October 9, 2002
Deflation appears to be the most popular word used by
economists these days. Except for
some prices that insensitive to short term economic environments, they argue
that prices already are falling. Certainly,
stock market prices continue to fall down.
Do the facts indicate that deflation is here or is
approaching? If you look at the
latest prices received by producers, they are down at all stages of processing
from the previous year. Adjusted
for food and energy, prices in all sectors remain down.
However, the degree of price decline has been slowing.
Prices of crude materials less food and energy have increased 11 percent
since the beginning of this year. The
same category at the intermediate level began rising in January.
Only finished goods have experienced falling prices even after
subtracting food and energy at the producers' level.
At the consumer level, prices have not declined.
In the past year they are up 1.8 percent and are now growing at a 2.2
percent rate. This is not high
inflation, but it also is not deflation.
The facts are better if food and energy are excluded.
The 2.4 percent gain for this "core" inflation in the past year
has slowed to 2.1 percent in the past quarter.
However, this really is not significant.
Federal Reserve Chairman Alan Greenspan prefers to look at
the consumption deflator less food and energy that is reported monthly with
personal income. From previous year
levels, that number has expanded between 1.5 percent and 1.7 percent all year.
If there is a tendency, it is toward more rapid price changes in the most
Thus, except for prices paid producers, deflation is not
apparent nor is it becoming more likely at this time.
Indeed, even wage surveys reflecting payment intentions for
next year show gains of 3.3 percent. This
is slightly higher than the 3.2 percent currently being received by workers
(before more rapidly growing benefit costs are factored into the pay).
Thus, the facts do not support deflation as a current
condition or one toward which we are going at the current time.
The only deflation is in equity values and the prices of low quality
However, that deflation of asset values suggests a problem
with price deflation.
As underlying inflationary conditions shift either upward
or downward for long periods of time, the asset values underlying productive
resources get out of proportion to the revenues they are generating.
We know that in rapid inflations, those who hold fixed claims, such as
bonds, suffer serious erosion of purchasing power in those assets they hold.
The hyperinflation in Germany in the 1920s impoverished the middle class
in that country.
A shift from inflation to deflation works in reverse, up to
a point. Bond holders do very well
as prices fall. However, the amount
of debt owed by producers was based upon more revenues being generated from
their assets than is now happening. As
a result, some bonds cannot be redeemed; forcing companies into bankruptcy.
Thus, only high quality bonds, where a great deal of
reserves support the bonds or where the taxing power allows governments to take
from some to pay to others, can pay during deflations.
The rising default rates could undermine the capacity of lending
institutions to continue lending. The most recent experiences of this behavior are in Japan in
1988 and Thailand a decade later.
However, the strain not only is on bond holders.
Contracts may have been written that cannot now be met because of the
reduced cash flow from production. Unless
those contracts can be modified, such as United Air Lines currently is trying to
do, the company will fail. The
result will be substantial job loss while the new flying entity buys airplanes
at reduced prices and writes new contracts at more realistic rates relative to
Even governments can get in the way of smoother economic
adjustments to a different inflationary environment. Brazil's governments provided
an inflation bump in addition to inflation adjustments to its retirees.
The argument was that retirees should be compensated for waiting until
after prices rose sharply before their salaries were adjusted.
Unfortunately, the bump still exists in Brazil.
As inflation has slowed, the retiree adjustment has become increasingly
excessive. Indeed, once workers
qualify for retirement (after ten years), Brazilian government workers make more
in retirement than they do by continuing to work.
Until this system is fixed, periodic financial crises are likely in that
Of course, the equity holders get what is left after
contractual arrangements are paid. If
the contract arrangements (including indebtedness) no longer are appropriate for
the current price environment, then the resulting profits fluctuate much more
than other income sources.
This clearly is happening in some sectors of our economy but it should not be an economy wide problem, even if investors currently act as if it is.