The fear of deflation

We're used to worrying about inflation. Those of us of a certain age can recall what it was like, and what it was like to make it go away -- can anyone remember when a 12 percent mortgage sounded like a good deal?

Now, however, people in the know are worried about the opposite: deflation, a decrease in prices. The economist Nick Perna writes:

Deflation can be a nightmare. As prices fall, the incentive to postpone purchase grows and further weakens the economy. Lenders struggle as the value of loan collateral erodes and the ability of borrowers to repay weakens. Meanwhile, the loan amount stays the same in dollars.

Astoundingly, he says, The Federal Reserve Board "is actually worried that inflation is too low."

To get an idea of why, we can look at Japan, which has suffered a deflationary spiral for several decades. Here's a picture of their price trend:

What is life like in deflation? It's not pretty. The New York Times describes what it's like in Japan.

Just as inflation scarred a generation of Americans, deflation has left a deep imprint on the Japanese, breeding generational tensions and a culture of pessimism, fatalism and reduced expectations. While Japan remains in many ways a prosperous society, it faces an increasingly grim situation, particularly outside the relative economic vibrancy of Tokyo, and its situation provides a possible glimpse into the future for the United States and Europe, should the most dire forecasts come to pass. 

Here are some numbers.

• Japan’s economy remains the same size it was in 1991; during the same period, the United States economy doubled in size.
• Companies and individuals have lost trillions of dollars in the stock market, which is now just a quarter of its value in 1989.
• The average price of a home is the same as it was in 1983.

The psychology effect is great, The Times says: "Deflation has left a deep imprint on the Japanese, breeding generational tensions and a culture of pessimism, fatalism and reduced expectations. While Japan remains in many ways a prosperous society, it faces an increasingly grim situation, particularly outside the relative economic vibrancy of Tokyo, and its situation provides a possible glimpse into the future for the United States and Europe, should the most dire forecasts come to pass"

Those gizmos in your home explain deflation

Try this: tally up all the items in your home that qualify as "impact of computing" devices, which is any hardware device where a much more powerful version will be available for the same price in 2 years.  

Include: Actively used PCs, LCD/Plasma TVs and monitors, DVD players, game consoles, digital cameras, digital picture frames, home networking devices, laser printers, webcams, TiVos, Slingboxes, Kindles, robotic toys, every mobile phone, every iPod, and every USB flash drive. Count each car as 1 node, even though modern cars may have $4000 of electronics in them.

Do not include: Tube TVs, VCRs, film cameras, individual video games or DVDs, or your washer/dryer/oven/clock radio just for having a digital display, as the product is not improving dramatically each year.

The Futurist presents this challenge to make a critical point:  You will be surprised at how many devices you now own that did not exist in the 80s or even the 90s. In fact, 1.5% of world GDP today is comprised of products where the same functionality can be purchased for a price that halves every 18 months.

The result: a good form of inflation The Futurist terms the "techno-sponge." Here's how it works.

What we are seeing is that the gigantic amount of liquidity created by the Federal Reserve is cycling through technology companies and increasing their earnings. The products they sell, in turn, increase productivity and promptly push inflation back down. Every uptick in inflation merely guarantees its own pushback, and the 1.5% of GDP that mops up all the liquidity and creates this form of 'good' deflation can be termed as the Techno-Sponge.

And so, turning traditional economics on its head:

At this point, if the US prints another $1 Trillion, that will still merely halt deflation, and there will be no hint of inflation at all. It would take a full $2 Trillion to saturate the techno-sponge, and temporarily push consumer inflation to even the less-than-terrifying level of 4% while also generating substantial jumps in productivity and tech company earnings.

Just anecdotally, I've seen no slowdown in the spread of productivity-enhancing devices, from the iPad to the Kindle to the new smart phones. I haven't checked into technology purchases by businesses during this recession, but I suspect that where computers and other devices are critical, and not just nice to have, investment has continued apace.