There’s been a lot of talk recently about deflation – no I’m not talking about the New England Patriots – so maybe it’s a good time to talk about what it really is and why so many economists seem to be in a tizzy about the possibility. For most of the folks who spend their time pondering such things, deflation is a general fall in the price level, something the average person probably has a hard time seeing as much of a threat. Economists, on the other hand, see deflation as a mortal threat to economic growth. I tend to agree with the average Joe – I don’t hear anyone complaining about cheaper gas prices – but the economists do have a few good points as well.

So what is deflation really? Economists label a fall in the general price level as deflation and based solely on the US experience in the Great Depression, fear it like a werewolf fears a silver bullet. Central bankers the world over see falling prices as something to be avoided at all costs. Mario Draghi and the ECB announced their conversion to the cult of Quantitative Easing last week in response to fears that Europe is falling into the clutches of the dreaded drop in prices. They seem to believe that, faced with a lack of demand, the thing to do is raise prices. Any CEO who announced a price hike as a means to dispose of excess inventory would be laughed out of his boardroom but most any economist will tell you that while it makes no sense on a micro level, it makes perfect sense from a macro economic perspective.

But back to that definition of deflation as a fall in the general price level. What does that really mean? What are economists really trying to measure when they talk about inflation and deflation? Rising or falling prices, in aggregate, simply tell you about the purchasing power of your money. If prices are rising – inflation – your money doesn’t buy as much stuff as it did before the price rise. If prices are falling – deflation – your money buys more stuff than it did before the price fall. One can’t help but think that Americans – and everyone else in the world – would have a very different view of these phenomena if it were explained to them in such clear terms. Inflation and deflation are about money and what you can buy with it. Inflation means you can buy less and deflation means you can buy more.

So, if inflation and deflation are about the value of money why do economists go to so much trouble constructing price indexes like the CPI and PPI? After all, there are more direct methods of viewing the value of a currency. We can measure the value of the dollar – or Swiss Franc or Euro – against other currencies directly in the foreign exchange markets. We can view them versus a commodity index or gold. Ignoring the conspiracy theories and assuming the good intent of the economists, I can only surmise that they are trying to find a better measure of the value of money. Like so many other government led efforts though, this one appears to have come up quite short. If you doubt that, consider that the CPI conveniently missed the obvious inflation of housing prices in the last decade specifically because government economists thought they had found a better way to measure housing inflation by using imputed rents. The goal was to smooth out the ups and downs of housing prices so the Fed wouldn’t respond to every wiggle in prices. Apparently they accomplished that job a bit too well as even extreme movements in housing prices were not enough to get the Fed’s attention – until it was too late.

So I say, ignore the CPI and PPI except as a means to devine future Fed policy and concentrate on the market prices for currencies. That will tell you much more about what is going on in the world and how it might affect your investments and your life for that matter. Let’s see what’s been going on lately and why economists have become so concerned about deflation.

There has been a lot written lately about the rising dollar and when measured against the rest of the world’s currencies it is easy to see why. The Yen has been falling in value against the dollar since the introduction of Abenomics which so far has consisted of the BOJ buying up every financial asset that isn’t nailed down and an open acknowledgement by the government that they’d like to see the Yen fall. It has worked like a charm and the Yen has fallen 36% against the dollar since the beginning of 2012. In terms of achieving their goal of a cheaper currency this is an unmitigated success; economic performance is another matter. More recently the Europeans have jumped on the bandwagon with Draghi openly rooting for a cheaper Euro and now enacting a policy specifically designed to quicken the process. Take a trip around the world’s currency markets and you’ll find similar movements from Sydney to Ontario. The dollar it appears is much loved and its value reflects it.

Measured in other ways the dollar has also been on the rise. Maybe it is just coincidence but the price of gold measured in dollars has fallen by almost exactly the same percentage as the Yen since late 2011. The CRB index, a broad commodity index, is down about 40% in the same period, again roughly the same as the Yen. Using our market based measures of the value of the dollar reveals that our currency has been rising in value and that is what has economists in such an uproar. Yes, they really are concerned that we can buy more stuff than we could 3 years ago with the same number of dollars, at least in theory.

