Is Deflation Really That Bad?

People in the financial world don’t have nightmares about werewolves or falling off a cliff, they wake up in a cold sweat crying out one bone-chilling word: “Deflation!”

Ordinary (or should I say normal?) people don’t suffer from this affliction.  In fact, I’d dare say most people don’t even think of the word deflation, much less dream about it.

However, to those in the financial world, whether investors, economists, accountants, or central bankers, the word deflation conjures up visions of the Great Depression and Japan’s Lost Decade (it’s been 2 decades, actually, but it’s always referred to as 1 for some reason).

Is deflation really that bad?  It all depends on what you mean by the term.  For some odd reason, the term refers to two very different things.

One refers to the end of a credit expansion that ends in debt defaults, bank failures, and tremendous and long-lasting economic collapses.  That’s the nightmare one.

The other thing deflation refers to is when money supply doesn’t keep up with economic growth.  In my opinion, this one isn’t bad at all. 

Can you imagine what life would look like if the cost of goods went down by 3% a year instead of up 3% a year?  Would you really have nightmares if the cost of computers, cars, TV’s, food, clothing, etc. went down each year?  I don’t think so–everyone loves a sale!

And yet, this is why people get so confused, because deflation refers to two entirely different things.  Can you imagine going to the grocery store and seeing hamburgers labeled “Rat Poison”?  You know hamburgers aren’t poisonous, but the label would definitely throw you off.  The same is true with the word “deflation.”  It refers to something yummy like a hamburger, and at the same time something terrible like rat poison.  No wonder people fear deflation.

Historically, deflation (the good kind) got a bad name in late 1800’s United States.  After the Civil War, the U.S. experienced years of declining prices as the government worked to get its finances back in order and U.S. currency back on the gold standard.

It was great as long as you hadn’t borrowed lots of money.  This was a boom time for railroads and manufacturing industry like Carnegie Steel.  If you owned stock in James J. Hill’s railroad, the Great Northern, you received 8% dividends that bought more and more stuff each year, plus you benefited from the railroad’s growth! 

The cost of things were going down because the U.S. economy was becoming more productive.  It was great unless you owed debt.  Debtholders hate deflation because it means they must pay back loans with dollars worth more each year.

This was especially painful for marginally profitable farmers.  Industrialization had made farming more productive, which meant marginal farmers couldn’t break even.  They borrowed to try to keep up with productive farmers, but this just created new problems.  You can’t pay back loans or farm profitably if the value of the corn you produce is going down faster than the debt you owe. 

So it is with every technological advance.  I’m sure caveman Ug was put out of the hunting business by caveman Thug who invented a new, more effective spear.  Such is the way of the world.

This industrial/technological/economic shift led to the populist movement and William Jennings Bryant’s “cross of gold.”  But, none of that helped the poor farmers who needed to find economical work.  Eventually, they went to work in factories and a new boom occurred.

But, the legacy of deflation as a bad thing lived on.  The very vocal minority of unprofitable farmers (and especially their political demagogues) made enough of a ruckus that deflation has a bad name to this day.

Next time you wake up in a cold sweat dreading deflation (not very likely, huh?), just reflect on which type you dreamed about–the hamburger, or the rat poison?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Is Deflation Really That Bad?

What will happen if the credit market’s other shoe drops?

Recent bond and stock market turmoil has turned full attention to credit markets. What has surprised me is that conditions for credit markets aren’t that bad. Am I mad, you may be thinking?

Here’s my line of reasoning. There are three things that can really beat up the consumer credit market: availability of credit, interest rates and employment.

The fireworks seen so far are almost purely due to the availability of credit. Market participants have been scared by recent credit defaults and delinquencies, and so they are refusing to grant such markets more credit.

But, interest rates and employment are just as important, and they are doing great right now. Both look as good as they have since the 1950’s and 1960’s, with long term interest rates at 4-5% and unemployment down around 4-5%.

What would happen if this were to change, and why doesn’t anybody seem to be discussing this?

I guaranty that if interest rates increase and employment starts to fall, you will see many more defaults and delinquencies. In other words, what we are witnessing in credit markets could just be the tip of the iceberg.

With Congress threatening 27.5% tariffs on Chinese goods and China threatening to sell the huge amount of US Government Treasury bonds they hold in response, the threat of higher interest rates is real. With credit market troubles in the US forcing the Fed to intervene and the dollar falling, higher interest rates are even more of a threat.

With the housing market supplying so many jobs since the 2001 recession and the housing market crashing, employment problems could just be surfacing. With recent retail sales so poor, additional employment problems could be rearing their ugly head, too.

I don’t know how this will play out, but I’m watching it carefully. If the economy continues to be strong, then interest rates and employment will not be big concerns.

But, if the economy continues to slow, the dollar continues to fall, retails sales continue to look punk, the housing market continues to decline, or protectionist sentiment in Congress gains momentum, look out below!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Credit spreads too thin?

John Mauldin’s latest Thoughts from the Frontline Weekly Newsletter featured an excellent article by Michael Lewitt of Harch Capital Management.

The subject was the state of credit markets. This may seem like an unimportant subject to many observers, but it impacts the financial markets and global economy in ways most don’t grasp.

Specifically, the article talked about how credit spread are still very thin compared to historical average. What are credit spreads? Generally, they are the difference between the yield on a risky credit (corporate debt, mortgage backed securities) compared to a non-risky credit, which is considered to be a government bill, note or bond depending on the maturity of the bond.

When the credit spread is wide, market participants are worried about credit risk and are demanding a large spread over risk-free securities. When the spread is thin, the market is unworried about credit risk and is demanding very little compensation over risk-free securities.

Historically, credit markets go through swings of greater and lesser toleration for credit risk. Typically, the market gets complacent after a long period of low defaults and then gets over-concerned after a short period of high defaults.

Right now, we have just recently come off some of the lowest credit spreads in history. The normal result is a market shake-up that returns low credit spreads to high credit spreads. These can be very disturbing events, as it was in 1998 when Long Term Capital Management collapsed.

Credit markets tend to reflect the market’s toleration for bearing risk. When the market is complacent, it signals trouble may be ahead. When the market is worried, it frequently signals a great time to invest. In my opinion, we are on our way from complacent to worried, and that means opportunity lies ahead.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.