scholar, famously said he would toss shrink-wrapped pallets of money out of helicopters if that was necessary to avoid a scenario such as deflation. Yet his consensus on the FOMC is delicate; some Fed governors still worry about inflation.

The reality is that we’ve lived through a mean season of deflation already. How else to describe a 50-percent drop in the price of houses in some areas? And one of the biggest deflationary trigger is heavy loads of debt, something we’re drowning in. And growth is very slow-to-faltering. So while I’m skeptical of any easy predictions about an overall deflationary spiral, we should be concerned (which is why drastic government budget cutting is the last thing we should be doing). The stock market, whose equities would be decimated by deflation, is anxious, too.

We have more tools to fight deflation than in the 1930s. But once it takes hold, even the Fed may have fewer arrows than it thinks (see Japan, Lost Decade).

Today’s Econ Haiku:

We’ll cap that well now

That’s BP’s latest promise

The check’s in the mail

Comments | More in Deflation, Dollar, Eurozone, Federal Reserve, Great Recession, Macro/Big picture

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