The Five Ways Deflation Has Already Taken Hold
Of the seven varieties of deflation, five are already at work in the U.S. economy.
Commodity Deflation: In 2009 and 2010, the increases in commodity prices revived memories of the 1970s inflation spiral that resulted from the earlier mushrooming costs of the Vietnam War and the Great Society programs. Speculators and investors further inflated that bubble. Many pension and endowment funds, as well as individuals, became convinced that commodities were a legitimate investment class, like stocks and bonds, and they piled in and even doubled their bets as prices soared.
In recent years, many investors have been impressed by China. Yet despite efforts to reorient that economy toward domestic growth, it remains export-driven. The slow global growth of the last five years will probably persist in this age of deleveraging. Considering the continuing retrenchment of U.S. consumers, the demand for exports from China and most other developing countries will be muted, as will their related need for commodities.
I predict further declines in commodity prices as oversupply continues to swamp demand amid weak global growth and a hard landing in China.
Wage-Price Deflation: Wage-price inflation causes wages to push up prices, which then drive up wages in a self-reinforcing cycle. This, too, was an affliction of the 1970s, when it combined with slow growth to cause stagflation.
Back then, labor unions had considerable bargaining power. Furthermore, many top U.S. executives felt an obligation to ensure that their employees’ wages kept pace with inflation. They failed to realize that, as a result, inflation was transferring their profit to labor -- and also to government, which taxed underdepreciation and inventory profit.
This brought about a collapse in corporate profits’ share of national income to 7 percent from almost 14 percent in 1982. At the same time, the share of profit going to employee compensation rose to 67.5 percent from 61.5 percent.
In response, and in the face of intense foreign competition, corporate leaders restructured. Union membership and power plummeted as operations and jobs moved to cheaper locations offshore and as the economy became increasingly high- tech and service-oriented.
The wage-price spiral peaked in the early 1980s as consumer-price-index inflation began its three-decade-long decline.
Today, the wage-price spiral has been reversed. Contrary to most forecasters’ expectations, wages are being cut, the casualty of excess capacity in the labor market, weak job growth and stubbornly high unemployment.
Financial-Asset Deflation: Perhaps the best recent example of financial-asset inflation was the dot-com collapse in 2000. It was the culmination of the long bull market that started in 1982 and was driven by the convergence of a number of determinants. Declining inflation rates in the 1980s and ’90s pushed down interest rates and lifted price-earnings ratios; U.S. business restructured and productivity leaped, starting in the 1990s; U.S. consumers embarked on a three-decade-long borrowing-and-spending binge that drove their savings rate to 1 percent from 12 percent, and their borrowing rate to 135 percent of after-tax income from 65 percent. Meanwhile, consumption spending increased to 71 percent of gross domestic product from 62 percent.
The bull market was accompanied by a leap in P/E ratios that fueled a 17 percent annual increase in the Standard & Poor’s 500 Index (SPX) from the second quarter of 1982 through the first quarter of 2000.
Ultimately, the good times led to rampant speculation, especially in new tech stocks, and to the 2000-2002 collapse. But the speculative investment climate simply shifted from stocks to commodities, foreign currencies, emerging-market equities and debt, hedge funds, private equity and, especially, housing.
The long bull market that began in the 1980s was followed by two bouts of financial deflation, in 2000-2002 and 2007-2009, as stocks declined by more than 40 percent for only the fourth and fifth times since 1900. A financial inflation/deflation cycle has also occurred among financial institutions that greatly leveraged their balance sheets over the past three decades and are now being forced to raise capital, while reducing risk and leverage.
Tangible-Asset Deflation: The big increase in commercial real estate in the 1980s was spurred by beneficial tax-law changes and by financial deregulation that allowed savings-and- loan banks to make commercial-real-estate loans. Deflation set in later that decade due to overbuilding and the changes in the 1986 tax law. Bad loans mounted and the S&L industry went bust. Today, commercial real estate is recovering, though inflation and deflation have occurred repeatedly in that sector since World War II.
The staggering house-price deflation of the past six years is the first since the early 1900s. There is still more downside despite some recent evidence of a recovery. Excess inventories are the enemy of prices, and there are about 1.7 million excess housing units in the U.S., over and above normal inventory working levels. Before the housing collapse started, housing starts and completions averaged about 1.5 million per year. So the excess remains huge.
Currency Deflation: Relative currency values are influenced by monetary and fiscal policies, CPI inflation/deflation rates, interest rates, economic growth, import and export markets, an economy’s attractiveness as a haven, capital and financial investment opportunities, the carry trade, military strength or weakness, and government actions. In recent years, Japan, South Korea, China and Switzerland have all tried to support their exports and limit imports by preventing their currencies from strengthening.
After several years of weakness, the dollar has revived in recent months. I see it as the haven in a weak, and possibly recessionary, global economy.
Standard Inflation/Deflation: This is the most familiar type, caused by a substantial gap between aggregated supply and demand.
While this prevailed in the 1970s, it is highly unlikely today as commodity prices collapse, high unemployment persists and deleveraging suppresses private demand. In a world where surpluses of goods and services dominate, the Fed rightly worries about falling producer and consumer prices, not the reverse.
Inflation by Fiat: I developed this concept in 1977 to encompass all the ways by which Congress, the president and regulators raise prices.
Increases in the minimum wage are a case in point. So, too, are higher tariffs on imports. Agricultural-price supports keep prices close to equilibrium. Federal contractors are required to pay union wages, which usually exceed nonunion pay. Environmental-protection regulations may improve the climate, but they boost costs that tend to be passed on in higher prices. Wage increases for government workers must be paid in higher taxes sooner or later.
In the late 1970s, I calculated that inflation by fiat added two percentage points to the CPI. There was some deflation by fiat in the 1980s and ’90s, namely the reform of federal- welfare programs requiring recipients to work or be in job training.
Now, in reaction to the financial collapse, Wall Street’s misdeeds and the worst recession since the 1930s, substantial increases in government regulation and involvement in the economy are certain -- and therefore, so is more inflation by fiat.
So, five of the seven deflation types are in place today. In addition to worker dismissals, cuts in wages and hours worked are being used to reduce labor costs (wage-price deflation). Commodity prices continue the decline that started in early 2011 (commodity deflation). Excess inventories threaten even lower housing prices (tangible-asset deflation). Stocks are overdue for a decline when investors realize that weakness in global economies can’t be offset by huge injections of liquidity by central banks (financial-asset deflation). And the dollar appears to be reasserting its traditional role as a haven (foreign-currency deflation).
If persistent excess supply and weak demand for goods and services cause the CPI and the producer-price index to fall 2 percent to 3 percent per year, as I expect, those who predict inflation will be in for a big shock.
(A. Gary Shilling is president of A. Gary Shilling & Co. and the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the fifth in a five-part series. Read Part 1, Part 2, Part 3 and Part 4.)
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