As with most things, I read a lot of the arrival of deflation and how bad it is. But no one does a particularly good job of explaining WHY! I suspect part of the reason is that the “why” doesn’t make for great headlines and that there’s a perception among the media that people either won’t take the time to understand—or can’t understand. I don’t believe either, so here’s an explanation of WHY deflation is going to be so problematic.
Consider that you are one of the lucky few that can still afford to buy a new car. You still have your job, your current car is aging, so you figure now is the time. After all, the automakers are offering screaming deals right now. That $50,000 BMW you’ve wanted for some time is on sale for $43,000. Let’s make a deal, you say to the sales guy!
What you just benefited from was a price decrease due to oversupply. But how do you distinguish between deflation and price decreases? They’re not the same.
Ever think to yourself that around June it’s time to buy a new PC for the house, or a new DVD player? You say to yourself, “nah, I’ll wait a few months—the price will come down.” That has been a common phenomenon in consumer electronics for a couple of decades now, but that’s never been the case with much of anything else. Have you ever said, “I’m going to wait to buy those fish sticks because next week they might be cheaper?” Of course not, because our general expectation is that the price of just about everything (except electronics) goes up, not down.
So suppose that your expectations changed and you started to figure that the cost of the BMW might come down even more in a few months. You wait. And in a few months you see that the price continues to slide—perhaps you wait some more. After all, why would I pay $43,000 today for something that might cost $42,000 later? Eventually you make the purchase because your car died, but think about what that waiting does. Consider what it would do to the price of a house, or just about anything else. This constant “waiting,” for prices to come down causes consumers to delay or cancel many planned purchases. Instead of booking your family vacation six months out, you wait—and the fact that the resorts aren’t booked actually causes them to lower their prices even more. As this downward spiral goes on for a while (this is called: Demand Destruction), more people are laid off and investments decline—this reinforces the problem as the spiral continues.
Over capacity in manufacturing eventually leads to consumer prices at or below production costs. Because factories have idle capacity, they start to be less concerned with fixed costs and more with variable costs, the largest of which is labor, so reduction in wages becomes inevitable. Individual or “across the board” wage reductions are becoming more common already, but most people still think they’re temporary. Only in sectors such as housing, or where union contracts are being negotiated, is it becoming clear to people that their wages are going down just as they go up during deflationary times. Anyone thinking that a wage cut is “temporary” is kidding themselves. Sure, when growth resumes people will again be entitled to cost of living and merit based raises, but it’s not as though wages are going to instantly “jump” back to where they were the day the recession (or depression) is declared over. We will be starting at a new base.
As demand destruction drives deflationary trends, production destruction is one of the results that follow. Already we’re seeing manufacturing capacity idled. Ramping back up after a sustained shut down period is a slow process. Skills have been lost. Factories sold off. Supplier capacity to deliver the goods has shrunk. Already we’re seeing big oil companies pull back on their investment in new drilling or refining capacity, which means future growth, will be more limited than it otherwise would have been. When things do turn around, the lack of available supply can result in a rapid shortage of goods and services. Hyperinflation is the risk—not for the reasons people think—not because the government has been printing money, but because the productive capacity we entered this recession with isn’t present when we start to come out of it. We will need to “grow back” to where we were. This is one of many reasons the Great Depression dragged on for so long. But there are many others.
I read a good example today of the food cycle: Food is an easy example to consider because we’re all consumers. As prices drop, and families become more worried about layoffs, they begin to use the food inventory in the freezer and pantry. Some don’t even realize they’re doing it—they’re just being a little stingier, sometimes unconsciously, at the grocery store. Everything gets used, even the old cans of tomato paste, half-eaten boxes of cereal, and the fish sticks in the back of the freezer. The rapid reduction in sales causes the grocery store to cancel or severely reduce orders to restock. The elimination in orders cause the food processing companies to lay off workers and idle plants. With no demand from those processing plants, farmers and ranchers curtail future production: for example if corn is not selling, then fewer acres will be planted and less fertilizer used (leading to a destruction of the ability to produce fertilizer); if chickens are not selling, or the price keeps dropping, fewer will be kept to produce, instead most will be sold or eaten. This effect is compounded by livestock sold and acres unplanted due to bankruptcies. Commodity futures are likely to exacerbate this effect. By the time inventory at the consumer, retailer, and wholesaler levels have been depleted and demand returns to the vital minimum, the supply deficit may take more than a year to correct, since the fields are not planted and the brood stock has been sold off. At this point, people become acutely aware that no amount of money can correct the gap between what is required to feed people and what is available.
Exacerbating the problem is that we’ve never experienced deflation in such a heavily (or even moderately) leveraged economy. While prices and wages are coming down, anyone with a loan outstanding is still stuck paying yesterday’s price for their goods. The one thing that doesn’t come down during deflation is the principle on money you’ve already borrowed. Thus, as wages for homeowners or profits for business are coming down, the burden of repaying past debt becomes even heavier. Similarly, the ability to refinance debt becomes all but impossible. In tough times of the past, the one kind of lending that was sustainable was asset backed loans. Whether it’s your house, office building, or farm equipment; borrowing against assets has never been severely limited. But in deflationary times, the lender knows the values of the assets you’re trying to borrow against are likely to come down, so their willingness to lend against those assets is much more limited. And even things like credit scores mean less—what good is a high credit score if you’re at as much risk as everyone else of losing your job and being out of work for a year?
Deflation can and will have a horrible impact on the economy. And if we experience any real or sustained deflation, it will be yet another sign that we’re in for a depression that will last many years.
Those who survive are not going to be the ones that simply hunker down. Financial survival is going to require making smart sacrifices—early. And it’s going to mean getting creative. New value propositions, new ways of getting to customers, and new ways of managing business are going to emerge over the next couple of years. We’re about to experience the most incredible period of business model innovation the world has ever seen in such a short period of time. The key, of course, is figuring out how to be a participant, not a spectator. The key is becoming an innovator yourself!
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