Deflation: The Good, The Bad and The Ugly
This commentary continues a series intended to address some of the misconceptions in the flurry of recent media reports about deflation.
My last commentary ("Deflation: The Basics") began by defining deflation as strictly a monetary process, and one that is solely in the control of the Federal Reserve: deflation is the revaluation of the monetary unit of account. In the US, the monetary unit of account is the dollar. When it is revalued -- by the Fed issuing too little money for the needs of the economy -- the nominal price of goods and services measured in dollars goes down.
Deflation causes nominal prices to fall, all else equal, but "falling prices" is not the definition of deflation. Mistaking the result of deflation for deflation itself has recently led many commentators into some important conceptual difficulties.
For example, James Paulsen -- the perceptive and articulate chief investment officer at Wells Capital Management -- wrote in his October Economic and Market Perspective that there is a distinction between "good deflation" and "bad deflation." This has a nice ring to it, but we'll see that, upon examination, it's a framework that confuses more than it illuminates.
Paulsen writes that "good deflation" is when businesses are "able to constantly produce goods at lower and lower prices due to cost-cutting initiatives and efficiency gains. This has allowed GDP growth to remain strong, profit growth to surge and unemployment to fall without inflationary consequence."
As an example, Paulsen points out that "In the late 1990s, computer price deflation fell to negative 40 percent a year! The result was an annual growth rate in real unit sales of computers surging to almost 80 percent!"
Indeed, the unit prices of many technology goods have fallen consistently -- and, indeed, this is good. But this "good deflation" is simply productivity growth, or "efficiency gains" as Paulsen puts it. And so "good deflation" is good because productivity growth is good -- and that's because productivity growth means wealth growth.
When productivity grows, producers may elect to share their growing wealth with consumers in the form of lower prices, perhaps in an attempt to expand the overall size of their market or to meet competitive challenges. That's clearly what has happened with technology goods over the last several decades. But under other circumstances a producer might elect to keep the wealth all to himself in the form of higher profits by not lowering prices. Either way the economy grows thanks to increased productivity -- it's just a question of whose pocket the growth ends up in. So it's not just falling prices that make the "good" in so-called "good deflation."
Moving on now to "bad deflation," Paulsen writes that currently "…bad deflation has emerged because even though selling price inflation is still trending lower, corporations can no longer keep up with cost reductions and/or efficiency gains."
Paulsen continues, "The world has been driven by a deflationary force since 1990 -- a force that represented bad deflation for Japan at the same time as it represented good deflation for the United States. The same deflationary trend which constantly defeated Japan in its effort to revive its economy had, simultaneously, been responsible for the ‘miracle 90s' U.S. economy… What seems to be happening, however, is bad deflation in the east is creeping westward!"
This is where Paulsen's good/bad model starts getting into conceptual difficulty. Because while Paulsen posits that "good deflation" is the result of efficiency gains, "bad deflation" is something that it is caused by other factors that Paulsen doesn't explain in his commentary -- and efficiency gains are relegated to being not a cause, but merely a defensive strategy to try to "keep up with" it.
Thus he is left with no explanatory model for his "deflationary force" -- and no ability to specify why it led to "good deflation" for the US and "bad deflation" for Japan, nor why it's turning from "good" to "bad" now in the US. Indeed, in this model "good" can be recognized as good not for any intrinsic reason, but only because the economy in which it takes place prospers. Conversely "bad" can only be recognized as bad when the economy in which it takes place founders.
By recognizing that deflation itself is the revaluation of a country's monetary unit of account by that country's central bank, we have a model for understanding the nature of the "deflationary force," and seeing how it's more than just a causeless global contagion that "the world has been driven by." We can see it as arising from specific policy errors of the Federal Reserve and the Bank of Japan, and we can understand why it has occurred in the latter half of the 1990s in the US, and earlier in Japan. And against the backdrop of those understandings, we can overlay observations about productivity growth as an entirely separate factor.
But if we wish to preserve Paulsen's terminology for expository purposes -- or just because we like the ring of it -- then we should substitute "falling prices" when he says "deflation" -- to make it clear that these aren't the same thing as each other. Then we would say that "good falling prices" are due to producers sharing productivity gains with consumers. And "bad falling prices" are due to actual deflation: revaluation of the monetary unit of account by the central bank.
Put this way, we can respond to the single biggest misconception about deflation that has appeared repeatedly in the press: that "falling prices are good for consumers." Perhaps we could say that this is true when we have "good falling prices," that is, due to productivity gains. But it is manifestly untrue when we have "bad falling prices." When prices fall because the central bank revalues the monetary unit of account, your gains in your capacity as a consumer are offset by your losses in your capacity as a producer. And everyone is both, so at best you break even.
But the press accounts usually overlook the core issue that really makes monetary deflation so bad. If you are a borrower, you are contractually committed to making loan payments that represent more and more purchasing power -- while at the same time the asset you bought with the loan to begin with is declining in nominal price. If you are a lender, chances are that your borrower will default on your loan to him under such conditions. And it's not just debtor/creditor relationships: any long-term contract for goods or services denominated in nominal dollars will have the same problem.
The entire economy suffers from the cascading dislocations triggered by these defaults. It's why "bad falling prices" means monetary deflation isn't just bad -- it's "ugly."
Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer toSmartMoney.com.
