deflation

Why Inflation?

Philip Brewer — Wed, 12 Oct 2011 10:24:12 +0000

We know how inflation happens—excess growth in the money supply. But why does inflation happen? (See also: Can a Little Inflation be Good?)

Most people have a misunderstanding of inflation, because certain recent inflations—those of the 1970s in Europe and the United States—were unusual.

The 1970s inflations were largely side-effects: Working to keep their economies running at full speed, central banks boosted the money supply on the theory that accepting a certain amount of inflation would allow the economy to run with a lower level of unemployment. That theory turned out to be false, but that's not the important point. What's important is that "side-effect" inflation is the exception.

Most inflation—going back over hundreds of years and dozens of countries—is deliberate inflation, inflation produced with a goal: to reduce debt burdens.

Most often, the goal is to reduce the burdens of government debt. (Makes sense—governments control the money supply, and they tend to run up a lot of debt.)

Sometimes the goal is to reduce the debt burdens of ordinary folks. This isn't as common, in particular because inflation tends to hurt those with money, and people with money tend to have influence over the government. But, especially in democracies, and especially when society ends up divided between the few (who are very rich) and the many (who are poor and often in debt), the many turn out to have enough influence to call for some inflation to lower debt burdens.

Inflation does work for this purpose, but it doesn't work very well.

First of all, inflation only reduces the burdens of debts that already exist (and then only debts at a fixed interest rate). That's great for a government with a big public debt, and it's okay for homeowners (if they have fixed-rate mortgages) and recent graduates (if they have student loans at fixed rates), but it actually sucks for anyone who needs to borrow money—because they're going to face very high interest rates.

Inflation also produces all sorts of distortions. It creates phantom profits (where much, all, or even more than all of the gain is just inflation)—not so bad, except that phantom profits are often taxed just like real ones. It causes suffering because many prices can go up daily, while incomes often go up only annually. It makes it hard to plan for the long term (because you don't know what prices will be tomorrow, let alone 10 years from now).

The fundamental problem with inflation is that it fools people—it obscures true values and that leads people to make bad decisions. They get a good raise, and think they're better off. They see growing sales, and think their business is growing. Only later—when they see that prices have gone up and that even with the extra money that's come in they're no better off than they were—do they realize that they'd been misled. And if they made commitments based on that misunderstanding of their real situation, they may be in real trouble.

Right at this moment, things rather hang in the balance. As I said, the pressure for inflation is always strongest when the money is in the hands of the few and the many are in debt. Especially in a democracy, that's a dangerous situation.

Inflation is terribly pernicious. It's a blunt instrument that does reduce the burdens of debt, but does so in a crude fashion, with winners and losers selected for no more reason that that they had already borrowed (rather than being about to borrow) and that they had borrowed at fixed rates. There are things you can do to reduce the harm that inflation will do on your household economy (check out my post How to Live with Inflation), but even better is to avoid inflation.

Perhaps knowing why inflation happens will help with that.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

U.S. Banks and the Tokyo Drift

Jabulani Leffall — Thu, 21 Oct 2010 12:00:10 +0000

You already know the story, but perhaps it may happen again. It's that familiar.

A nation reeling from popped real estate and financial collapse mopes through a recession and struggles with a crisis of confidence, its president making pledges that everything will be okay.

It sounds like a broken record, doesn't it?

Well, except I'm talking about Japan and the president in question is not Barack Obama but Junichiro Koizumi, and the year in question was 2001, not 2010.

But it is 2010, and parallels to Japanese banking in the 1990s and our banks in the "oughts" now abound.

Four words: bad loans and deflation risk.

That's five words, but it's important to note that recently, U.S. banks such as BB&T and Sun Trust both set up special panels to explore potential exposure to deflation.

Deflation is the general decrease in the price level of goods and services across the board, usually due to a systemic downturn and the resulting desperate effort to cut prices to compete. Deflation also sometimes results from monetary policy that overdoes it in an effort to avoid inflation. Ironic, isn't it?

According to Reuters:

BB&T ran its books through a stress test to gauge the bank's performance in a scenario in which there is deflation for the next 10 years, as part of the bank's own internal projections of various economic scenarios, Chief Financial Officer Daryl Bible said."