Why is that a concern? Well, that is a long and complicated story but it seems to me that it boils down to the fact that a rising dollar means we can buy more foreign stuff. Yes, we can buy more gasoline and gold and copper too which are at least to some degree American products, but the concern seems to be that we will use our newly more valuable dollars to buy more Japanese and European stuff rather than American stuff. A falling Yen means that Toyota and Honda could maintain a constant Yen price for their cars that would translate into a lower price in dollars. In other words, a lower Yen allows Japanese companies to cut prices in foreign markets and still make the same amount of Yen – or more if they also see an increase in volume because of those lower prices. It isn’t that simple since Toyota and Honda don’t exclusively manufacture their goods in Japan – indeed they make a lot of their cars here in the US – but that is at least the fear. Conversely, if American companies maintain the dollar price of their goods, a lower Yen means the price of American goods rises in Japan and higher prices, all else equal, means lower sales for American companies in Japan.

This is what is meant by another phrase we’ve heard recently, currency wars. Countries try to lower the value of their currencies so they can cut prices in foreign markets thereby gaining market share and jobs in their home countries. Rather than enact policies that increase domestic demand – by creating jobs and raising incomes – they try to “steal” demand from other countries. In other words, since their politicians won’t enact economic policies that increase domestic demand, central bankers are forced to increase the purchasing power of their neighbors in an effort to increase demand for their domestically produced products.

You might by now have noticed a flaw in this program. We live in a global economy and every country cannot lower the value of their currency at the same time, at least relative to each other. If every central bank runs a policy of creating ever more of their own currency in excess of the demand for it, the result will be that all currencies fall together versus something more tangible and of more finite supply such as gold. No country would gain a benefit over another but each unit of currency would buy less and less. We’d get an inflationary spiral. But that isn’t the current situation – yet.

The current concern is that prices are falling in Europe due to a lack of domestic demand and with no appetite for structural reforms the ECB is intent on devaluing the Euro so European countries can reduce prices outside Europe where demand is more robust – and the only place that currently describes is the US. In other words, they are exporting their falling prices problem to the US. Theoretically at least, that might force US companies to lower prices in response, hitting profit margins in the process. Lower profit margins and fewer profits mean fewer stock buybacks, lower dividends, less capital spending and less hiring. And if European companies steal volume from US companies it might mean fewer workers which would lead to reduced demand and even lower profits and so on and so on. That’s the deflationary spiral the economists are concerned about.

Of course, all this is in theory. The world is a lot more complicated than this simplified vision of the world’s central bankers. For US companies a rising dollar means lower costs for the things we have to import, especially commodities. It also means we won’t be wasting so much capital drilling oil wells and at some point more capital will be directed to investments that actually increase our productivity allowing us to compete with the low prices of Japan and Europe while maintaining our profits.

That will take time of course and the concern about falling prices is the short term effect, the deflationary spiral I mentioned above. It seems that the world’s central bankers do not trust the capitalist system to adjust to those lower prices. They seem to think that once prices start falling they will never stop, that supply and demand will never balance again. I can assure you that they will – one thing I’m sure of is that Americans want to buy more stuff – but it would likely involve considerable pain while it is happening and that is what the central banks are trying to avoid. Personally, I think we’d be better off letting it happen and allowing the companies that can’t survive it to fail. We’d come out the other side with a healthier, leaner economy but the extent of the pain and societal cost is impossible to predict. And so don’t be surprised if the Fed is forced to alter their rate hike plans or even consider more monetary stimulus.

Deflation is not something to be feared. Indeed, it is the central feature of a capitalist system. Falling prices are the natural result of rising productivity, the prize at the bottom of the capitalist cereal box. But I guess there can be too much of a good thing. Rapidly falling prices – or more accurately, a rapidly rising currency – cause problems because companies, individuals and governments don’t have a chance to adjust. The immediate effect of ECB QE was to increase the rate at which the dollar is rising and thereby increase the odds that a crisis develops because the world can’t adjust quickly enough to dollars that are more dear and increasingly scarce. We live in a dollar centric world and it is awash in dollar debts, a product of past Fed and Treasury dollar weakening policies. The faster it rises the more likely it becomes that those debts can’t be paid. They say the road to hell is paved with good intentions and the ECB laid down a thick layer of tar last week.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.