Money Sage (archive)

Several months ago, shortly after the inception of this blog, we forecast that the flood of sunny assurances from the FED and from the economics fraternity, as well as the compulsive hand-wringing about "Inflation" and too much growth would give way to a new focus: recession. In this prediction we were correct. Now, we will venture forth with yet another prediction. We expect that before too long a word which has seemingly disappeared from the lexicon of "analysis" and "reportage" will be making its return from near-death.
This word: DEFLATION.

The tendency to analytical myopia and to obsessive fixation on the "issue" of the day to the virtual exclusion of all else is a hallmark of contemporary financial and economic and Wall Street commentary, as well as the heretofore more sacrosanct pronunicamentos from the FED. This propensity oversimplifies, and generally distorts significantly, the analytic picture. So it is with the absence of the word DEFLATION from the current dialogue, if one chooses to dignify it with this word.

Recession and deflation are NOT synonymous, nor is there any necessary relationship between the two. Recession, which is the pallid, distant cousin to DEPRESSION, does not produce, nor is it produced by, deflation. It is true that in a recession -- particularly a serious one -- some prices fall. However, these pockets of falling prices -- even if they encompass such important items as houses or cars or appliances, do not constitute, nor do they normally lead to, deflation. Recession, basically is NOT a serious event. We do not mean to downplay its significance to those who lose their jobs, part of their income, or who see a significant diminution of their lifestyle and a rise in their level of apprehension. However, in the big picture it is simply a very mild manifestation of the normal and inevitable down portion of the business cycle.

Deflation, on the other hand, is something of profound and far-reaching significance. The onset and firm embodying of a basic deflationary trend in the economy has massive and long-lasting consequences for the basic health of the economy, for prosperity, for living standards, and for growth, or the lack thereof.

Deflation, simply defined, is a marked, fundamental, and long-term downward trend in price. While it has become fashionable in certain circles to distinguish between "bad" deflation and a supposedly "good" deflation, we view this distinction as being fundamentally erroneous. DEFLATION is the inseparable partner of DEPRESSION. A serious deflation in asset prices is a potential leading indicator of a forthcoming general deflation. Additionally, an asset price downtrend, if sufficiently widespread and IF it affects an asset class whose prior inflation has been generated substantially by massive LEVERAGE -- ie., the employment of borrowed money -- has the potential for catalyzing a general deflation. In these circumstances, a general deflation is likely to produce some variant of DEPRESSION, NOT RECESSION.

In the current economic situation, oceans of ink have been spilled on recession-speculation. Will we have a recession or won't we? Has it begun yet? When will it begin? How long will it last? How deep will it be? How soon will there be a recovery? What does the FED need to do, to prevent, or contain, such a recession as may be looming (or, is already underway?)

There is a veritable pandemic of obsessive fixation upon RECESSION. The contraction in housing and the downward trend of real estate prices is viewed through the prism of its impact on aggregate demand and the possibility that it will curtail consumer spending, thereby producing RECESSION.

We are certainly not dismissing these concerns, for they are important. However, what is missing from the so-called debate is a serious consideration of the possibility that the downward trend in real estate prices together with the credit contraction could produce not recession, but rather a movement toward a general deflation and consequent DEPRESSION.

This, we believe, is the central issue. It is the reason we have focussed intently on what we see as the decisive consideration: bailing out, promptly, the banking system. The banks constitute the fulcrum of the inflation/deflation nexus: the threat of a general deflation developing, and producing an economic DEPRESSION is the critical one. In this context, "recession" would be merely a passing phase.

We believe that it is for this reason that an extremely knowledgable economist named Ben Bernanke has FINALLY asserted his authority at the central bank. It is not recession that he fears, we would opine: it is a general DEFLATIONARY COLLAPSE. He understands all too well that there is no such thing as a "good" deflation.