Deflation, by Chris Farrell, covers a topic that is almost unheard of in present day America, what happens when prices fall? We are so accustomed to inflation, the opposite of deflation, where prices rise over time and a dollar is worth less tomorrow than it is today that we hardly even think about deflation.
In his book, Mr Farrell argues that the next century will be ruled by deflation. He pins the trend reversal on increasing globalization, the spread of capitalism, and the internet. I can attest to the internet’s deflationary power because I experience it first hand with my software business. Not only can I sell to customers around the world, I also have to compete with other companies around the world. Some of those companies reside in 2nd or 3rd world countries with lower costs of living and lower income needs. That means they can drag my prices down. To remain competitive, companies including my own lose pricing power and the customer gains it.
It sounds like deflation is a great thing for John and Jane Doe consumer right? Well, as companies lower prices to remain competitive, they bring in less revenue. Why should I buy a car today when it will be cheaper tomorrow? With less revenue due to slimmer margins and deferred sales, businesses cannot support their payroll expenses. Worker wages are often referred to as “sticky”, meaning that workers are resistant to lowering wages. Who *wants* to have their income cut?! When a business cannot lower wages across the board, they resort to laying off workers. Sure, a carton of eggs in deflationary times might only cost 50¢ but that doesn’t help the unemployed person very much.
The biggest losers in a prolonged deflation are debt holders. The “Buy it now, pay for it later” mentality of inflationary times does not transition well to a deflationary setting. Consider this scenario. John Doe buys a house with a $250,000 30 year mortgage at 4%. At the time he buys the house, he is making the median American income of $50,000. The monthly mortgage payment is around $1200. That would peg his yearly housing costs around 29%, a number that falls into the popular rule of thumb to keep housing costs below 30% of gross income. Fifteen years later amidst constant deflation and his income may have been reduced to $30,000, but his mortgage has not deflated. It now consumes 48% of his gross income. Everything else that John buys costs less due to deflation, but his mortgage payment has not decreased.
Is Mr. Farrell a doomsday sayer or is there some merit to his predictions? According to Vanguard’s 2015 Global Economic and Investment Outlook deflation is a concern of well learned economists.
A deflationary threat will likely continue to hover over the world. In aggregate, reflationary monetary policies will continue to counteract the disinflationary drag of post-financial crisis global deleveraging. As suggested in Vanguard’s past outlooks, recent consumer price inflation remains near generational lows and, in several major economies, is below the targeted inflation rate.
Key drivers of U.S. consumer inflation generally point to price stability, with core inflation in the 1%–3% range over the next several years. Nascent wage pressures should build in the United States in 2015 and beyond, but low commodity prices and the prospects of a strong U.S. dollar should keep inflation expectations anchored. In Europe, deflation remains a significant risk that will not soon disappear
Some of those words might have stuck out to you, like “targeted inflation rate” and “price stability”. After learning hard lessons over the past century, central banks have agreed that a targeted inflation rate of about 2% is ideal. They try and control that by raising or lowering interest rates (this is what ultimately sets your mortgage rate) and adding or removing money from circulation (liquidity).
I wouldn’t recommend the book Deflation to anyone unless they were die hard monetary fans. The book reads a lot like a term paper or thesis and tends to take its time snaking around various historic examples and anecdotes to make its points. I had to check it out of the library twice and still gave up before finishing it. You can read more about macro economics (what inflation and deflation are categorized under) on this website.