Tuesday, August 10, 2010

Good Deflation and Bad Deflation

"You keep using that word. I do not think it means what you think it means."
Inigo Montoya, Princess Bride

To some extent, I have to say "I give up". I will grant that inflation and deflation no longer mean what they used to mean. Prior to the 70's, inflation/deflation pretty much just applied to the money supply - inflation meant an expanding money supply, deflation the opposite. Somewhere along the line, though, rising prices became "price inflation" and then just "inflation".
 
Why do I mention this? Well, it is something of a dirty secret that for most of the pre-Fed Reserve / pre-FDR history of the Republic, prices *declined* over time. That's right - the general expectation was that a pound of whatever would cost less in a year than it did that day.

I know ... it seems like it must be wrong, but I double-checked it and its true.

How did anybody survive? Well, for starters, the U.S. was a nation of savers and so people only spent when they really had to anyway. I mean, think about the entertainment or consumer spending options of Little House on the Prairie and you get the picture.

Business survived by being more productive and that is the real key to the story - so long as your costs of production decline faster than prevailing prices, you actually make more money (and expand your business and so on...). Actually, this should not be all that unfamiliar even to those of us living in the modern (inflationary) economy - think about PCs and how much less they cost today. And yet, plenty of money is still being made by PC manufacturers (though perhaps more of it by Asian manufacturers than ever before...).

I got to thinking about this because of all of the talk about the risk of deflation going around these days. Heck, even I am guilty of talking about it from time to time.

But as is actually not so often the case, maybe it *is* different this time. If deflation comes to America (and/or Western Europe), it will not be the "good" kind - the kind associated with ongoing productivity increases, quality of life increases, and a reasonable balance between spending and saving.

No ... we are most likely going to see the "bad" kind. This kind shows itself in buyers refusing to buy and companies desperately cutting prices to coax even a trickle of consumers through the doors. This is the kind were there is significant wage pressure and a grinding sense of malaise. In other words, Japan in the post-bubble aftermath.

This is not an "investable" post. I do not have any stock tips for you, nor many ways to play deflation (good or bad) if it does come ... though I suppose it is better to be a creditor in a deflationary environment, provided your borrowers can still pay you back.  I also imagine we are going to want to be investing in companies that have the "juice" to drive even more operating efficiencies - like I said before, if you can cut your costs of production, you can actually thrive in a lower-price environment.

Nevertheless, I have been thinking about this issue a lot lately, and just wanted to get some thoughts "down on paper" as it were.

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