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January 06, 2009

Deflation May Be the New Normal

Deflation has been the rule in high tech ever since I first programmed a multi-million dollar IBM 7090 forty-seven years ago which had less computing power than my current $100 watch. We high-techies have learned that we have to double the usefulness of what we sell every eighteen months if we want to charge the same number of consumer dollars for our products. In most cases we haven't been able to keep up with the relentless progression of Moore's law (the amount of computing power you can get for a dollar doubles every eighteen months) and prices have fallen.

Maybe we should all learn to live with deflation.

It wasn't that long ago that it cost dollars per minute to call coast-to-coast in the US. Today there is no incremental cost for us to use video Skype with grandson Jack on the left coast. His other grandparents in Ireland pay the same amount. Cell phone rates are kept up monopolies and cartels but will soon crash. Most people can get basic (pretty basic) DSL broadband access for what dialup used to cost. Broadband prices are even lower for even more in much of the rest of the world.

Suddenly it looks like the rest of the economy may be going the way of high tech. Oil and housing prices are back to 2004 levels (even as I write this, gas is back up a few cents, though). Most other commodities including agricultural goods have crashed as well. Industrial products like steel and fiber are available at bargain prices. The IRS reimbursement rate for mileage went down on New Year's Day. Even wages are actually down given less overtime, smaller bonuses, less 401(k) match, smaller medical benefits, and actual givebacks by unions seeking to save jobs. Despite a recent bounce, the stock market is where it was ten years ago.

Interest rates paint the same picture. Some people are accepting negative rates on very short-term treasury notes. Are they dumb? Not if deflation is going to continue because the purchasing power of their investment is increasing as long as most of the principal is safeguarded. In fact getting six percent interest in a time of five percent inflation is a much worse deal; you have to pay taxes on the six percent which means you're probably losing purchasing power. If you get no interest in a year when there's five percent deflation, you've got a real gain in purchasing power and you don't even have to pay any taxes on the gain. No wonder governments hate deflation.

Deflation is hell on debtors whose debts get harder and harder to repay. Deflation is great for savers who gain (tax free) by postponing consumption. Do we really want to go back to being an economy of debtors? Inflation is miserable for the retired and others living on a fixed income; deflation is a pay raise to everyone receiving social security (although a problem for the indebted treasury).

One fear in times of deflation is lack of retail spending because prices will always be lower soon. We in high tech know that is nonsense. Every one who ever bought a computer or an MP3 player knew that she'd be able to get the same item for less six months later; but still we buy electronic items. You don't wait until next year to eat because beef prices may be down; you don't even postpone phone calls a few months in hopes that prices'll fall. In inflationary times you fill your gas tank when it's half empty; in deflationary times you let it run nearly dry; but you still need the same number of gallons to drive the same number of miles.

Come on, Tom, you say, you don't really think energy and housing prices can go down long term, do you? I do actually although chances are that governments will print so much money that we'll have inflation again. After all, it's conventional wisdom that we need inflation and that we can't live with deflation. Inflation's a "painless" way to pay government and private debt and lets government collect taxes on nominal income which is actually just inflation reimbursement (some interest and some capital gains).

The price of energy in terms of how much human time is needed to earn an amount of inhuman energy has gone steadily down through history. Think what 200 horsepower would have cost when you needed 200 horses to get it. Monetary inflation has hidden some of that deflation in energy cost. Long term, when we have more nuclear, wind, and solar sources and have either convinced ourselves that CO2 is the harmless gas it used to be or learned to sequester the CO2 from burning coal, the price of energy will continue to fall.

Moore's law is finding its way into more and more products and services. First computing started on the deflationary path along with every toy or tool with computing in it; communications followed soon after; transportation'll come next as smart cars increasingly run on electricity from a smart grid with all kinds of diversified smart inputs. Cheaper houses are easy to envision; cheaper real estate unlikely until population growth stops and people stop emerging from poverty, hopefully because they've all emerged.

When we've had to, we've used adjustment formulae for inflation. We can do the same thing with deflation although the politics are admittedly tough. Can you imagine Congress passing an annual cost-of-living DECREASE formula for social security or annual deflators in union contracts? On the other hand, if we didn't let inflation run rampant, we wouldn't need the sudden deflationary pain of recessions and depressions to put things back in balance.

This post is so far from conventional economic wisdom – and from most of our experience – that it makes even me nervous. It could be that inflation'll come surging back from the flood of money governments are now printing once we start circulating and recirculating that money again. It may be that we need inflation. But we've lived with deflation in high tech and the results haven't been all that bad. We do live in a time of abundance compared to the scarcities of the past.

UPDATE: According to the Wall Street Journal, reporting on the just released minutes of the December Federal Reserve Board meeting: ""Some members saw significant risks that inflation could decline and persist for a time at uncomfortably low levels," the Fed said." But whom will that low inflation be uncomfortable for?

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