inflation -vs- deflation, a brief look at the consequences
This blog aims to take a look at inflation and deflation in a broad and simple way to make the main points.
Imagine a world in which we had 10% inflation of everything - prices, costs, and wages - every year. Imagine that in this world you made $100k and were thinking about buying a $200k house. You buy the house, ... and incur debt of about 2x your annual salary. At the moment you have 0% of your annual salary as equity in the home and lets assume you have no savings.
In 1 year you are making $110k, have paid off lets say $2500 of the house, and the house is worth $220k. Now you have debt of 1.8x your annual salary and have about 20% of your annual salary as equity in the house. In 5 years you are making $160k, you owe perhaps $180k on the house, and the house is now worth $320k. Now your debt is now just 1.1x your annual salary (down from 2x) and you have nearly 1x your annual salary of equity in the house.
This is good. The inflation of wages, costs, and prices constantly devalues debt (making debt held less of a burden), and creates a savings account in the house (or other assets which hold value -vs- depreciating). Also your pay is constantly increasing which will have a positive psychological effect as you feel better making $100k than $60k even if your net buying power is the same.
In this inflationary scenario you have nearly 1x your annual salary of equity in the home, your debt is just over 1x your annual salary, life is probably good. You may miss the good old days when gas was $0.25 and a new Corvette was $5000, but overall its acceptable.
Now imagine a similar deflationary scenario. Every year costs, prices, and wages drop 10%. You buy a house, again, thats 2x your salary. $100k income, $200k house. The next year you are making $90k, the house is worth $180k, and you've paid off again lets say $10k of the house. Your debt is now 2.1x your annual salary and you have negative $10k of equity in the home.
Flash forward 5 years. You are making $60k, you have paid off $15k. Your debt is now 3x your annual salary, your house is now worth just $120k and you still owe roughly $180k, you are $60k or an entire years pay underwater. Probably, you can no longer make your house payment and you face bankruptcy.
You don't have time to enjoy the cheap gas or low prices for a steak dinner, you're broke.
This is possibly the most relevant element of inflation -vs- deflation in my view: debt is far less burdensome in an inflationary environment (assuming again that wages, costs, prices all inflate). There are other effects as well.
Motivation to spend -vs- motivation to save. In an inflationary environment people are motivated to spend money now -vs- save it, as the buying power of their savings is constantly lessened. In a deflationary environment you have little motive to purchase as the cost of something will be lower in the future, and the value of whatever you have purchased will also be lower in the future. If you knew that a new Corvette was $50k today but would be $75k in 5 years, you would be much more motivated to buy your dream car today than if that car was going to cost $35k in 5 years.
Inflation creates an intrinsic logical motive to purchase to spend to consume to invest. Deflation creates anti-motive to do those things as you could buy cheaper in the future, your investments and assets are likely to lose value, and so forth.
The examples above are unrealistic and extreme, of course. Wages, costs, and prices won't ever move in perfect synchrony. Its likely that wage inflation will lag price inflation and that this will cause a period of discontent and an economic hiccup. For example, when gas hit $4.50 last summer, I don't remember anybody getting an automatic raise. Similarly, when it hit $1.50 late last fall, I don't remember anybody getting an automatic pay cut. So in the short term, deflation can seem good and inflation can seem bad. And in either case, not all assets or costs will inflate/deflate the same amount, this will create imbalances that harm some and help others. For example, the big drop in natural gas prices recently hurts CHK (a seller of nat gas) but helps DOW (a user of nat gas).
As oil shot up in price last summer, companies like ASH or NCX (NCX is no longer an active ticker) were hurt by the sudden increases in raw material costs. It takes time to pass those cost increases along to customers. Similarly, ASH was aided by the sudden drop in prices late last fall (their customers had already been passed some of the higher costs, and another lag exists in lowering costs, etc.).
So changes in the pattern of inflation and deflation are chaotic and typically somewhat troublesome. Wages are likely to lag inflation (leading to more trouble) and all of this... but inflation is clearly preferable if one had to choose. It may well be that some amount of inflation is preferable to stable prices, costs, and wages as well for a variety of reasons including the psychological effect of having your income go up, even if that doesn't bring you more buying power.
But whether inflation or stability prices is the preferable scenario, I can't see any way around deflation being disastrous for an economy. It was deflation, not a bank bailout, that caused Japans lost decade(s?).
The dramatic events in the world in the last 12 months are the aftermath of excessive inflation (in housing prices, commodity prices, stock prices) turning suddenly to dramatic deflation (in house prices, stock prices, commodity prices). The change of course causes tremendous turmoil. We are likely to face turmoil again in the turn back to inflation.
If you were Bernanke or whoever is ultimately in charge... of a country with enormous debt, who's citizens have considerable debt... you would probably want some inflation. Its power to ease the burden of debt is vast, and I cannot imagine a scenario in which the current situation does not play out to inflation. The powers that be no doubt want some inflation, and I'm sure they will get it. Thats not necessarily bad, mind. If inflation cannot be restored, the consequences to the economy and markets may well be dramatic and unpleasant for the basic reasons given above.
But in any case, my goal here was to provide a simple overview of inflation and deflation and some of the consequences of each, not to make any kind of market or economic prediction. I think its clear that avoiding a prolonged period of deflation is critical.