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    Prices Fall, Deflation Looms

    By Michael Wolraich on Wed, 04/15/2009 - 10:13am | Business

    U.S. consumer prices fell unexpectedly in March and recorded their first annual drop since 1955, government data showed on Wednesday, as slumping demand pushed down energy and food costs. [Reuters]

    Falling prices? It's like a national fire-sale. What's not to like?

    Plenty. We know all about inflation, of course. Rising prices are intuitively bad, and people still remember the inflationary 1970's. But deflation is a distant memory. It hasn't been a problem for decades. Eight decades in fact. The last time the U.S. faced severe deflation was during the Great Depression, when prices fell at 10% annually. And the most recent example of severe deflation in the industrialized world occurred in Japan in the 1990's, as the country suffered through a decade-long recession.

    There are several problems with deflation. First, the value of illiquid assets like homes falls, so current home owners literally lose wealth. Second, the cost of debt increases. Imagine that the interest rates on home mortgages drops to zero, so you buy yourself a $500K house. At 10% deflation, that home is worth $450K the next year, so you've effectively paid $50K for the debt, even though there was no interest.

    The deflationary cost of debt coupled with the expectations of lower profits discourages consumers and businesses from spending and investing. Why buy a house now, even at zero percent interest, if it will be worth less than what you bought it for in a year? With lower demand, prices drop further, which further discourages spending. This is the deflationary spiral that triggered the Great Depression.

    In addition, credit is the fuel that drives the economy, which is why the government is spending so much to persuade the banks to start lending again. But the government must also persuade individuals and businesses to take the loans. Normally, it accomplishes that by lowering interest rates, a key recession-fighting tactic. But if the cost of debt and low profit expectations discourage investors from taking loans even at effectively zero interest, then the government's most reliable recession-buster is rendered impotent. This is the liquidity trap that Paul Krugman has been warning us about and which Japan faced in the 1990's.

    It's not time to panic yet. There are signals that the economy is improving, and while prices dropped in March, they rose in January and February. But do be concerned, and be aware that low prices are not necessarily a good thing.

    Topics: 
    Business

    Comments

    whoa, kemo sabe. national fire-sale??? Prices fell 0.1 percent, while core inflation (ex food and energy) crept up 0.2 percent. hardly a travesty.

    I'm not saying deflation isn't a pernicious beast and couldn't present a problem (all one has to do to realize the danger is think about his or her own consumption behavior - who among us hasn't thought about buying a particular item but decided to hold off because we've seen so many sales of late, we just know the prices are going lower??), but right now a little price relief is a good thing.

    as i've written in the past, I have a strong suspicion that within a year or two, we're going to be crying about inflation. and that will prove a much tougher beast to slay because it will require some very tough fiscal and monetary sacrifices.


    by Deadman on Wed, 04/15/2009 - 12:39pm

    I agree that the deflation is still limited, and as long as it remains so will not be catastrophic. But "price relief" is not a good thing at times like this. It discourages investment and lending at a time when we desperately need it.

    If the economy rebounds, we could face inflation, but until then, the recession will hold prices down. Contrary to the expectations of some, currency investors have not shed the dollar during the crisis. Instead the dollar has gone up as investors have fled riskier global currencies, creating more deflationary pressure.

    I see only two plausible scenarios for inflation amid recession. 1) A dramatic oil shortage could drive up enerprice prices which would filter up through the economy, as happened during the stagflation of the 70's. 2) The rest of the world could recover while the U.S. founders in recession. Import prices would then go up, and currency traders could dump the dollar. But the U.S. economy still makes up such a large proportation of the world economy (almost 25%) that this seems improbable. I suppose that there's also a 3) The Treasury prints more money, but this seems highly unlikely.


    by Michael Wolraich on Wed, 04/15/2009 - 2:33pm

    i still disagree with you that some price relief is not a good thing for the vast majority of Americans. assuming the stats are correct, can we just say prices are at worst flat? no problem there.

    Yeah, after years and years of persistent, pernicious underperformance, the dollar's done quite well since late 2008, boosted by increased risk aversion, a flight to (perceived) quality and the rapid decline of many emerging economies. but i am quite confident this is a temporary phenomenon, and one reason for that may end up being scenario #2 for your inflation/recession theories.


    by Deadman on Wed, 04/15/2009 - 7:05pm

    On deflation, I'm didn't make much of an argument. I just summarized classic econ theory. If you disagree with the received wisdom, you should cite some evidence or theory to the contrary.

    My argument against #2 is that the U.S. is too big sink while the the rest of the world floats. With 25% of the global GDP, if we go down, we're taking the world down with us. That is what happened this year and, I think, in every other recession since the Depression, though someone can correct me on that. It's not that the U.S. can't fall behind, but i think that it will have to happen in a long slide over decades, not in a sudden collapse. When China's economy is bigger than ours, it will be a different story, but even if they continue to grow at 15%, it will take a while. I'll explore this in the hyperpower post that I promised Acanuck.


    by Michael Wolraich on Wed, 04/15/2009 - 7:32pm

    Im not sure what you mean in terms of deflation. All I was saying is that the fact that prices were basically flat y/y, and that significantly lower energy prices (from levels that were boosted by a speculative bubble) accounts for much of the small decrease, does not get me all hot and bothered. for most regular families, it's actually a small blessing. and in a relatively short time frame, the main concern will be inflation, which I do think could hit with or without significant economic growth.

    Im not so sure the US won't suffer a rather abrupt fall in power, but i don't think it will happen in a year either. 10 years tho i think is quite realistic, and as ive discussed in an earlier post, i believe it could be the popping of the U.S. debt bubble that triggers the shift in relative power.

     


    by Deadman on Wed, 04/15/2009 - 8:02pm

    In 2007, China's economy grew at a staggering 23%.  At this rate, it would take China just over six years for its economy to reach the size of the current US economy - just under $14T.  At 15%, it would take slightly longer - just over nine years - for China's economy to appraoch $14T.


    by DF on Wed, 04/15/2009 - 8:06pm

    They're not going to grow that fast this year. World Bank forecasts 6.5%. You also have to calculate in the US growth rate. I haven't had a chance to do the calculation, but it seems unlikely that they'll catch us in the next ten years.


    by Michael Wolraich on Wed, 04/15/2009 - 9:27pm

    Sure, I didn't say they would catch us in this time frame, just that an economy of our current size isn't necessarily that far off at recent rates of growth.  6.5% still yields a doubling time of about a decade.  And it seems unlikely that the US economy will be growing at anywhere near that rate in the next couple of years.


    by DF on Sat, 04/18/2009 - 11:01am