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Monday, May 30, 2011

The Dangers of Deflation?

Let's discuss this article, The dangers of Deflation, by Ken Little of about.com. Note the cool facial hair and intellectual looking glasses in his photo. Obviously he knows what he's talking about right?

And here are his credentials:
Ken Little is the author of 12 books on investing and personal finance topics. He has also served as technical editor for two other personal finance books. Ken has spent many years writing about complex financial topics in a manner that is informative and entertaining.
Ken has served as the Business Editor of a major daily newspaper and Vice President of Marketing for a large financial services company, and has completed many assignments as a free-lance editor and writer. In addition to being a personal finance author, Ken was the chief financial writer for a large mutual fund and consultant to several large financial services companies.

A search will show that his opinion is the mainstream one held by every govt official from the Prez on down. I chose Mr Little because he writes clearly, and came up first in a search for "dangers of deflation".
We are going to rearrange the article a bit, first quoting the sections on inflation then on deflation.

As always, he gets the italic font, my comments in normal type.

First we do inflation. Writes Mr Little:

Inflation is often defined as too much money chasing too few goods and services. The result is rapidly rising prices.
One wonders where did this "too much money" come from all of a sudden? Did it grow on a tree? My Poppa told me that just doesn't happen. Do you know the answer, Mr. Little?

Also, where did this shortage of "too few goods and service" come from? Was there a tsunami and nuclear accident that did it, like in Japan recently? Is that what happened to the USA?

May as well cut to the chase. Mr Little, as is common in the non Austrian world, has his eyes on the symptoms. Too much money, too few goods and services, no attempt to figure out why that happened. Which of course means it will keep on happening until we fix the root cause of the problems, not band aid them over.

An Austrian would say the too much money did indeed grow on a tree. It's new paper money printed by the Treasury, or new digital money "printed" by the Federal Reserve Bank, that is causing the inflation.

As for the too few goods and services, there is a cute little fairy tale you will hear on TV about this. It's all China's fault. Those upstarts had the nerve to get rich and powerful, and now they can afford to eat real food instead of rice, drive in cars instead of walk barefoot,and their larger more developed economy is gobbling up the goodies. That's why there is less for us.

But it's just not true. If they are wealthier, it is not because they printed more yuan. Otherwise Zimbabwe would be the richest nation on Earth. They are richer because they figured out how to produce more than they used to. [And it wasn't rocket science. They merely made their economy freer than it used to be. That's all it took]. Once they produce more, they have more to use and more to trade with. That's how they are wealthier.

What does all that mean for us? That China's new economic position is not causing less goods and services to exist for everyone, but more. And we all know this. Our houses are full of Chinese stuff.

The Austrian answer to why there are too few goods and services is because businesses are being punished for producing them. They are taxed and regulated to the point where it is too costly.

So much for inflation. Now let's see Mr Little on deflation.
Deflation, the deep and persistent,  drop in prices is a more dangerous threat to the economy than inflation.
Good intro, summarizing his position. we await the proofs of this statement, and Mr Little will not disappoint.

Cutting government spending to reduce deficits is normally a good thing.

However, the U.S. economy is in danger of slipping into a deflationary cycle and reduced government spending will not, in the short term, be replaced by increased spending from the private sector.
Plenty of questions here. What is a deflationary cycle, why is it a bad thing, and how do you know we are in danger of "slipping into" one? We shall keep these questions in mind as we read on.

Without a spending stimulus from somewhere, the economy could fall into a deflationary spiral that will make the 2008-09 financial crisis seem mild in comparison. Plenty of new concepts here. What is a "spending stimulus"? How does spending "stimulate" an economy? Where is the "somewhere" that the stimulus will come from? Mars? Jupiter?

If we all agree that inflation is a bad thing, does that make deflation a good thing?
For stock investors and the economy, both inflation and deflation are dangerous conditions.

Deflation is usually defined as ongoing and across the board price reductions.
That's one definition, and since it's his article we'll go with it.

While this may seem like a good thing for consumers, deflation happens because there are fewer purchasers of goods and services, often because of a recession.

So across the board price reductions happen because there are fewer purchasers of goods and services. Meaning less demand. For some reason, Mr Little forgot about the other determinant of price, supply.
Not only that, he says deflation comes from recessions.

