Deflation

deflated_walmart

Lately there has been a lot of talk about deflation. As normal consumers, we probably don’t feel the same was as what the politicians and economists are talking about. Things we want keep going up in price, our wages keep getting lower and there is not enough interest being paid on our GIC savings account. What gives?

There is a lot of ignorance when it comes to talk about deflation. The majority of people are only concerned about the prices of the things that they want to buy. The word deflation certainly pertains to that point since the very definition of the word means “the general lowering of the price of goods and services”. The underlying factor of why goods and services get cheaper is because the value of money is actually increasing over time. This effect of increasing value has very dire consequences on the state of an economy.

deflationary_flow

The diagram above shows what happens in a deflationary spiral. It’s what the doomers hope for. Or those that think that the next Apocalypse is upon us. It’s essentially a self-fulfilling loop that slowly erodes away confidence in an economy and it’s what led us to the Depression in the 1930’s.

Consumer Goods and Services

Let’s be honest. We’re all materialistic. We love buying things to make ourselves feel good. Despite what we have, we always want more, but what we enjoy more than anything else is a good deal. That’s why sites like RedFlagDeals and SlickDeals exist.

walmart_rollbackImagine this scenario though. If you knew a car you wanted to buy would go down in price tomorrow, would you buy it? What if you knew by next week it would be 10% off. A month later it’s 25% cheaper. Would you wait? An average consumer would wait. Why pay full price when you know can get it cheaper? That’s what deflation will do to consumer purchasing habits. Delay spending and wait until the price lowers.

Corporate Profits and Debt

Remember that corporations are out to the protect the well being of their shareholders. Their goal is not to provide full employment nor give the lowest prices to their customers. Falling prices inhibit a corporation’s goal of providing forever increasing returns on shareholders’ investments. A prolonged slump in prices and profits would inevitably lead to the reduction of the workforce. This is a reaction by corporations to keep costs down because in general labour is the most expensive part of any company.

I have written before about bonds and how they represent debt to a corporation. Just like many individuals, corporations also have debt that they have to repay. A little known fact is that deflation actually makes old debt more expensive to pay. Companies take on debt because they expect inflation to make that debt cheaper to pay in the future. This is how an economy uses leverage to generate wealth. Prolonged deflation would make debt unbearable for companies who rely too much on leverage for growth. Think small technology start-ups.

Good Paying Jobs

Have you ever heard someone say that they were satisfied with the pay they were getting from their job? I didn’t think that existed either. Deflation has a profound impact on wages for workers as well. It’s not just prices for goods and services that are impacted. Recent studies have shown that the median income in Ontario has actually fallen over the last decade. This means more and more people are working in jobs that are lower in pay year after year.

will-work-for-foodIt’s not a pretty sight when year end compensation talks with the employer comes down to begging for your salary to not be lowered. Now that would be extremely uncomfortable.

If this situation wasn’t already bad, remember that the average Canadian is under a debt load representing 163% of their annual income. Just like corporations, individuals will continue to struggle with paying off that debt while wages continue to decline.

Investments

Deflation is probably the worst thing that can happen to any investment class. Whether it be stocks, real estate or commodities, deflation has a negative effect that can eliminate value. During times when the value of money becomes more valuable, the only thing that makes sense is to hold on to money or investing in something that protects your principal while providing you an interest or dividend.

With less investment money, there is less likelihood that companies will continue to grow. This in turn leads to smaller profits and less employment opportunities for the unemployed. If there is anything that can be said about deflation, it’s that it’s evil.

Deflation is Bad

As a consumer we might be cheering for lower prices so that our material wants can be satisfied. For an economy as a whole, deflation is scary and can lead to many years of lost economic productivity. A similar scenario can be drawn in Japan, where for over a couple of decades the country has experienced various periods of deflation. During that time span, wages fell, home prices fell and demand for goods and services never rebounded. Even to this day Japan still struggles to keep consumer prices going in a positive direction.

If deflation teaches us anything, it’s that it’s bad. If we see widespread falling prices for an extended period of time we shouldn’t be cheering. We should be fearful, because it’s not good for the economy.

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