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Monday December 15, 2008 - 19:14:57 GMT
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Deflation Economics and the Dollar

Deflation is one of those semi-mysterious economic events that is often
talked about but rarely seen. In simple terms it is a general and
persistent decline in prices. For the consumer that might seem a boon.
As prices decline a dollar buys more goods. Those folks who have jobs
or cash see the value of their holding increase, the longer they wait
the greater the potential gain.

But while deflation might grant a short term individual gain it can be
hugely damaging to the overall economy. When falling prices become
widespread and sustained they generate a self-reinforcing cycle of
economic contraction: faltering consumption leads to reduced
production; as demand for their products shrinks businesses reduce
payrolls; unemployed workers cannot spend which again reduces
consumption, production and then employment. A deflationary cycle is
one way recessions turn into depressions.

Deflation is often a monetary phenomenon caused by a drop in the supply
of money or a restriction in credit. During the Depression the failure
of almost a third of US banks severely curtailed the supply of money in
the economy. Not only was the multiplier effect of bank deposits
backing a supply of credit many times larger than the deposit base
lost, but in many cases the original deposits vanished as well. With
vastly fewer dollars circulating in the economy prices tumbled. People
bartered for goods instead of buying and in some places local
governments tried to create their own currencies to replace scarce

Something akin to that monetary contraction is happening now as banks
restrict credit to financial institutions and consumers. The cars and
houses that might have been bought with borrowed money sit unsold.

Deflation can also have a supply and demand origin. A long term
increase in the supply of a particular good or in its manufacturing
cost brought about by productivity improvements can reduce the price
charged for those goods. Competition from foreign, lower cost
manufacturers might do the same. This might be called beneficial
deflation, in that consumers often respond to these types of limited
prices decreases by spending more on other items. The general level of
consumption does not fall and everyone has more goods and feels
wealthier. An example of this selective goods deflation is the effect
of manufactured goods from China over the past generation. For many
items prices have hardly risen in a decade or more. There are more and
better quality goods available and though paychecks for many have
stagnated, consumption has not. When presented with a cheaper good
consumers do not save the difference.

Supply generated deflation also tends to be limited in scope, not all
goods in an economy are affected. And though it tends to tamp down
overall inflation it does not produce a generalized decline in prices.

Demand can also falter when consumers have reason to fear for future
jobs and income and so postpone or eliminate consumption. This
reduction can become generalized if the prospective slowdown is severe

The more widespread and prolonged the price declines the more dangerous
for the economy. When price declines affect a majority of goods and
services, consumers begin to anticipate a lower future price and
postpone purchases. Just as inflation promotes current consumption in
place of future consumption because goods are bought today in
anticipation of higher prices tomorrow, so deflation substitutes future
consumption, when prices are expected to be lower, for current spending.

A clear example is the current residential housing market. In many
places home prices are now at the lowest levels in years. If these
prices had been offered a year or two ago they would have brought out a
slew of buyers. But now the same house at the same price attracts no
offers. Why? It is not only that mortgages are harder to obtain and
that people are reluctant to make a large purchase in a recession. The
US economy has, until very recently, had half a decade of very good
growth. Not everyone has lost their jobs or a fortune in stocks. Not
all bonuses have been spent. Nor has the desire to own a home
completely dissipated. Home buyers are holding back because they are
waiting for prices to go lower. Home price deflation has become the
norm, it is the market expectation. And it is these recalcitrant buyers
who are helping to drive prices even lower.

But housing is just one market. The same circle of anticipation of
lower future prices forestalling present consumption can become general
in economy. It is endemic deflation that is so feared by economists.
Contracting consumer spending is not just an individual consumer
decision. American GDP is 70% consumer spending. If consumers add
anticipation of lower future prices to layoffs, lost wealth in stocks
and home equity, the potential drag on economic growth becomes very
large. Falling consumption means fewer goods produced and a shrinking
manufacturing sector which in turn generates cutbacks in production and
employment as producers match output to sales. Laid-off workers buy
even less, prompting more production cutbacks further layoffs and a
spiral of declining production, employment and consumption.

In order to avoid the contracting economic spiral generated by
deflation governments and central banks have one policy—re-inflation—or
print and spend money. The Federal Reserve and Treasury have created
trillions of dollars in the past year in their attempts at rescuing the
banking system. Trillions more may yet come. President elect Obama has
talked of a stimulus package of more than $500 billion. The Fed Funds
target rate is 1%; it could well go to 0.5% or lower at this week’s
meeting. The effective rate has been less than half the target rate for

Inflation, deficit spending, very low interest rates, these are the
tools the US government is using to fight incipient deflation. Is it
any wonder the dollar has lost heavily in the past several weeks?

Joseph Trevisani

FX Solutions, LLC

Chief Market Analyst
[email protected]

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