Can the Deflation Equation Produce Good News for the U.S. Economy?

December 17, 2008 by  
Filed under Economics

In its December Economic News Release, the Bureau of Labor Statistics seems to confirm that the U.S. economy has clearly entered a deflationary period.  To be accurate, the BLS does not actually make judgments like that for public consumption.  “Deflation” is Mr. ToughMoneyLove’s hard truth assessment of this recent data.  (What would you call it?)

Here is a chart of the most telling data – the monthly percentage changes in the urban consumer price index over the past year:

Check out the CPI ski slope nosedive for November.  I think (and many economists agree) that the downward trend will continue into 2009.  Unfortunately, other opposing evil forces are at work.  OPEC – perhaps joined now by Russia – is striving mightily to cut production in a desperate attempt to force oil prices back into the unconscionably high zones of earlier in 2008.  (Let’s all hope for a colossal OPEC failure on this one.  Wouldn’t it amusing to see a 2009 yard sale of limos, jets, and boats by all of those oil sheiks?)

The knee-jerk reaction to this news of deflation is woe is us, it’s a sure sign of a deepening recession or worse.  Not so fast, says Mr. ToughMoneyLove.  Let’s logicize our way through this.  (Do you like my new verb “logicize”?  I was inspired by the same Presidential dictionary that brought us “strategery.”)

The fall in consumer prices is being matched by strong monetary policy actions taken by the Fed and the Treasury, flooding the business credit markets with billions in new money.  Meanwhile, the Obama team is gearing up to use a massive fiscal policy weapon, a near $1 trillion economic stimulus package.  This package is reputed to contain a government infrastructure spending component and a significant consumer spending component, perhaps including a middle class tax cut. 

Before everything hit the fan earlier this year, consumers were relying on credit to spend because the combined costs of the things they were buying exceeded their personal incomes.  But the triple-whammy combination of falling consumer prices, monetary policy actions, and fiscal stimulus actions described above may change that significantly.  The flow of business credit induced by Fed actions should enable businesses to make stuff that consumers want to buy.  Consumers will have more purchasing power (due to deflation) to buy that stuff.  And, consumers may not have to borrow (or borrow as much) to exploit that spending power because the stimulus actions will prop up incomes and put more money into consumers’ pockets.  That, my friends, is a recipe for re-starting our economy without a return to the consumer credit abuses of recent years.

The “x-factor” in this positive-outcome deflation equation appears to be unemployment.   If the unemployment curve flattens over the next few months, then things can play out as I have described.  On the other hand, if unemployment continues to spike, there may not be enough consumers with paychecks to take advantage of the lower consumer prices.  In that case, the “woe is me” contingent will have prevailed. Economic activity will continue to decline and ….. well who knows what happens next.

Even if deflation now produces good news later, we will not necessarily be out of the woods on the inflation side.  I think the price for huge government deficits remains to be paid.  But let’s first turn this economy around so that more people can get back to work.

So that’s my amateur economic analysis of this recent data.  What’s yours?

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4 Responses to “Can the Deflation Equation Produce Good News for the U.S. Economy?”
  1. I’m worried about “triple whammy” you describe leading us to more of the same excess we’ve seen over the past few years. While prices may be coming down (or alternative, spending power may be going up), I don’t think the fundamental psychological problem of overspending has been addressed. What gave rise to consumer consumption problems in recent years wasn’t that incomes were too low or prices were too high, it was that people either didn’t know how to manage their money and their mind or knew and didn’t care. The combination of deflation and stimulus won’t change this.

  2. Mat says:

    I’d add just a few things.

    It appears from the most recent data that the majority of this deflation is a deflation in oil prices, foodstuffs and the like have remained steady. This leads me to wonder how real it is.

    Further, sustained deflation is a very nasty thing. Eventually it lowers wages in a spiral with prices that would continue to remove liquidity from the markets.

    Lastly, in part because I don’t believe we are in any kind of sustained deflationary period, I’d be more worried about future inflation. Since november the government has basically been printing money which will eventually lead to high inflation. This will devalue the dollar (not all that bad) and likely make it more difficult for the government to find loans. While it might be nice for the government not to be taking out loans I’m not convinced it won’t still need them in a year or two.

  3. Dorothy says:

    I like your analysis. I understand MoneyGrubbingLawyer’s concern that “the fundamental psychological problem of overspending” hasn’t been addressed, but I’m thinking, 1) people have heard enough stories of “how bad it is out there” (or experienced it themselves) to get scared enough to mend their ways, and 2) it seems like more and more people keep discovering ways to become entrepreneurial, and are learning to generate income even if they don’t have the jobs. Imagine if the economy is actually making a permanent shift to smaller, more entrepreneurial businesses, and is less dependent on large corporations for our jobs? What then would be possible?

  4. vilkri says:

    Inflation is a good thing when you owe money. So, if the government keeps running up its debt, it can make the debt smaller by creating inflation. The US is the only country in the world that can do that since no other country has virtually all its debt in its own currency. Unfortunately you can do this only once, and you can’t be too obvious about it, either. Eventually our creditors will demand that we take on debt in other currencies such as Reagan’s Samurai bonds which were issued in Japanese Yen. Let’s hope for as much inflation as our creditors can bear and laugh all the way to the Chinese factory where the stuff is made that we buy cheaply here.

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