The deflation debate is heating up. Everywhere you look, there's an article about whether deflation is good or bad, inevitable or manageable. The Federal Reserve, for one, has recently taken a strong stand against deflation, including promises to add as much liquidity to the system as necessary in order to maintain at least modest inflation.
Depending on your view of how free markets function, this is either a heroic act of necessary intervention or a disastrous meddling with natural market forces. Which view is correct?
This past week, investment manager and writer John Mauldin wrote a simply fantastic piece untangling the complicated subject of deflation. In an article titled "Presupposing Deflation," he provides a broad overview on what deflation is, when it's good, when it's bad, and what the various schools of economic thought have to say about handling deflation. For those who want an in-depth understanding of deflation, this is a must-read article.
To whet your appetite, below are a few questions you might have on deflation, along with Mauldin's answers.
What's so bad about deflation? Wouldn't we all benefit from lower prices?
… deflation can have a dark -- a very dark -- side. It is one thing for a business to cut prices because they have figured out a way to lower costs. It is another thing for them to have to cut prices because there is too much product produced by all their competitors yet they have not figured out how to deliver that product (or service) with lower costs. … And therein lays the concern in economic circles about deflation. No one is actually concerned when prices drop for good (productivity and competitive) reasons. The concern is when prices start to fall because of too much supply and lack of demand. This typically precedes a recession.
Speaking of supply and demand, what's the current status of U.S. industrial capacity?
In the U.S., we are currently using less than 75% of our production capacity. Historically, the long-term average is 82%. There is little incentive for businesses to invest in new production lines when they can produce all the consumer wants now. The rather large part of what business investment there is stems from introducing new cost-cutting systems or replacement of worn out machines. There is not a lot of equipment being bought to add to capacity.
Considering that we're still operating below economic capacity, what does that suggest about our current "economic recovery"?
Recoveries from recessions are usually led by increased business investments, growing consumer spending and a boom in housing. We are seeing nothing like a real increase in business investment, consumer spending never really dropped so it is only capable of rising very modestly and housing is still near peak averages. If consumer spending were to drop or housing to soften, we would slip back into recession. Recessions are inherently dis-inflationary. That means inflation declines during recession. Since we are so close to "0" inflation, it is quite possible we could see actual deflation.
How is the Federal Reserve handling the deflation threat?
The Fed is hoping that if they can keep the consumer and housing music going long enough that eventually the economy will grow enough to reduce the excess capacity and business investment can take up the slack from consumers. But to do so means they must keep short-term rates low for quite a long time. The Fed all but promised to do so this last week. … Therefore, we are going to have a lot of economic stimulation from the Fed for quite sometime. I think it is clear they are not going to raise rates until inflation is comfortably back above 2% and/or the economy is growing above 3% for a rather long period of time. Since I do not think either of these will happen this year, rates are going to stay on the lower end of the scale for some time.
For the rest of John Mauldin's discussion of deflation and its potential consequences, be sure to check out the full article.
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