Deflation - On Every Front Imaginable

The ugly head of deflation has once again shown itself, and it scares me quite a bit. Link to latest BLS deflationary CPI. There are two major concerns that I have about deflation.

The first is asset deflation. Housing is the example that has been true for a very long time. People are foregoing the purchase of houses with the knowledge that prices will be less at a future date. This has caused contraction in the housing industry and all industries related to housing (e.g. Construction, Mortgage Banking, Basic Materials). Then, there is the wealth effect on home owners who will spend less because they feel poorer because their house is worth less. There are also externalities in localities and neighborhoods caused by the default and foreclosure phenomenon.

The other asset deflation happened in financial markets. As stocks declined and credit tightened, margin calls ripped through the financial system. This caused individuals, firms, and banks to sell assets to meet margin calls which further caused declines in asset prices. Again this too causes a wealth effect that reduces overall spending.

The second is price deflation or deflation expectations. In his landmark Nobel work on inflation expectations, Milton Friedman showed us that the macroeconomic challenge we faced was not just a trade-off between unemployment and inflation. He posited that when inflation rose too high, inflation expectations would cause stagflation (a period of high inflation and high unemployment). Friedman was bucking the popular trend at the time that if policymakers let inflation rise unemployment would fall. The intuition behind his theory was that as prices rose, workers would demand high wages causing prices to rise further - inflationary expectations causing an inflationary spiral. So, in the 1970s when inflation rose and at a point unemployment began to rise as well, he began his rise to prominence.

Many who are students of the Friedman/Hayek (or Chicago) School of thought, have begun or continued to see the world only through the scope of inflation expectations, but today the real fear should be deflationary expectations. Very similar to the theories and ideas articulated by John Manard Keynes during the Great Depression (some not all). The intuition is very similar to inflationary expectations, just in the opposite direction. When monetary policy makers can no longer effectively increase the money supply (or cause some level of inflation) and when prices are falling they continue to fall. Basically, consumers forgo large portions of consumption with the understanding the prices will fall in the future. This foregone consumption reduces sales, increases inventories, and forces business to close and/or lay-off workers. The greater number of unemployed workers reduces overall demand in the economy which exacerbates the entire deflationary cycle (or spiral).

Can We Prevent Deflation?

My hope is that the multi-front war the Obama Administration plans to fight will make a dent in this cycle. First, the stimulus package which I just hope and pray will be large enough. Second, the TARP money with I hope and pray will stem the foreclosure tide, and renew greater confidence and solvency to the financial system. Third, renewed and restructured financial regulation to bring back confidence in financial markets. Fourth, a large sweeping reform of the health care system to curtail rising costs and stem the bankruptcies directly caused by health care expenses.

I know the TED Spread has narrowed in recent days which means there is less fear in markets, but it is still double the ordinary spread and I think the real economy could cause that fear to come back rather quickly.

We might all need to find religion.