Deflation Primer

Deflation is the debtor's worst enemy just as inflation is the debtor's best friend. In inflationary times the value of the asset you borrowed money to buy goes up so quickly that you can always sell and come out ahead despite the interest you paid in the meantime. In deflationary time, the outstanding amount of the loan can easily become greater than the current value of the asset. Now you're underwater and can't sell without putting money in. If you're having trouble making the payments, you have big trouble.

Obviously we have deflation in the housing market today. But what's much scarier is that we may be going through a period of much more general deflation, perhaps triggered by housing, perhaps just overdue. Commodity prices have also come crashing down, also from lofty peaks of course. Deflation is what characterizes depressions (which I'm not predicting but deflation is serious stuff). Deflation also tempts governments into hyper-inflation as a cure; can you count to $850 billion?

Deflation of an asset is self-perpetuating. When houses could do nothing but go up, you offered more than the asking price before the realtor was through showing you the place to beat out the next guy. When house prices are going down, you think long and hard about making any offer at all. If you do offer, it's low. And you don't budge much in negotiation. When fuel prices were going up faster than the wheels could spin on gas pumps, we filled up when the tanks were half empty to avoid paying more tomorrow ; so did the guys with the huge storage tanks – and they borrowed money to do so. Now I drive to near empty because the gas I buy tomorrow'll probably be cheaper than what I'd pay today . The guys with the huge storage tanks have to sell to pay back their loans but the stuff now cost less than when they bought it (if you were concerned about hoarders, deflation is your revenge). Now the pendulum is swinging towards deflation even though neither houses nor commodities have yet gotten cheaper than they would have been had they only tracked the general rate of inflation for the past five years.

In times of inflation, any Wall Streeter'll tell you "cash is trash". In times of deflation, "cash is king". Everyone all of a sudden wants to see and feel his or her cash; banks are debtors; depositors are creditors. Deflation is the debtor's worst enemy; but deflation is only the creditor's friend if he or she can get paid back. More in the next post.

Comments

[Delwyn Lounsbury]

Everyone is hung up on inflation being here forever.
Since the only cure for inflation is deflation, we have to have deflation. The sooner the better. Runaway inflation and hyperinflation is what led to Hitlers rise to power. The Germans were so down they grabbed at the first ray of hope that came by. They got the anti-christ. There was a German nihilism movement. Websters New World Dictionary says nihilism leads to terrorism.
The populace was down in the dumps.

World wakeup. The Greater Depression is ahead. Deflation will slow government down. It's been growing like a weed.

[kid mercury]

this will be an inflationary depression, the devalued dollar is the key. dollar's current rally is a short-term counter trend and we will see the resumption of inflation in the not too distant future, probably 2009 if i had to guess.

in terms of why there is inflation, first money supply is clearly rising

http://www.321gold.com/editorials/saville/saville100708.html

second this depression will be like the argentinian inflationary depression of 2001. the US is a debtor nation with more debt on the way. eventually it will either not be able to secure more debt and/or will default on existing debt. the result will be to pay off debt by expanding the money supply, which will debase the currency and cause prices to rise.

i've posted about inflation vs deflation on my blog which may be useful:

http://www.kidmercuryblog.com/t379157/
http://www.kidmercuryblog.com/t381813/

[Daniel Rubio]

'Deflation is what characterizes depressions (which I'm not predicting but deflation is serious stuff).'
A blurry line it is, especially when many economists define both in terms of GDP decline...its not 'named' until after its tallied and its effects have been felt.

I've been reading some definitions on depression as 'a decline in 10% or more real GDP', recession anything less.

And the losses in % terms (housing prices, stock market ) have all been above 10% in the last months. True this is for a very short period, but we are not very far away from a 'technical definition' of a depression.

Another interesting source ( and the article itself is also good ) is this chart from PIMCO http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/Investment+Outlook+Gross+October+2008+Fear.htm

The figure shows the average YoY% change in housing prices, stocks, bonds. This is a more representative timeline, and look at where the line ends, almost or at a -10% decline.

GDP is not calculated on these same numbers, but if housing, stocks and bonds have all declined at these rates, I don't see why GDP wouldn't be along the same lines.