Why does Japan in the 1990s keeps coming up?

At the outset of the U.S. crisis in early 2008, the American Enterprise Institute examined Japan's lost decade, about which the think tank says that an "economic cycle driven by a collapse in the market for an asset — such as land or housing — to which the banking system is heavily exposed is a dangerous beast."

That "dangerous beast" was Japan 20 years ago and it ended just 10 years ago. That dangerous beast could also loom here in the U.S. today. The common denominator: bad bank loans were, by and large, the culprit.

As the Reuters piece points out, Japanese banks discovered what is now known as the "lost decade"; deflation means that loan collateral values decline, exacerbating already under-performing loans.

The article goes on to say:

Loans may become more likely to fail, as borrowers tire of paying high rates of interest to finance assets that are worth much less than they had been previously. A second credit crisis could emerge."

If regional powerhouse U.S. banks such as Sun Trust and BB&T — both of which received TARP money and both of which are present in areas hit by rising foreclosures — are either thinking about or hedging against deflation, then it's only a matter of time before cheap money and sluggish economic growth increases the possibility of making widespread deflation an actual reality.

Indeed, the risk of continued deterioration of already bad loans continue to scare U.S. banks, which have a danger of falling further into hock on outstanding loans to say nothing of the continued "quantitative easing" at the U.S. Federal Reserve and currently low Treasury yield curves.

Who better to explain what might happen than Bank of Tokyo-Mitsubishi UFJ, Japan's largest bank and "lost decade–bad loan" poster child?

According to a Bloomberg piece earlier this summer, the bank's proprietary trading chief Kenichi Imai had this to say:

With the effect of government stimulus measures wearing off, the U.S. economy may face a prolonged soft patch, rather than a double bottom."

Soft Patch? Opposite of a hard patch? Flaccid? Sounds maybe a little bit, I don't know...deflated, even.

Let's hope not.

As Bill Isaac, chairman of LECG Global Financial Services and a former FDIC chairman, points out, deflation is not good given that U.S. banks are still assessing non-performing and under-performing loans and testing their balance sheets against deflationary scenarios.

Think you've heard this already? Just wait.

This article is from Jabulani Leffall of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

All About Deflation

Philip Brewer — Thu, 05 Aug 2010 13:00:05 +0000

Deflation is back in the news, and for good reason: It's a real risk.

Let me say up front that my own experience makes me much more inclined to worry about inflation. I have first-hand experience with the harm of inflation: the 14 percent inflation of 1980-1981 devastated my very first budget. Deflation, on the other hand, has always been a purely theoretical problem, and one that doesn't even sound all that bad. Falling prices? What's not to like?

So, here's the first thing: Deflation isn't falling prices. Just as inflation is the money becoming less valuable, deflation is the money becoming more valuable.

Prices tend to fall during a period of deflation, but prices change for lots of reasons, and other factors can easily cause some prices to rise, even during deflation. For example, widespread drought could easily cause food prices to rise during deflation.

Cause of deflation

Just as inflation is caused by an increase in the money supply, deflation is caused by a decrease in the money supply — but it's not quite that simple.

The "money supply" isn't one single thing. Anything that you can spend is money, so that's not just cash and checking accounts and money fund balances. For example, the available credit in your Home Equity Line of Credit (if the collapse in housing prices has left you with any) is pretty close to being money, as is the available credit on your credit cards. Even the value of your brokerage account is practically money — you could sell your stocks and have the cash in four or five days.

The supply of those sorts of money collapsed during the panic at the beginning of the crisis, as credit lines were cut and asset values crashed. The effective supply of money fell even further, because people quit spending — and money that people won't spend has little effect on prices.

The Federal Reserve stood against this collapse in the money supply by creating bank reserves and by buying assets (putting cash in the hands of whoever was selling — mainly the Treasury and the government agencies that support the mortgage market). Most people (including me) saw that surge in bank reserves and money and assumed that inflation was right around the corner. It's now pretty clear that the Fed was right and I was wrong. All that money just barely managed to stave off deflation.