It's time for us to see another side of the story. And indeed, right here is the key part of this whole post. It's a quote from the famous Henry Hazlitt:
When the stock of money is not increased, falling
prices are a normal result of increased production and economic
progress. They need not bring recession, because the falling prices
are themselves the result of falling production costs. Real profit
margins are not reduced. Money wage-rates may not increase, but
real wages will increase because the same money will buy more.
Falling prices with continued or rising prosperity have occurred
frequently in our history.

So let's get things very clear here. Is Mr Little talking about a recession being a problem, and discussing ways to solve it? No, because he is saying that deflation is caused by a recession often. The recession is not under discussion now. It's low prices that worries him. They are a bad thing in and of themselves.

Which is odd, very odd. If we are in the middle of a recession, meaning high unemployment and people are broke, the last they need is higher prices. They need lower prices. [And if we are not in the middle of a recession, then those low prices came from increased prosperity, causing no one any harm, as Henry Hazlitt explained.]

To parallel the definition of inflation, deflation is too many goods and services chasing too few dollars. To capture those few dollars, companies must slash prices.

Here we are getting to important questions. How did it happen that there are "too many" goods and service? Did someone leave the On button overnight in the factory by mistake? And too many for who? The world?

Also, how did it suddenly happen that there are "too few" dollars? Did Goldfinger get into Fort Know and steal the dollar bills there instead of the gold?

From the point of view of pure economics, there is no such thing as "too many" goods and "too few" dollars. The situation is what it is. The amount of goods is called the supply. The amount of dollars ready to spend is called the demand. Those two factors determine the price for which the market will clear, meaning all goods will be sold.

The Law of Supply and Demand is like the Law of Gravity. You cannot outsmart gravity, and you cannot outsmart the law of supply and demand.
Many industries operate on fairly thin profit margins, thanks in many cases, to pressure from competitors in the global market.
Which is a good thing, of course. The consumer, meaning everyone, benefits from this.
And I'm not sure why competitors in the global market have to be the source of competition. Why is there no competition from domestic companies? I suspect this is leading up to a sob story. Those bullies from China are offering better prices than our red blooded American industries, and the govt has to step in and help the poor dears.
Companies don’t have to reduce prices too far before they eliminate any profit and if the trend continues, prices may drop below the cost of producing the product.
A sane company will reduce prices only because the costs of production have gone down. Unless they made a mistake and thought there would be a market for all their products, when there isn't. Meaning they made a bad business decision, or just plain bad luck got them.

Well, ces't la vie. Nobody guarenteed anything for me. I was never promised that I would have my job or my money forever, come what may. And that is the case with everyone who ever existed since time began.

So I'm not sure what he's driving at. If prices go down, the consumer benefits. Normally they only go down because the producer is able to lower prices and still make money. And if prices go down because of competition, either from here or from abroad, well that's the American way; it's what made our country great. The ones who can't make money anymore find themselves other jobs where they can.

Without any way to make up the difference, it doesn’t take long for companies to collapse.
This is what happened in the Great Depression. Companies folded because they could not sell products for a profit.

And why did it happen then? Who was outcompeting them? Was it China? The Soviet Union? Germany's Weimar Republic? Was anyone making cars abroad and selling them in the US? Making anything abroad and selling it in the US, for that matter?

This whole fairy tale explanation makes no sense. Why could they sell for a profit one day before the Great Depression, but not for ten years afterwards? Because there was a Depression? And what caused the Depression? People getting fired? And why were they fired in the first place? Because companies were not able to make a profit? That's circular reasoning.

Mr Little, though he doesn't understand the problem, thinks he has the solution. A company isn't making a profit? Stimulate it "from somewhere".

As a side note, companies could not borrow money to stay in business because the financial markets collapsed - sound familiar?
Because consumer demand is weakening around the globe, the fear is that overseas markets for goods will disappear.

Consumer demand is weakening around the globe? When did you write this, Mr Little? Because commodities are all going up up up. How do you explain this?
Stock investors can do little to protect themselves from runaway deflation.
Runaway deflation? Where? Have you gone shopping lately?

End of critique.
I wrote this whole post not to refute Mr Little per se. The main reason is the revelation I got from reading that Hazlitt quote, that a company will not lower prices normally unless they will make money by lowering prices. Meaning that their production costs have lowered. In other words, somewhere along the line, someone found a way to make a cheaper mousetrap, and thus the price of mousetraps went down, and we all benefit.

And if prices go down because of high unemployment, the key is to tackle the unemployment the right way, not tackle the low prices. Go for the jugular, for the root cause.

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