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Krugman Spots Deflation

Posted: July 12th, 2010 | Author: | Filed under: Uncategorized | No Comments »

As most of you know, I have been warning of a trend toward deflation for some time. The debate about whether we are headed for inflation or deflation has been a huge one amongst economists for the past few years and continues to rage on. Now Nobel Prize recipient and New York Times economics writer Paul Krugman shows evidence supporting a deflationary trend is afoot.

From the New York Times
The Conscience of a Liberal
Trending Toward Deflation
Paul Krugman
July 11, 2010

What is deflation? Simply put, it is the opposite of inflation. Inflation is the expansion of the total money supply and deflation is the contraction of the total money supply. I believe it is important to include credit and debt wealth when looking at total money supply, as has been put forth by the Austrian Economists. Ours is an economy built on access to credit, and one that is falling apart as credit shrinks and debt wealth evaporates. (Krugman, incidentally, is not of the Austrian school, but subscribes to the Keynesian model the Fed and government use which does not account for debt and credit availability as part of money supply in the same way.)

Many imagined that with all the stimulus money the Fed was pumping into the economy we would soon find ourselves with an expanded money base and risk of inflation or even hyperinflation. People would suddenly have a lot more money and so merchandisers would be able to charge more and more for their goods. But since the banks are in such a terrible state teetering on the brink of collapse, the stimulus money they received in order to keep credit and loans flowing was never lent out. Instead of trickling down into the economy it was hoarded by the banks themselves in a mass effort of self protection, and so has never had an inflationary impact on the economy.

Deflationary pressure is also stemming from the collapse of available credit and debt wealth.  According to economist Dean Baker of the Center for Economic and Policy Research in Washington DC, the housing bubble created EIGHT TRILLION DOLLARS of imaginary wealth that will eventually completely evaporate. The 700 billion dollar stimulus package was no match for that kind of destruction of wealth in the economy, and so even if it had reached the general public and made its way into actual use it would not have been enough to stop the contraction of the total money and credit supply.

What does deflation mean for you in practical terms? The most pressing issue is that any debt you hold will become more and more “expensive” to pay off. Today’s dollars will be worth more and more tomorrow. Already we see how this has happened in housing. The same $500K that bought you a modest home in Los Angeles five years ago will now buy you two! So already your money is worth twice what it was in real terms. If your money is going toward debt, therefore, that debt is costing you twice as much as it did five years ago in real terms. The face amount of your debt payment has stayed the same, but what that money can buy now has increased. On top of that, if a deflationary spiral takes hold more jobs will be lost and all markets will suffer.  In times of deflation prices go down, but our ability to pay falls even more sharply.

What to do? First and foremost I reiterate what I’ve said in the past: get out of debt now! It would also be wise to avoid taking on any further debt until markets stabilize. This is a time to save. Rather than thinking about investing you may want to concentrate on how to keep what you have. Ben Franklin’s old adage, “A penny saved is a penny earned,” is apropos of the times. Only, in a time of deflation you might think of it as “a penny saved is two pennies earned… maybe more!” If you can live frugally and are able to save you will see very good opportunities to invest later on down the road. Let the storm pass. It is probably a good idea to limit your exposure to stocks and real estate now. Stay in cash and short term treasuries. By saving you are earning.

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