Donnerstag, August 05, 2010

A Ray of Sunshine In The Darkness...

I've been full of doom and gloom the last couple of days.

To counteract some of that, let me talk about a ray of sunshine in the darkness. But beware: that ray of sunshine isn't going to make your day.

As we all know (or should know: pay attention!), wages have been stagnant and net increases in earnings haven't helped consumers out of their doldrums, as they just haven't been showing up.

Consider this: both real and nominal wages have been pretty stagnant, indicating that while there are no real increases in wages, at least inflation is not eating up purchasing power.

What if I could present a scenario where purchasing power will increase over time?

It's called deflation, and it's where the economy is probably heading.

Consider this and understand what may well happen when the next credit crunch comes along: given the inevitability of a credit crunch towards the end of this year and into the next as all those non-performing commercial real estate objects have to be refinanced, this is almost a certainty, rather than being speculative. If inflation moves below 1% in the face of stagnating demand, the economy will enter a new equilibrium, like that of the Japanese economy, where deflation has kept growth down severely, preventing, as well, job growth and anything like a strong expansion.

Instead, deflation will, for the average working consumer, provide the first real increases in purchasing power as the economy continues to slow and growth becomes a fond memory.

Like I said, that ray of sunshine wasn't going to make your day.

During deflationary periods, monetary policy is ... well, difficult at best and usually completely ineffective. The only way to get out of deflation is to reverse consumer expectations (that prices will continue to fall) and to pump up prices artificially. However, this must be coordinated with all other players in the market to function properly (i.e. everyone has to raise prices, not just a few).

The only real way out of deflation is to run the printing presses at full speed in order to inject liquidity, liquidity, liquidity into the markets. This would be an option if the government wasn't already heavily in debt, and would drive the dollar down severely, drawing inflation into the country through imports.

Unless, of course, other countries are deflating as well...

Deflation, whilst wonderful for the consumer, will be devastating to the economy. Faced with permanently falling prices, companies will scale back investments and employment in order to maintain profitability, further worsening the situation. It destroys innovation, since the only investments will be in tool and techniques to reduce costs, rather than to innovate and bring new products on to the markets.

Hence: while there is a ray of sunshine in our darkness, it is really an indication of just how dark it really is.

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