Deflation Micro vs. Macro

Deflation

By Joshua Burnett

If you’re anything like me, one of the problems you run into when trying to convince someone that the hyperinflation scenario will occur is an argument that revolves around us currently being in a deflationary period. People (and those involved with the economy and stock market especially) have a hard time seeing looming hyperinflation (that might occur as soon as a year and a half away) when what they’re currently seeing is… deflation. But wait a second; how in the wide world of sports are we seeing deflation when we’ve been printing money like our lives depend on it?

Let’s return to market fundamentals, and the ever-present difference between macro and micro economics. First, let’s look at a definition of deflation. Deflation has a primary definition and then a commonly understood method of measure, the latter of which is unfortunately normally mistaken to be the definition of deflation itself.

Deflation Definition: “Contraction of credit and available money.”

Measure: “A fall in the general price level.”

This measure is seen in changes in the Consumer Price Index, or CPI, which is a measure of the average price of consumer goods and services purchased by households. This is the simplest way to measure inflation or deflation simply because it does for prices what the gold standard did for the dollar: it ties abstracts to concrete definitions. A loaf of bread is a loaf of bread; always has been, always will be. We get the same level of nutrition out of it that we did a hundred years ago and we’ll get the same amount of nutrition a hundred years from now (assuming a constant recipe, of course). Whether we pay 25 cents, $1.50, or $100 a loaf gives us a relative measure of the purchasing power of the dollar. Since the measure of deflation is a lowering of the CPI, people often mistake that for a sure-fire sign of deflation.

By people, I mean micro economists.

But instead of looking at the measure, we should turn our attention to the definition. The definition of deflation is a “contraction of credit and available money.” THAT is obviously not happening. So why do people think that we’re currently in a deflationary period? Well, the CPI is down 1.3% from a year ago, which happens to be the largest annual decline since April of 1950 There is a two-fold reason for this: the first involves the incredibly high oil prices we saw as recently as 13 months ago when oil spiked at approximately $140 a barrel. Because of this we saw the price of literally everything go up as the cost of transporting goods and services drastically increased. Since then the price has plummeted.

If I could drastically simplify things and say that the CPI closely follows the price it costs to transport everything, you’ll instantly see the greater of the two reasons why the CPI shows prices declining; it’s because they are.

The second reason is simple and very much tied to the recession: if you’ve walked through a mall recently you’ve seen more sales than Black Friday and the day after Christmas combined; it approaches the relatively absurd. Businesses are selling things much more cheaply to simply continue to do business; it’s not that the prices of goods are going down to them, they’re simply choosing to take a cut in profits to continue to do business.

So by combining:

(a) the fact that things legitimately got cheaper as oil prices dropped at an incredible rate and

(b) businesses are selling things more cheaply to compensate for lessened consumer interest (incidentally really the only stocks that gained in value through the worst of the recession were the ones selling cheap stuff, e.g. Wal-Mart and McDonalds, etc) and you have the recipe for a false deflation reading: i.e. “a fall in the general price level.”

What we must do is forget for a moment what the commonly accepted measure of deflation is and look instead at its definition.

This year we’ve seen a budget deficit of $1.85 trillion and we’ve seen the Fed increase the money supply by almost a fifth in a matter of three months.

The Congressional Budget Office has predicted total deficits of $9.3 trillion over the next decade (without, incidentally, compensating for any type of universal healthcare system).

We’ve even seen Chinese students openly laugh at Secretary of the Treasury Geithner when he made the statement that the dollar is a safe place to store money.

A measure is only good as long as it accurately gauges what it’s supposed to gauge. If conditions exist that influence the CPI beyond the realm of strictly determining money supply we can no longer look to the CPI as the sole determiner of inflation or deflation. Because of the peculiar economic circumstances of the past 13 months, we have to look to the macro events for perspective.

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Image courtesy of Danilo Rizzuti / FreeDigitalPhotos.net

Deflation

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