Written by 6:02 pm abroaden weekly insights

The D-word that scares all economists


Hello, and welcome to issue 006 of the WTF is going on in the Economy? Newsletter! 

Here in Europe, it looks like we’re successfully beating the initial onslaught of pandemic (for the most part). 

As our attention turns from infection rates to the economy, there’s a word terrifying economists. 

The word starts with the letter “D.” 

It’s happened before. 

And the results were catastrophic. 

However, the word you’re thinking of isn’t depression.

It’s deflation.

You’ve probably heard of deflation’s opposite twin “inflation.” 

With inflation, prices continue to increase, with deflation, prices go down. 

We’ve seen many striking images of inflation, such as people in Venezuela paying for bread with a box full of cash. These unfortunate folks have to live in such conditions where prices for everyday goods change by the minute. Almost always, high inflation comes hand in hand with bad politics. It’s tragic, it’s sad, and people suffer.

And yet, between the two, deflation is the evil one. 

Here’s how it works: 

Deflation will happen when an economy slows down. 

Consumers (i.e., you and me), will either lose our jobs or be wary that we might lose them in the future.

We decide that it’s better to stop spending and instead save.

Businesses, on the other hand, want us to keep spending because that’s how they function.

To get us to part with our dear cash, retailers will start lowering their prices with sales and other discounts. 

While this tactic might initially work at first, it will only reach consumers who have money to spare.  Businesses still want to stay in business so they’ll continue discounts.

Consumers quickly catch on that prices are dropping.  Instead of rushing out the door to nab a deal on a new refrigerator, they’ll think to themselves, “Hey, if I wait an extra few months, then I’ll probably get a better deal.” 

Again, desperate businesses will once again cut prices, trying to get customers. And still, customers wait for even more discounts.

This cycle continues to repeat until companies are selling their inventory at a loss, they can’t pay their bills, and they go out of business.

As the prices continue to deflate — hence deflation — people lose their jobs, businesses stop investing, and loans don’t get repaid. 

The result? That other “D” word we mentioned earlier: depression.

Depressions, like the great one 90 years ago, are notoriously hard to exit.  

Today, the Great Lockdown created the worst economic contraction since the 1929 stock market crash that ushered in the Great Depression.

There is a real fear right now that we could be heading towards a deflationary cycle (deflation in economist-speak).  If that proves true, the 2020s could be a repeat of the 1930s. 

You might be thinking to yourself, “Thanks, Elliott, now I’m terrified,” and I’m sorry for that. 

But don’t panic just yet: economists, central bankers, and governments are on it.

Here’s how they’ll do it. 

First, protecting the consumer’s purchasing power is paramount to preventing deflation. If people have some sort of income certainty, they’ll be more likely to spend. Governments already started providing unemployment and stimulus payments directly into consumer’s pockets. They will continue to do so as we recover.  90 years ago, mass payments like this were unheard of, which fed the destructive deflation. 

Second, we can (almost) safely say that austerity won’t be coming back anytime soon. Executing this policy when the economy is strong is beneficial. Doing it during a downturn creates deflation. Indeed, the last depression we saw happened only a few years ago in a place called Greece, thanks in large part to austerity policies. Policymakers will try to avoid making cash contingent on cost-cutting. 

Finally, the central banks already stepped up to backstop the debt market by purchasing outstanding loans (bonds).  We talked about this in our first issue. In short, central banks give companies and investors cash by purchasing their debt. This influx of cash lets companies make investments and pay salaries and bills.  

There’s a good possibility that not only will these policies avoid deflation, but they’ll also create moderate inflation.  That’s actually a good thing governments will welcome.

We’re borrowing tons of money right now to avoid deflation. Governments will have anywhere from a few months to many decades to pay it back. If we have inflation, it will cost us less to pay back the original amount. Likewise, if we have deflation, then paying back the loan gets more expensive. Inflation will definitely be our friend.

So how do economists spot deflation? 

Great question! I’m glad that I asked!

Economists use a consumer price index like this one for Europe to look at the most recent inflation trends. This indicator measures the annual change in prices for consumer goods and services. It calculates each month, so for example, economists can compare March 2020 to March 2019.  This index is the gold standard for inflation measurement.  If the number goes negative, then prices are deflating.

However, you’re probably not going to check these indexes daily. 

Instead, try observing changes you see in your day-to-day lives. 

  • Are big, essential items like cars, water heaters, and dishwashers continually going on sale? 
  • Do different electricity and gas companies suddenly spam you with discounted offers?
  • Is the rent dropping in your neighborhood?  What about home prices?
  • Are airlines sending you even more promotions like free checked bags to get you back on board? 
  • Do you hear your friends talk about waiting for prices to go down before spending? 

It’s anecdotal, but they do provide some degree of evidence of it happening in front of you.

  These items aren’t weighted equally. Some industries are more competitive than others, meaning promotions are more common.  

Importantly, don’t take every sale as a sign of deflation. Screaming like a lunatic because there’s a midseason sale on vacuum cleaners doesn’t end well. Trust me, I tried that one weekend a while back and managed to embarrass my toddler — and nothing embarrasses small children.

Instead, be mindful that sales shouldn’t keep getting better and better. Discounts are an inevitable part of any recession.  If you see something you want on promotion, go ahead and buy it (assuming you can afford it). Otherwise, you risk the chance of the deal disappearing (along with the company, too). 

How will all of this play out and will we experience deflation? Right now, it’s too soon to tell.  Government policies take a bit of time to ripple through the economy.  

Until then, let’s hope that deflation doesn’t set in. If it does, we’ll be looking at a long, challenging road ahead.

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