DEFLATION?

Perhaps it was two weeks ago. I was browsing in the sports department of an unnamed large department store and found myself in front of the big display of golf balls. I was looking for a softer ball, better for shots around the green and for putting. I had planned to go home with a box of new, shiny, non-scuffed golf balls. But something had changed in my decision-making process. In the past I might have just picked what I thought was the best ball, or perhaps the one I would just like to “try out” and, not thinking much about the price, I would drop it into the shopping cart and be off. But for some reason that day, I began to look more carefully at the little yellow price tags above the stacks. They ranged from $9.98 for twelve, soft, Maxi-fly Noodles to $35.00 for Pro V 1 Titleists. There were many choices in between. I was irritated and puzzled or perhaps puzzled and irritated. I could not make up my mind. I felt a resistance to simply picking a set of golf balls based on only what I wanted. Something else was brewing. Now for some reason the price was a factor and so without thinking much about it I found myself doing a mental cost-benefit analysis which included factors such as the number of balls (12 or 15?) their type (long for distance, long and soft, or soft for greenside control?) and of course the price of each type. In the end, I picked up a box of Maxi Fly Noodles at $9.98 and dumped them in the basket. But then I hadn’t gone more than a short pitching wedge shot from the display, when I decided that I really didn’t need these balls. I returned them to the display. What had happened? A short time later it struck me that were you to multiply that episode at the golf-ball display a few hundred million times over (for our 300 million population) and you’d have an economic crisis.

This morning I clicked on my favorite morning web site “Market Watch” to read where the stocks on the NY exchange had fallen precipitously again. The DOW hovered about the 8000 mark. And I found that that dirty word that no one would dare mention “recession” has become more common. The other “no-no” word “de de dep…ssion”, (aw shucks, you know what I mean!) has actually raised it’s ugly head like a snake in the woodpile, appearing in print here and there. But this morning my eye caught a piece entitled: “Is deflation in the cards?” (See Market Watch, Nov 19, 2008.) Perhaps it was the strange word “deflation”. Is'nt it inflation we worry about? That’s when your money loses purchasing power and over time is worth less and less. Yeah, that’s why traditionally Americans don’t save much. Our experience is only with inflation. We all know that if you stuff $100 dollars in the mattress one year, and take it out at the same time the following year you will have only $94.50 in buying power of the original “C” note. We always worried about inflation. That I could understand. But now the new scary word is “deflation”.

But what’s to worry? That’s the opposite of inflation, so prices fall. Yeah, that’s good right? Gas prices have dropped down so fast I can’t keep up with them. Who is selling at the lowest price? The guy on the corner is now pumping gas at $2.25, I bragged to my wife. Who retorted casually, without looking up from her book, “Conoco Service Station on Rt 25 is lower, they had a price posted yesterday at $2.17 and today its $2.15." The newspapers report falling prices for nearly everything, from corn to soybeans and even gold!. All the local stores are slashing prices too. I learned from my wife that Kohls has a sale planned for the day after Thanksgiving, Black Friday Sale. “They are cutting some prices by as much as 75%,” she announced, with a big anticipatory grin. She’s happy, why are we supposed to be worried about this..this… deflation?

The word, of course, makes one think of an auto tire going flat, and that’s what it is. It is a “flattening out” of consumer demand and the lowering of prices of goods in general over a sustained period of time. It is the deflation of the “demand tire” on the vehicle of the economy, and of course, like a flat tire on a speeding automobile (and in an economy) makes the car slow down to a thumping, rubber-flopping, rim-grinding crawl—that gets you not to where we were going, but straight to the nearest repair shop! So deflation is the lowering of prices in general over the board…all prices. But what causes the decline is that demand (like my demand for a box of golf balls) dries up during a deflationary period. Without demand the economy does not roll.

Lest’s look at that more closely. Because if the price of goods falls regularly, consumers have an incentive to delay purchases until prices fall further. So instead of rushing in to Kohls to snap up the sale stuff, customers may pass up the big “Prices Slashed” signs on the window, with the assurance that prices will probably be lower after the sale. After Kohl’s first day of desultory sales, the manager might call up its supplier and cancel an order it had for next month delivery. If Kohl’s can’t sell its present inventory of stock how can it order more? Imagine that happening throughout the nation’s economy, to other Kohls stores, or to the meat-market, the gas station, the corner drug store, the home appliance outlet, and, of course, the automobile dealer on the high road. But as well, the companies which supply all those retail stores are also idled. The suppliers have no orders to fill and perhaps must lay off employees. The manufacturers who serve the suppliers have a glut of unsold goods and therefore cut their raw material orders—and to stay in business must cut expenses by firing employees.

Finally, investors who loan the cash for purchasing stock, paying bills or long term expansion, are sensitive to these circumstances and instead of lending or investing they now hold on to their cash. For them, the such circumstances are high risk, so they tend to hoard cash rather than risk investment, in a deflationary time the purchasing power of the cash they hold is rising and they don’t have to take risk to increase the value of their holdings. Their decisions to hoard money all add to the decline in available money supply and with less money to “chase goods” in the markets prices fall even lower. This leads to the vicious cycle of lowered demand leading to lowered prices, leading to less available cash, leading to lowering demand. Do you see the problem? It’s demand that drives the vehicle of the economy, and without it, all comes to a crawl. The lower demand and the vicious cycle may reduces over-all economic activity so much to contribute to what is known as a deflationary spiral. Now that sounds familiar, like something that happend as an aftermath of the 1929 crash.

For other evidence of lowered demand see: China shifts course and export demand slows, Int Herald Tribune, Oct 20 2008; Economic crisis slows gadget spending, blue-ray adoption, http://www.switched.com/2008/10/20/economic-crisis-slows-gadget-spending-blu-ray-adoption/

But what causes the slow-down in demand in the first place? Now there’s the question! Was it the high gas prices earlier in the year? The strains on the economy of the Iraq War? The credit meltdown on Wall Street which reduced confidence in the economy? Whatever it was..consumer’s perceptions have changed. Hey I’m going back to that sports department and try again!

For an answer to the above question "...what caused the slow-down in demand?" Nuriel Roubini in his piece in Forbes (Nov 19, 2008) entitled "Twenty Reasons Why We're Not Consuming" gives a twenty part list why demand is down and the nation is not consuming as it did in the past.
Some of his reasons briefly stated: the US consumer is shopped out, debt-burdened, and without adequate savings. They own homes with negative equity or of falling value, while MEWs (mortgage equity withdrawls) had been as high as $700 billion dollars in 2005, in the third quarter of this year they are at $20 billion dollars, so homes can no longer be used as ATM machines, real wage growth has been stagnant for several years, employment has been falling over the last 10 months, the recent inflation due to gas price and food cost hikes (now abated) has used up reserves especially for low-income workers, the glut of housing, durables, and autos on the market will take a long time to work out of the system, and finally, rising rates on credit (such as mortgages, autos, credit-cards and student loans) as well as reduced availability of credit have sharply curtailed the ability of consumers to borrow and spend. See" http://www.forbes.com/opinions/2008/11/19/consumer-debt-savings-oped-cx_nr_1120roubini.html

Sometimes known as "Dr.Doom", Roubini is a professor of economics at NYU. He forecast the Wall Street crisis well before it happened, but of course no one believed him, hence the epithet "Dr Doom".