I've been hearing the term deflation being bandied about by TV news pundits with Japan being used as the popular example of this phenomenon for the past few months. The claim is that if the trend of price drops in the U.S. continues then we will be headed for deflation. When I first saw these stories I wondered what exactly is wrong with falling prices? Well…

Everywhere you look assets are worth less than they were a year ago. Gas prices are lower, house prices are lower, and stock portfolios are lower. At first I considered this a net positive. According to Zillow my house is now worth 10% less than what we paid for it almost two years ago and my 401(k) lost about 35% during the 2008 calendar year. However I treated this as a "correction" since these were in effect paper losses since I bought my house to live in not to flip it and I'm not planning to spend out of my 401(k) until retirement. On the other hand lower gas prices and cheaper consumer goods at Christmas time had a real and positive effect on my bottom line.

In addition, despite the media's claim that people were hoarding we planned to ignore the hype and help the local economy by continuing our plans to have our bathroom remodeled and get a new car later in the year (my wife has her eye on the Ford Flex).

As each week passes I've been less sure of our plans to "help the local economy" and last week's announcement by my employer to eliminate 5,000 jobs within the next 18 months began to make the plans seem downright irresponsible. At this point we've decided to hold off on the purchases and are debating the safest way to hold on the money and still retain value. My behavior sounded familiar and I looked up Wikipedia for information about deflation in Japan it was interesting to see the parallels

Systemic reasons for deflation in Japan can be said to include:

  • Fallen asset prices. There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.
  • Insolvent companies: Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks have delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks make even more loans to these companies that are used to service the debt they already have. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested (by The Economist) as methods to speed this process and thus end the deflation.
  • Insolvent banks: Banks with a larger percentage of their loans which are "non-performing", that is to say, they are not receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans.
  • Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.
  • Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.

The crazy thing is that this sounds like a description of the United States of America today. That's when I understood that the threat of a deflationary spiral is very real. If people like me start hoarding cash then businesses get less customers which causes them to lower prices in return. With lower prices, they make less money and thus need to cut costs so they have layoffs. Now the local situation is worse giving people even more conviction in holding on to their cash and so on. The bit about imported goods kicking the butts of locally produced items in the marketplace is also especially apt given the recent drama about the automobile bailout

Anyway, it looks like we are at the start of a deflationary spiral. The interesting question is whether there is anything anyone can do to stop it before it fully gets underway.


 

Sunday, 25 January 2009 16:22:28 (GMT Standard Time, UTC+00:00)
And, in general commodities beyond oil appear to have falling dollar prices, going back to late Summer 2008. Beyond the hoarding of dollars, I see two cross-cutting pressures on individuals:
-deflation in a world of mortgages being the larges single expense doesn't free up much cash, particularly if a worker has to replace their job with a 'deflated price' alternative
-the government is in a unique position with the dollar, as it is deflating against commodities and assets, including other currencies, whereby they can -- and are -- simply injecting cash by 'printing' it as additional credit

So... while we have a window of deflation right now, it seems reasonable to assume that the additional injected cash, pending stimulus, and the world government's generally poor record on hitting the mark on money supply might lead to a snap-back to very high inflation within 2009. This can be very painful to displaced workers, as employment and wages traditionally lag other economic variables.
Will Ballard
Sunday, 25 January 2009 16:39:29 (GMT Standard Time, UTC+00:00)
Good post, I'm feeling the same way about purchses myself. Trent over at thesimpledollar.com has a good write-up on deflation and why it's bad as well.

http://www.thesimpledollar.com/2008/11/16/personal-finance-101-deflation-and-you/
Sunday, 25 January 2009 17:58:40 (GMT Standard Time, UTC+00:00)
See http://www.google.com/search?q=deflation+site:globaleconomicanalysis.blogspot.com for some great articles about deflation.
Jordan Smith
Sunday, 25 January 2009 18:09:10 (GMT Standard Time, UTC+00:00)
As each week passes I've been less sure of our plans to "help the local economy" and last week's announcement by my employer to eliminate 5,000 jobs within the next 18 months began to make the plans seem downright irresponsible. At this point we've decided to hold off on the purchases and are debating the safest way to hold on the money and still retain value.


Just what the local puget sound economy needs now, 85,000 upper middle class people afraid to spend their money. Thanks Mr. Ballmer!
Anonymous
Monday, 26 January 2009 00:40:54 (GMT Standard Time, UTC+00:00)
That is, indeed, the theory behind the idea of a stimulus.

The only economist to write comprehensively on depression-based economics in the past century has been John Maynard Keynes. He pointed out that at some point, lowering interest rates (which typically spur investment) has no effect, and one needs government expenditure to "jumpstart" the economy. It's also why the original Paulson plan was to buy troubled assets - because then the government could "realize" the losses, and the banks would be solvent. Eliminating three of those above concerns. Of course, buying equity does the same thing and is a better idea (the Gordon Brown plan, adopted in part by the US).

Paul Krugman usually has a good take on Keynesian-type economics.

In terms of your decision: remodeling your bathroom is a dual decision - it increases, in Adam Smith's terminology, both the exchange-value and the use-value of the house. If you look at the remodeling costs, and compare that to the forecasted increase in house value, it may (or may not) make sense to do the remodeling. However, you'll also be deriving use-value, which (while it cannot be measured), is also worthwile. Evaluating the degree to which your decision is based on the change in use-value or exchange value is something only you can do. Remember, however, since you're intending to live there for a while, the expected return on investment in the future is higher than it is now, and may be at least as high as it as when you intially made the decision.

blah blah blah

In other news: doing something because "everyone else is doing it" is never logically sound. Since you (presumably) don't have to worry about losing your job, you have a guaranteed revenue stream. That means you don't have to worry (nearly as much) about saving money and so on.
Michael
Monday, 26 January 2009 00:41:41 (GMT Standard Time, UTC+00:00)
Your CATCHPA doesn't accept capital letters, despite the image being in capitals.

Threw me twice.
Michael
Monday, 26 January 2009 19:48:25 (GMT Standard Time, UTC+00:00)
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Wednesday, 04 February 2009 19:34:52 (GMT Standard Time, UTC+00:00)
NPR's excellent Planet Money featured a similar comparison with Japan last week - see http://www.npr.org/blogs/money/2009/02/hear_japans_lost_lesson.html#more. Very interesting takeaways!
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