Wednesday, April 11, 2007

Deflation and Other Interesting Econ

I just finished a fascinating book on Deflation (Deflation: What happens when prices fall by Chris Farrell). I have always enjoyed economics and this book is about the most compelling econ book I have ever read.

The main premise of the book is that we are moving into a deflationary period thanks to the following factors:

1. Federal Reserve Policy
2. Overproduction (Mostly from China)
3. Productivity advances in the service sector
4. Outsourcing

He looks at previous deflationary periods such as the deflation of the 1870s-90s, the Great Depression and Japan's deflation of the 90's.

Of course, if you look around you will say that he is nuts. Fuel prices, education, health care and raw materials are all higher. However, in total, he is correct. Prices for finished goods and services are dropping. This has tremendous impact on what will happen in the future.

First, the Federal Reserve has only theories on how to combat deflation. They have no real experience in counter-deflationary policy. Second, if deflation were to get out of hand, it would devastate our system of high personal debt. Debt in inflationary periods is good because the money used to pay back the debt will be worth less in the future. However, during deflationary periods, it will be the opposite.

Being in the technology industry, I am accustomed to falling revenue and prices. In fact, if RentQuick were still able to charge the same service rates that we did back in 1998, then we would be a significantly larger company. It is just something you learn to live with.

However, in the world of real estate, falling prices will be devastating. The only good part is that you won't have a supply side deflation (you cannot really make more land).

So where is the best place to be during a deflationary period? Mr. Farrell asserts that cash, i-bonds or corporate bonds will do best. Stocks apparently stink during deflationary cycles, which makes sense because revenue will drop first and payroll will be "sticky". Hence, earnings will drop.

Are we headed for a deep deflationary period? That is unlikely for the following reasons:

1. Fed policy will at least try to stabilize prices unlike during the depression where the federal government balanced the budget and the goal was adherence to the gold standard. (The gold standard is deflationary since there is a limited supply of gold available, thus money supply is restricted.)
2. The US is no longer on the gold standard. As stated above, this would allow more flexibility in Fed policy although at some risk to the dollar's exchange rate.
3. If prices are dropping, then there will be a point where the producers will move out of those products which do not offer a positive return on investment. This should reduce the supply of these products and stabilize the prices.
4. As the barrier to outsourcing drop, you will see wages in white collar outsourcing rise to meet those of the US. This makes sense that there will eventually be parity across borders once all barriers are removed. Yes, US salaries will drop, but others will rise. (Reference China's increase in executive pay in those companies that have taken over foreign firms such as Lenevo's purchase of IBM's PC division.)

So what should the individual do to prepare for deflation?

1. Reduce consumer debt. Pay off credit cards .
2. Adjust investment portfolios to favor bonds and cash over equities.
3. Continually increase knowledge, skills and certifications to increase your productivity and performance to counter lower wages.

There, I played an Economics Professor for a day. To think I got a D in Econ in the 11Th grade!