Deflation: The Good, The Bad and The Ugly
This commentary continues a series intended to address some of the misconceptions in the flurry of recent media reports about deflation.
My last commentary ("Deflation: The Basics") began by defining deflation as strictly a monetary process, and one that is solely in the control of the Federal Reserve: deflation is the revaluation of the monetary unit of account. In the US, the monetary unit of account is the dollar. When it is revalued -- by the Fed issuing too little money for the needs of the economy -- the nominal price of goods and services measured in dollars goes down.
Deflation causes nominal prices to fall, all else equal, but "falling prices" is not the definition of deflation. Mistaking the result of deflation for deflation itself has recently led many commentators into some important conceptual difficulties.
For example, James Paulsen -- the perceptive and articulate chief investment officer at Wells Capital Management -- wrote in his October Economic and Market Perspective that there is a distinction between "good deflation" and "bad deflation." This has a nice ring to it, but we'll see that, upon examination, it's a framework that confuses more than it illuminates.
Paulsen writes that "good deflation" is when businesses are "able to constantly produce goods at lower and lower prices due to cost-cutting initiatives and efficiency gains. This has allowed GDP growth to remain strong, profit growth to surge and unemployment to fall without inflationary consequence."
As an example, Paulsen points out that "In the late 1990s, computer price deflation fell to negative 40 percent a year! The result was an annual growth rate in real unit sales of computers surging to almost 80 percent!"
Indeed, the unit prices of many technology goods have fallen consistently -- and, indeed, this is good. But this "good deflation" is simply productivity growth, or "efficiency gains" as Paulsen puts it. And so "good deflation" is good because productivity growth is good -- and that's because productivity growth means wealth growth.
When productivity grows, producers may elect to share their growing wealth with consumers in the form of lower prices, perhaps in an attempt to expand the overall size of their market or to meet competitive challenges. That's clearly what has happened with technology goods over the last several decades. But under other circumstances a producer might elect to keep the wealth all to himself in the form of higher profits by not lowering prices. Either way the economy grows thanks to increased productivity -- it's just a question of whose pocket the growth ends up in. So it's not just falling prices that make the "good" in so-called "good deflation."
Moving on now to "bad deflation," Paulsen writes that currently "…bad deflation has emerged because even though selling price inflation is still trending lower, corporations can no longer keep up with cost reductions and/or efficiency gains."
Paulsen continues, "The world has been driven by a deflationary force since 1990 -- a force that represented bad deflation for Japan at the same time as it represented good deflation for the United States. The same deflationary trend which constantly defeated Japan in its effort to revive its economy had, simultaneously, been responsible for the ‘miracle 90s' U.S. economy… What seems to be happening, however, is bad deflation in the east is creeping westward!"
This is where Paulsen's good/bad model starts getting into conceptual difficulty. Because while Paulsen posits that "good deflation" is the result of efficiency gains, "bad deflation" is something that it is caused by other factors that Paulsen doesn't explain in his commentary -- and efficiency gains are relegated to being not a cause, but merely a defensive strategy to try to "keep up with" it.
Thus he is left with no explanatory model for his "deflationary force" -- and no ability to specify why it led to "good deflation" for the US and "bad deflation" for Japan, nor why it's turning from "good" to "bad" now in the US. Indeed, in this model "good" can be recognized as good not for any intrinsic reason, but only because the economy in which it takes place prospers. Conversely "bad" can only be recognized as bad when the economy in which it takes place founders.
By recognizing that deflation itself is the revaluation of a country's monetary unit of account by that country's central bank, we have a model for understanding the nature of the "deflationary force," and seeing how it's more than just a causeless global contagion that "the world has been driven by." We can see it as arising from specific policy errors of the Federal Reserve and the Bank of Japan, and we can understand why it has occurred in the latter half of the 1990s in the US, and earlier in Japan. And against the backdrop of those understandings, we can overlay observations about productivity growth as an entirely separate factor.
But if we wish to preserve Paulsen's terminology for expository purposes -- or just because we like the ring of it -- then we should substitute "falling prices" when he says "deflation" -- to make it clear that these aren't the same thing as each other. Then we would say that "good falling prices" are due to producers sharing productivity gains with consumers. And "bad falling prices" are due to actual deflation: revaluation of the monetary unit of account by the central bank.
Put this way, we can respond to the single biggest misconception about deflation that has appeared repeatedly in the press: that "falling prices are good for consumers." Perhaps we could say that this is true when we have "good falling prices," that is, due to productivity gains. But it is manifestly untrue when we have "bad falling prices." When prices fall because the central bank revalues the monetary unit of account, your gains in your capacity as a consumer are offset by your losses in your capacity as a producer. And everyone is both, so at best you break even.
But the press accounts usually overlook the core issue that really makes monetary deflation so bad. If you are a borrower, you are contractually committed to making loan payments that represent more and more purchasing power -- while at the same time the asset you bought with the loan to begin with is declining in nominal price. If you are a lender, chances are that your borrower will default on your loan to him under such conditions. And it's not just debtor/creditor relationships: any long-term contract for goods or services denominated in nominal dollars will have the same problem.
The entire economy suffers from the cascading dislocations triggered by these defaults. It's why "bad falling prices" means monetary deflation isn't just bad -- it's "ugly."
Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer toSmartMoney.com.