How deflation hurts

Falling prices doesn't sound so awful, but remember that falling prices are just a symptom. When the money unexpectedly becomes more valuable, the result is pain for anybody who has to come up with cash now to satisfy a deal where the price was set earlier — your rent, your cell phone contract, your health insurance all cost more than you thought they were going to when you signed the contract.

To make matters worse (and more complicated), some prices are less prone to changing than others. In particular, wages are generally sticky on the downside. That means that rather than a smooth adjustment with wage cuts, deflation tends to produce high unemployment.

The real place that deflation bites, though, is debt. Just as inflation makes winners out of people who borrowed money at low, fixed rates, deflation makes them losers, crushing their households under the burden of paying off old debts with money whose value rises further and further above what they borrowed. In a society where many people have debts, the pain is spread far and wide.

Dealing with deflation

Of course deflation has winners as well as losers, at least on the surface. Anyone with cash tends to benefit as their money becomes more valuable. Anyone with long-term bonds at fixed rates can do spectacularly well. Anyone with a secure job and little or no debt has a good shot at doing just fine.

In the real world, things aren't quite so happy. Those long-term bonds are especially likely to default; even the most secure jobs can be lost during a time of deflation. Even cash hasn't been a perfect safe haven historically, although our bank deposit insurance has held up OK so far.

The one good thing about deflation as a risk is that the steps to protect yourself are the same practical steps that we often talk about here on Wise Bread: reduce fixed expenses, avoid debt, boost your emergency fund. It makes more sense than ever to delay purchases, and since your money is getting more valuable, holding cash is a winning proposition.

The risk

As deflation starts to bite, more and more households start to follow this advice: They avoid debt, they reduce spending, they hoard cash. Because of that, besides hurting everyone with debts and making it tougher to find and keep jobs, deflation hurts the whole economy. This effect can snowball, producing a recession that's just about impossible to escape from — see the experience of the US in the 1930s.

Because of that, in 2009 there was a consensus within the Federal Reserve to do whatever it took to prevent deflation. (They proceeded to buy $300 billion of Treasury securities and $1.55 trillion of government agency securities.)

And that's what makes the current situation so risky: That consensus seems to have broken down. It's by no means clear that the Fed would repeat purchases on that scale. The upshot is that deflation, and all the pain it brings, is once again a real risk.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

New rate set for series I savings bonds

Philip Brewer — Mon, 03 Nov 2008 20:07:11 +0000

Every six months, the Treasury sets a new fixed rate for series I savings bonds. After tracking close to the rate on the Treasury's other inflation-indexed bonds during the Clinton administration, the rate was cut sharply starting in 2001, culminating in an interest rate of zero for the past six months. Today, though, the Treasury announced the new rate for the next six months: 0.7%

That rate isn't as bad as it sounds, because you get that plus inflation. Adding in the adjustment for inflation, the total annual return on a bond purchased this month will be 5.64%. (That's an annual rate that will apply for the next six months. A new rate, based on inflation, will be calculated every six months--but the 0.7% fixed part of the return will remain in effect for the life of the bond.)

There are several good features of the I Bonds. You can defer taxes on the interest until you cash the bond--up to 30 years. And, if you use the money for education expenses, you may not have to pay taxes on it at all. In addition, if there's deflation, your investment is protected to the extent that its value won't fall below the face value of the bond.

As an alternative to the series I savings bond, consider TIPS--Treasury Inflation Protected Securities. They pay a market rate determined at auction, rather than a fixed rate determined by the Treasury. Currently, they're paying as much as 3.25% (plus inflation). Obviously, that's a lot better than 0.7%. There are several downsides, though. In particular, new bonds are only issued on specific dates (although you can buy one at any time through a broker). Also, TIPS have a specific maturity date, and you can neither cash them in early nor hold them longer, the way you can with a series I savings bond. In addition, their protection from deflation isn't quite as good. (For more info, see my previous article about TIPS and I Bonds, and for information on the mechanics of buying them, see my article Treasury bills for ordinary folks.)

Inflation plus 0.7% isn't a great rate, but given that there's a real danger of the economy tipping toward either inflation or deflation (or first one and then the other), these bonds may be a good buy.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: