Forget Inflation; Deflation is a Bigger Risk

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Inflation has been a big topic of late, and with good reason. Rapidly rising prices around the world have compounded inequality, driven labor unrest that has disrupted companies and industries, and caused a banking crisis in the United States. Further, as I’ve written elsewhere,?inflation is a tax ?that disproportionately hurts the working class and those on fixed incomes.?

While there are many drivers of inflation, at a very basic level, inflation is the result of there being too much demand given the available supply. So how did we get here?

Demand Boom; Supply Disruptions; Fed Actions

As we all experienced, the 2020 COVID lockdowns crushed demand for goods and services as consumers were unable to spend money. At the same time, many government programs simply gave extra money to individuals when they had no outlet for spending it. As a result,?savings rates went through the roof. In April 2020,?the US personal savings rate hit a level of more than 33% , a level that equated to almost?$6.5 trillion of unspent money .?

Then as lockdowns ended and confidence rebounded with the widespread availability of vaccines beginning in 2021, consumers began spending like drunken sailors on shore leave. Except global supply chains, which had struggled in the era of trade wars, simply couldn’t keep up. China’s zero COVID policy compounded this problem, leading to persistent supply shortages in everything from automobiles to furniture to semiconductor chips.?

On top of this, the money-printing press went into overdrive as monetary policy sought to support the economy. Russia then invaded Ukraine, disrupting the supply of food, fertilizer, and energy as war and sanctions took root, throwing fuel onto an already burning inflation fire.

Tight labor markets added to the pressure on prices as companies struggled to find adequate help. Flush with elevated 401ks, baby boomers retired at accelerating rates and others, due to government handouts, found it uneconomic to return to the workforce. Health worries and ongoing medical issues also kept a meaningful percentage of workers from going back to work.?

In aggregate, these developments drove inflation to over 8% in 2022.

The Fed has been working to slow inflation by raising interest rates, making it more expensive for businesses and homeowners to finance expansions or purchases.?The goal, simply put, has been to decrease demand. And while recent data from the Bureau of Labor Statistics suggests the Fed’s actions are working (inflation has fallen to ~3%), let’s not forget that inflation is a rate of change, not a level.?

During the summer of 2022, gasoline prices hit $5/gallon in many US cities. If gasoline was $5.50 a year later, that would equate to 10% inflation. But if it simply remained at $5/gallon, gasoline inflation would be 0%. Likewise, if egg prices remained at $17/dozen for a year, egg inflation would be 0%. The point is that prices can remain elevated and hurt consumer confidence (and spending) even while inflation dissipates or disappears.

Forget Inflation; Deflation is the Long-Term Risk

The prevailing wisdom that inflation was “transitory” has morphed into one that considers it “persistent" or “sticky.” Yet as a professional trend-watcher, I have long felt that deep structural forces in our world point to a future of rapidly growing supply and falling demand. Over the long-run, this suggests a steady downward pressure on prices. And while the timing may be uncertain, few people are focused on the possibility of deflation.?

One of the most powerful structural forces I know is demographic change. The structure of a society’s age distribution is difficult to change rapidly, and as such, it’s a force to understand. And today, it’s easy to see that the world’s largest economies are aging. In general, when individuals move to a fixed income, they spend less. All else equal, this suggests?less demand.?

Second, technology advancements continue to accelerate. Whether in the field of biotechnology, quantum computing, artificial intelligence, or simple data analytics, innovations are allowing us to produce more output with the same (or even fewer) inputs. And if we start to think of robots as de facto labor, we see that technology may ultimately turn today’s labor shortages into tomorrow’s surplus. All else equal, this suggests?more supply.?

Energy advancements are also allowing us to capture more energy from the sun, wind, and?even tidal cycles . Combined with advancements in the development of small and modular nuclear reactors, it’s easy to foresee a world with abundant energy. All else equal, this suggests?more supply. Further,?if these scientific breakthroughs make fusion viable , climate-change related expenditures could drop meaningfully, which suggests?less demand.

Finally, globalization, which was a massive anti-inflationary force for decades, reversed during the last few years as lowest-cost, most-efficient, just-in-time supply chain strategies were replaced with flexible, resilient, just-in-case supply chains approaches. Globalization is not dead, but offshoring is being replaced with friend-shoring and near-shoring, a development that promises fewer disruptions and tariffs going forward. The eventual result should be?more supply, at a lower total cost with less disruption risk.

Many of these below-the-surface developments point to a world in which supply is likely to boom while demand moderates. This suggests falling prices are, in the long-run, more likely than rising ones.

Many of these below-the-surface developments point to a world in which?supply may boom while demand moderates. This suggests falling prices are, in the long-run, more likely than rising ones. (There is of course a very meaningful caveat to this thesis, and that has to do with the US dollar’s status as the global reserve currency. If the global community were to lose faith in the US dollar, America’s ballooning debt and persistent deficit would combine with a devalued dollar to create an elevated risk of hyperinflation…more in a future post!).

Why Deflation Matters

While many of us understand how inflation eats into our purchasing power and complicates many economic dynamics, deflation can actually be much more problematic on several levels.?

First, just think about how inflation affects consumer decision-making. Let’s suppose that you are considering buying a new kitchen table (your existing table is fine, but you’d like an upgrade). The price of the table is $2500. There’s no urgency to buy, but suppose you know that the table will be $2750 in the near future. You might opt to buy it before its price goes up.?Inflation encourages spending today.?

Deflation produces a mirror-image of this dynamic. If you know the $2500 table will soon be $2300, you might wait. Except when the it reaches $2300, you and your spouse are now wondering if you should wait for the $3000 table you really liked to fall to your $2500 budget.?Falling prices slow the pace of economic activity.?

Think about what these dynamics mean for cash and debt. Inflation means the cash or savings you have buys less and less over time; and given debt is really just a means of spending more than you have, it allows one to profit from inflation. Consider a house you an your spouse are thinking about buying for $400,000. To save $400,000 might take some time, and the value of the house might go up by the time to $500,000 or more by the time you had the money. Debt enables your purchase today, allowing you to profit from inflation.?

Just as before, deflation offers a mirror image. Deflation means that your dollars will buy you more and more over time. So why not save every penny you have? And if you think of debt as negative savings, you’ll realize why owing money is horrible if prices are falling. Borrowing $320,000 to buy a $400,000 house that appreciates to $500,000 is one thing. It’s a completely different thing if the house falls to $320,000. In the deflation example, your $80,000 down payment is worth $0. In the inflation example, your $80,000 down payment turns into $180,000. Inflation reduces the real cost of debt, while deflation increases it.

To understand how the value of debt fluctuates, let’s assume that you borrowed $100,000 to buy 50 cows ($2000/cow). Let’s assume the price of cows falls by 50% to $1000/cow. Instead of taking 50 cows to pay off your debt, it now takes you 100 cows. The real value of your debt has risen.

Companies likewise see their profits swing in a similar manner. Inflation might allow companies to raise their prices, but deflation usually shrinks profits, which might lead to layoffs and other cost-cutting measures. Unemployment might rise, reducing confidence and further restricting economic activity. And just as central bankers fear a self-reinforcing wage-price spiral (higher prices lead workers to demand more compensation, which in turn lets them buy more goods, which leads to higher prices…) in times of inflation, so too do they worry about an outcome in which falling prices lead to unemployment which leads to less demand and falling prices. A self-reinforcing cycle of falling prices can drive a slowing economy into a recession or even a depression.

The most severe bout of deflation in the United States turned the 1929 recession into the Great Depression. Even though it started with a stock market crash, it quickly snowballed into an economic contraction.?Real GDP in America fell by more than a quarter, one in four workers couldn’t find employment, and consumer prices fell by 25% while wholesale prices fell by 32%. Around one-third of the nation’s banks failed.? The Great Depression is an?oft-cited example of how debt and deflation can create a toxic economic cocktail .

Technological advancements, energy innovations, and demographics all point to a world of rising supply and falling demand. Deflation remains a long-term risk. And when we consider elevated debt levels, the possibility of falling prices is a scenario that should not be ignored. Many of the world’s largest economies bear large debt loads, a problematic status for a world in which deflation may be forthcoming.

China recently reported falling prices , a development that the?Wall Street Journalcalled “a warning sign for the world economy .” And deflation in the Middle Kingdom is driving consumer behavior that might generate the problematic self-reinforcing cycle I described above. The?Wall Street Journal?also quoted Wang Lei, a 40-year old who had reined in all unnecessary expenditures, as saying “it’s better to save more and be cautious.”?

Beijing also has elevated debt levels, something that led Eswar Prasad, former head of the International Monetary Fund’s China division, to warn that “The government’s approach of downplaying the risks of deflation and stalling growth could backfire and make it even harder to pull the economy out of its?downward spiral .” (emphasis added).?

While the US has not slipped into a period of deflation, the probability of it happening is much greater than zero.

America’s debt levels make the possibility of deflation particularly concerning. Credit card debt in the United States recently crossed the $1 trillion mark, while student debt is closer to $2 trillion. And government debt now well north of $30 trillion. While the US has not slipped into a period of deflation, the probability of it happening is much greater than zero. Could an end to the war in Ukraine lead to lower food and fuel prices? Could artificial intelligence eliminate jobs at a pace that creates a vicious cycle in which confidence, wages, and spending reinforce lower and lower levels? Or might plunging demand in China lead to excess global supply that is dumped on world markets, leading to global deflation?

If you were to ask 5 economists about the likelihood of deflation in the United States, I suspect you’d get 7 answers. This uncertainty, however, should not paralyze us from thinking through a scenario that would paralyze America and the world economy.?

It’s time to start worrying about deflation.

Note to reader: If you would like to get Navigating Uncertainty immediately upon publication, please subscribe (for free) at?mansharamani.substack.com .

About?Vikram Mansharamani

Dr. Mansharamani is a global generalist who tries to look beyond the short term view that tends to dominate today’s agenda. He spends his time speaking with leaders in business, government, academia, and journalism…and prides himself on voraciously consuming a wide variety of books, magazines, articles, TV shows, and podcasts.?LinkedIn?twice listed him as their #1 Top Voice for Global Economics and?Worthprofiled him on their list of the 100 Most Powerful People in Global Finance. He has taught at Yale and Harvard and has a PhD and two masters degrees from MIT. He is also the author of?THINK FOR YOURSELF: Restoring Common Sense in an Age of Experts and Artificial Intelligence ?as well as?BOOMBUSTOLOGY: Spotting Financial Bubbles Before They Burst . Follow him on?Twitter ?or?LinkedIn .