Thursday, November 20, 2008

Paging Dr. Stranglove

Or How I Learned to Stop Worrying and Love Deflation

The Washington Post has an article Falling Prices Raise a New Fear: Deflation.
"Everyone is having these huge sales, and consumers know if they wait longer, the chances of them not having a good selection is fairly small and the chances are that the prices will be lower," said Charles McMillion, an economist who runs MBG Information Services. "So why buy today? This is exactly why economists are always scared to death of deflation."

Using the evidence I pointed to in my "Currency Bubble" post, deflation is expected to be a less than earth shattering -0.77% per year. I can imagine the throngs of shoppers hitting Best Buy, seeing a brand new flat screen for $2,000 and telling the salesman, "Why buy today? I can expect to get this same TV for $1984.60 next year." Maybe my time preference is a little high, but I'm not waiting a year for a <1% discount.

Even I rather rashly stated "Why buy a TV that costs $1000 today when it may only cost $950 next month?" Of course, this implies an annual deflation rate of 46%, which would be a little more distressing, but in the same sense, how many have started biking to work waiting on gas prices to keep falling.

Will people ever so slightly decrease their purchases? Sure. Will it lead to massive layoffs? No. Companies will do small things to cut wages like dropping 401K matches, increasing health care premiums, give out 3% annual raises instead of 4%, etc... They will hire new people at ever so slightly lower rates. As long as wage rates are allowed to change, they will change.

Executives would not want to take on debt while prices and profits are falling.

Oh really? I kind of remember my Dad buying a $2,500 IBM PS2 in the late '80s. Now Dell is advertising new desktops from $399. Since prices have been falling for 25 years, I find it odd that HP's Net Earnings per share have been increasing annually from 2005 to 2007. I also find it interesting that they increased their commercial market debt between 2006 to 2007 from $5.2B to $8.2B. Even in the case of desktop computers where the retail price has been falling by roughly 7% annually, companies are still increasing profits.

Apparel makers have been hit hard. The recent consumer price index report showed that apparel prices fell 1 percent last month.

Clearly they need a bailout! Hit hard? Are you kidding me? How about energy companies who saw oil and gasoline fall 50%.

Plenty of items get cheaper over time. DVDs, Cell Phones, HDTVs, Lasik Eye Surgery. Just because the retail price of their product goes down, doesn't mean that they make less money. If it is cheaper to produce these products their profit margin can actually go up over time. Imagine being a power plant operator right now with the price of oil and natural gas falling off a cliff: Huge margins!

Here's how the math works. If prices are falling by 3% a year, but I have a business idea that can make a 3% nominal return on equity with near certainty, my real rate of return is 6%, which beats this scenario's cash real rate of return of 3%. Economic calculation and risk taking still goes on.

Are there bad side effects about deflation? Sure. Anyone who owns a home loses equity as the value of their home falls. I don't like losing equity, but my gasoline costs have plunged, and soon so will electricity rates, food items, and airfares. Deflation is a mixed bag.

The fear that deflation evokes is from the early years of the Great Depression. Keynesians are putting the ox before the cart by suggesting that falling prices led to unemployment and economic contraction, and dub this a liquidity trap. In fact, wage freezes, massive tax hikes, the Smoot-Hawley act, and Fed interest rate hikes killed the economy, and only then did prices drop precipitously.

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