The current economic mess is like watching a slow motion train wreck. Every week brings one more car piling up in smoke and flames along the side of the track. Indications of a major problem have been popping up recently without much fanfare - deflation.
What is deflation? It is a pronounced and continued downward spiral in prices for either a sector of the economy or the economy as a whole. We've been watching deflation occur in two big markets - housing and oil. Housing has been deflating for a year or two while oil just went into a massive, sudden downward spiral earlier this month.
If deflation means prices are going down, what's the problem? Well, deflation is like selling your soul to the devil for your grandest desires. The immediate effect is pretty nice, but the payoff in the end is a real killer. With deflation, low prices are great at first, but they tend to feed on themselves and can kill the economy.
Let's assume I make tortillas. As consumers slow their spending, I suddenly have more tortillas then I know what to do with. I have to get rid of them, so I lower my prices. I am able to sell off my inventory, but my total revenues are down. I have business debts I have to maintain, so I have no alternative but to let go of employees to save money somewhere. Now I can't produce as many tortillas and, eventually, will run into a situation where I may not have sufficient revenues to meet the monthly payments on my business debts.
Millions of businesses will be doing this. As they slash employment, the total spending by consumers will drop again. Citigroup, for instance, just announced a layoff of 52,000 people. Those 52,000 are not going to be spending money. It turns into one big loop that can be very hard to stop.
How do you fight deflation? The answer is simple - the Federal Reserve Bank cuts interest rates. By doing this, banks start lowering the cost of borrowing money. More people and business begin borrowing money and then spending it. This drives up demand and prices, thus putting deflation in the trash bin.
Unfortunately, there are two problems that really hurt us if deflation does hit the economy. The first is the simple fact that the Federal Reserve has already lowered the interest rate for banks to borrow money down to one percent. It could go to zero, but that isn't really much of a difference.
The second problem, of course, has to do with the banks. As you've probably notices, we are having a smidge of a problem in the banking industry. The current managers of most large banks have proven to be incompetent. Everyone jumped on the subprime mortgage bandwagon and it has all gone horribly wrong. The end result is any bank getting money at the moment is far more likely to hoard it to make the bottom line look better than it is to lend it. Even if banks do lend the money, who exactly is looking to take on more debt?
So, are we in serious trouble with deflation? The answer is not particularly clear at the moment. If the retail shopping season is really bad, it will not be a good sign.
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