Deflation in August

With a coordination that I am sure both found embarrassing, The New York Times and The Wall Street Journal both ran stories on Saturday with tips on how to deal with a bout of deflation.Chicklet-currency

This raises several questions. Do we expect deflation? If so, why? What is deflation, anyway? Why is it so bad? Is the advice from these two giants of the mainstream any good? And what was it about last weekend that inspired them to write about, of all things, deflation?

That’s a long post’s worth of rhetorical questions. So, without further ado, let’s dive right in. Personally, I do not expect deflation in the near term, at least not enough to notice. Whether or not it is expected, or even seriously worried about, in the larger investment community is a harder question to answer.

The WSJ opens its piece telling us that “The markets are signaling that a bout of deflation may be coming.” But the only market indicator cited is a rally in bonds. True, the yield on 10-year Treasuries is down this year, although it is up from where it was at the end of 2008. And yet a rally in bonds is not exactly an unambiguous statement about deflation. The bond market goes up and down all the time. Why is this rally a deflation prediction?

Further, the WSJ rather strangely cites narrowing credit spreads, smaller differences between what corporate bonds and risk-free treasuries pay, as further evidence of deflationary expectations. If anything, the opposite is true. Smaller credit spreads suggest more investor confidence in the economy and, presumably, less worry about disaster scenarios that might include deflation.

The thing is, getting a market quote for deflation (or inflation) expectations does not require reading tea leaves. The Treasury sells inflation protected bonds, known as TIPS. If you compare what TIPS offer over inflation to the going rate on unprotected bonds you can back out the market expected rate of inflation/deflation. (Both articles mention TIPS, neither discusses the implied inflation prediction.)

The TIPS maturing in 10 years currently pays inflation plus 0.92%. Since the regular Treasury equivalent yields 2.70%, we can infer that the market expects an average inflation rate of 1.78% over the next ten years. That’s low, but it’s still positive. That is, the market expects inflation not deflation. (For reference, for the ten years ending June 2010 inflation averaged 2.35%.)

But maybe the markets are wrong. It’s happened before. Perhaps there are reasons why a wise person would expect deflation. Maybe so, but neither the Times nor the Journal provides any, other than pointing out that inflation has been low lately. They also cite a few experts warning of deflation, but do not share why these experts think what they do.

So what is deflation, after all? At the most basic level it is the mundane obverse of inflation, a situation in which average prices decline rather than increase. And in and of itself a mild deflation, 1% or 2% a year, is not much to worry about, probably not something a person would ordinarily notice any more than a similar level of inflation.

It is at larger magnitudes that deflation becomes a problem, pound for pound worse than inflation. Under deflation, you have a weird incentive not to spend your money, since it is worth more every day. And for reasons mostly of social convention, we have great difficulty adjusting some prices, particularly wages, downward. Both those things can be very bad for an economy.

When we talk of deflationary nightmare scenarios, we are really thinking of two examples in particular: Japan’s Lost Decade of the 1990s, and the start of America’s Great Depression in 1930-32.

As for Japan, the term deflation has become a shorthand for a bigger and more profound economic dysfunction. The deflation, per se, was not that big a problem. Indeed, contrary to popular belief, Japanese consumer prices actually went up in the 1990s. (Producer prices fell.) The argument could be made that the US is entering a similar long-term malaise, but it does not follow that deflation will necessarily be a characteristic or side-effect of it.

And it is worth pointing out that, historically, deflation has occurred in good economic times as well as bad, just as inflation has occurred in bad as well as good. The late 19th Century, for example, a period of phenomenal expansion in the US, was characterized by deflation. More recently, during the Roaring 20s, deflation averaged –1.5% per year between 1925 and 1928.

Of course it is the period just after that, when the 1920s ended, that gets all the attention. During the first three years of the 1930s, deflation averaged –8.7%, for a total drop in consumer prices of -23.8%. That did serious harm. Consumers and businesses hoarded their ever more valuable cash and employers, unable to lower wages, laid off workers or went out of business instead.

Still, even in the early 1930s it is hard to disentangle the effects of deflation itself from the effects of the economic disaster that caused the deflation. America experienced a collapse of its financial system at the start of the Great Depression that makes the start of the Great Recession seem like light comedy. Add to this a government that seemed to have a knack for doing exactly the wrong thing at the wrong time and it is no wonder that the economy ground to a halt. Deflation certainly made things worse, but if by some miracle it had not occurred I do not think the country would have been all that better off.

And just as it is hard to separate the effects of deflation from the effects of the cause of deflation, it is hard to untangle the advice given in Saturday’s two articles. Is it meant as how to deal with deflation as a stand-alone problem, or as how to deal with the economic crisis of which deflation will be one of several nasty results?

If you are thinking just of deflation itself, the advice is, or should be, pretty simple. Avoid borrowing money, because the dollars you will pay back will be more dear than the ones you get now. Conversely, lending to others, for example by investing in bonds, is a good move.

Both articles mention that bonds are a good idea under deflation and both mention that the stock of companies with little debt should be preferred. The Times even explains why.

On the other hand, the WSJ tells us to avoid financial stocks because they might suffer in an economic downturn as borrowers have difficulty paying loans back. That certainly sounds familiar. But banks are by definition net lenders that should do well from deflation. Bank stocks can often be thought of as portfolios of loans, and loans would be good to own, right? Alas, this is one of those times in which the articles are not talking about deflation but about a (further) economic downturn.

The confusion between the effects of deflation and recession are most apparent, and obscuring, when the WSJ discusses equities in general.

Deflation is generally bad news for stocks, since a period of falling prices and weak demand tends to weigh down corporate earnings and, therefore, share prices.

First off, as an empirical matter it is not so clear that deflation is generally bad news for stocks. Stocks went down in Japan in the 1990s and in the US in the early 1930s, but that’s a sample of two. Moreover, consider how perfectly reasonable the following edited version of the quote sounds.

[Inflation] is generally bad news for stocks, since a period of [rising] prices and weak demand tends to weigh down corporate earnings and, therefore, share prices.

It is true that were we to experience a deflation of, say, –5%, then we would expect, everything else equal, that stocks would go down –5%. You would certainly have been better off in bonds under that scenario. But you would not have suffered a loss in real terms. Your stocks would be worth fewer dollars only because those dollars had become worth more, not because the stocks became less valuable relative to other stuff. Your retirement kitty might seem a little smaller, but your cost of living in retirement would also seem smaller.

Taken as an abstract and stand-alone event, and I know that is hard to imagine, neither deflation or inflation should have an effect on the real value or prices of the stock market. We associate deflation/inflation with bad stock market returns because, at least recently, periods of strong deflation/inflation have been coincident with bad economic times.

Are we headed for bad economic times, as in the Japanese experience? I do not have any special insight, but I do not think so. We have had a year of mixed economic news, with much well founded anxiety grabbing the attention away from a background hum of gradually improving confidence. All of which is typical of the start of a recovery. But, for all I know, it also describes the situation in Japan around 1993.

So why two articles on deflation on the same Saturday? Couldn’t they just as well have been written months ago? Indeed, I suspect they were. The reason they both appeared when they did can be summed up in a word: August. Time to run the “evergreen” pieces from the drawer and hit the beach.


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