Groveton’s Virginia

Deflation – Cheap Talk November 26, 2008

Background: I studied economics in college but I am not an economist.  I try to keep up with the “dismal science” but I am an amateur.  However, I have recently been mystified by all the talk of impending deflation, Stag-deflation, deflation and on and on.  So I thought I’d put my admittedly “arm chair” view out on the blog.

Deflation – I don’t buy it.  Deflation is a prolonged and sustained fall in prices.  It was part and parcel of the misery of the Great Depression.  Farming communities were hurt badly when commodity crop prices fell and then devastated when the multi-year drought befell much or rural America.  We all recall Tom Joad and the Grapes of Wrath.  Tom and his family moved from Oklahoma to California to avoid the dust bowl and the general deflation of farm products and the commitant increase in farm unemployment.  Hopefully, the present generation of the Goad family is not sitting on half built homes in the Inland Empire.  Or, maybe there will be a Grapes of Wrath – Part 2: Oklahoma was OK After All.

Liquidity Trap – The trouble with deflation, apparently, is that it starts a deflationary spiral where lower prices create lower employment which shrinks wealth and causes a further loss in demand which lowers prices and creates lower employment which shrinks wealth and so on and so on in a spiral of pain and disillusionment.  The bony fingers of faded history often point to liquidity traps as the root stock of a good, old fashioned deflation.  Under this interesting but ancient theory the wealthy in a society decide that the risk of investment has hit unprecedented levels so they stop investing.  Money is stored in economic sink holes like money market funds, savings accounts, T-Bills.  The money is not moving.  It does not create more money (a la the velocity of money) and this stagnation of investment causes deflation.

Thinking outside the spiral.  The usual fear in developed economies is hyper-inflation.  We’ve all seen this in the mid to late 1970 and into the early part of the 1980s.  Interest rates and inflation rates goose stepped through the US economy wreaking havoc along the way.  You’ll remember those bad old days during the Carter Administration as unemployment and interest rates and inflation all soared at the same time.  Prior to this period that combination of economic poison was not thought possible.  But Jimmy Carter entered the history books with Stag-flation as his contribution to economic thought.

Who wants to be a bank?  Today, the politicians are falling over themselves in order to give out a piece of TARP.  And the willing recipients are standing in line for a piece of the government cheese.  Fannie Mae, Freddie Mac, AIG, American express (reconstituted as a bank), GM, Ford, California, etc.  Everybody wants to wet their beak in the sugary water of a government backed loan or “injection of liquidity”.  And how will the government pay for all this?  They will just print more money.  Raise the deficit further.  Devalue the currency by making so much more of it.  And … spike inflation.

Inflation is the risk.  Oil prices are at a low.  Gasoline is easily under $2/gallon.  Commodity energy prices are falling.  But does anyone think this is sustainable?  They will go up again.  And the American consumer is spending less.  But does anybody believe that this will become a trend – even when the good times return?  Or, will the American people, kings and queens of consumption, start buying iPods, earrings, SUVs, vacation homes and everything else under the sun as soon as the good times are back?  Meanwhile, the fed is printing $7.2T for the bailout program.  Yes, that “T” is the abbreviation for trillion.  The US government printing presses are running day and night to create this many new Benjis and C-Notes.

Welcome back, Carter.  So, what happens?  Inflation, not deflation.  Prices rise, not fall.  Employment falls.  Investment falls.  Stagflagtion.

Groveton’sGrip: All this talk of deflation is hooey.  Our present plans have us on course for a major inflation.  Smart investors would be shorting bonds and municipals with short term interest rates.  Smart investors will be long companies with a lot of fixed rate debt on their balance sheets.