May 5, 2010

‘Deflationomics’ & It’s Utility in Today’s Economic Conditions

SYNOPSYS: Pinning Price Deflation at the very root (where it does not belong) of the unemployment spiral precludes us from benefiting from the usefulness and healing that Deflation can grant in certain contexts. If Price Deflation were truly the root cause of unemployment, there would be no employment left today in the High Tech industry!

- I -
It’s been part of the conventional wisdom for some time that deflation causes unemployment and widespread economic misery. It’s about time to investigate how far this is really true, and in a sweeping way as has been generally accepted.

It is true that in the past price deflation and surging unemployment have occurred together. In financial crises, what economies have seen is sudden destruction in demand leading to the laying off of workers. Price deflation is the response from the market mechanism to win back the lost demand. When the price deflation that the producers of goods and services are able to bear is insufficient to notch back the demand sufficiently with profitable operations, they lay off workers. The layoffs further reduce demand, which can (but not always) bring about another iteration of layoffs (aka ‘the deflationary spiral’) – the second iteration of layoffs comes when the firms did not do their math right in the first, and laid off too few to adjust to the ‘new normal’ in Demand.

The cause-effect loop is as below:

Demand Destruction -> Insufficient Price Deflation -> Lower Employment -> Additional Demand Loss

Pinning Price Deflation at the very root (where it does not belong) of the unemployment spiral precludes us from benefiting from the usefulness and healing that Deflation can grant in certain contexts. If Price Deflation were truly the root cause of unemployment, there would be no employment left today in the High Tech industry! If deflating prices would make us shelve our money and wait another day to buy, then there would be no sales for TV sets, iPhones, Laptops, and what have you. Yet we buy these articles as soon as each comes within our range of affordability and personal utility/value to us as individuals. And the High Tech companies have only seen rising sales volumes even as the price of the articles they produce have been falling for decades. Corporate America has seen its profits soar with cheaper sourcing from offshore and resultant lower pricing to the consumer.

The real cause of deflation-accompanied unemployment is a quantum reduction in demand where the industry is not able to deflate its prices enough (to regain the demand) yet turn profits without resorting to worker layoffs. This is what happened in the latest economic cataclysm as well. The Home Equity loan fuelled consumer demand fraction evaporated, and Corporations laid workers off to save their bottomline - In their assessment (right or wrong) they could not have deflated their prices enough to preserve the Topline and the bottomline, so they chose to lay-off and protect just the bottomline.

The way for employment to rebuild now is via the rebuild of the lost Demand. Letting a mild deflation regime occur will be an asset towards accomplishing the same. Unfortunately, the conventional economic thinking is to summarily oppose any chance of deflation, and that only inflation will cause the demand to pick up.
This is entirely false. Demand pick up can give us some inflation but manufacturing inflation is NOT going to cause demand! Instead, it is price fall that can stimulate more demand.
Economists tend to point to the Great Depression of 1929 asserting that the demand induced by WWII and the accompanying inflation is what took the US Economy out of the Depression. I would like to make a few statements here:

1. The Key to employment (including WWII case) is the pick-up in the Demand and NOT the inflation.

2. War is not the only way that Demand can get induced; it can equally be induced by lower consumer prices.

3. Demand pick up tends to pull prices up, and the price surge puts a damper on further Demand uplift. If instead, firms can lower prices further, that’ll support even more Demand. A case in point is High Tech businesses in the last few decades.

4. Looking at the profit (bottomline) growth that companies have reported for 2009, it looks more logical that they overdid the layoffs than under. In fact, many are back into the recruitment arena. They can operate at lower price points, and will be able to target higher sales volumes for which they will hire more not less.

- II -
Even more than consumer price deflation, what conventional economics seems to dread is Asset Price Deflation. Falling Home prices are seen as a sign of economic weakness. This seems to be the hangover from the time when rising home “valuations” were fuelling the consumer boom via Home Equity Lines of Credit. THAT speculative Euphoria is now over. The Demand that HELOC supported was Lost when the Home Equities turned negative - as soon as the first tranche of subprime borrowers threw in the towel on their mortgages upon their reset after the teaser period. There is no utility in ensuring inflated home valuations, yet analysts and policymakers are awaiting, attempting housing market ‘upturn’ to signal economic revival. If home prices were let deflate instead, and homes changed hands at lower prices, it would serve many purposes:

1. People with lower mortgage debt and payments are more enthusiastic and dependable consumers. This will help shore consumer demand back upwards.
2. The business of Real Estate itself will achieve higher volumes at prices more in line with supply-demand-payability for available homes.

~ III ~

In today’s scenario, lower prices of homes and consumer goods will lead the economy to higher business volumes and a pick up in employment level. Prices, of course, cannot fall indefinitely without additional worker layoffs coming into the picture (which would cause new loss in Demand) - as profits need to be kept in the black for the business to be sustainable. The best part is that the lowering of the two set of prices gives each other the cushion effect - so prices can get to a new equilibrium.

The blanket and ideological dread of Deflation, and the free-money policies aimed at manufacturing inflation, will have to be dropped to reap the great Opportunity in Lower prices.

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