In response to an article on actions the Federal Reserve consider relating to monetary policy, a blogger questioned me and asked "inflation, deflation, does it really matter?
When I mentioned the blogger’s comments to others, it became obvious to me that the impact of deflation was not well known. Some consider deflation merely the opposite of inflation. Nothing could be further from the truth!
Deflation is characterized by falling prices. With falling prices, purchasing power technically goes up whereas, with inflation, purchasing power of the currency goes down.
One could easily infer that declining prices would be a good thing. The consumer after all would be able to purchase more with their incomes.
Declining prices, unfortunately, also leads to declining incomes. In and of itself even that may be acceptable except, with deflation, all debt and unfunded liabilities become much more expensive to repay. Concurrently, and equally as destructive, the value of most assets declines. Eventually, the debt will become impossible to repay. This is where the destructive impact of deflation is felt.
At this point, the death spiral of deflation begins and the economy will collapse. Economic recovery is difficult at best.
Deflation is truly to be feared because it is so difficult to reverse the downward spiral.
To visualize the devastating effects of deflation consider the most recent housing debacle where the value of homes declined precipitously in many parts of the nation. The effect of the housing bubble bursting has been a massive dislocation of the lifestyles of millions of Americans. Scores still face foreclosure, millions of Americans are "underwater" on their mortgages, and millions of Americans are trapped by overvalued debt and undervalued assets. This is the face of deflation.
With the underwater mortgages your quality of life deteriorates if you are that homeowner. You are not able to sell your home without substantial loss. You may not be able to change your job. Your freedom of action will have been sharply curtailed. You have become a slave owner to your debt and to your home.
The education bubble is perhaps the next bubble to burst about to burst.
Many states are already seeing pushback on additional real estate tax increases to fund education at the elementary and secondary levels. Taxes on real estate are making already difficult homeowner problems almost unbearable.
At the university level, for example, the burgeoning student debt and the substantial increase in tuition rates are making the reality of higher education a nightmare for many rather than the dream the youngster was promised. Increases in tuition beyond the general inflation rate have been going on for decades. That trend is about to end. Many universities are increasing aid due to this reality. Tuition increases are not sticking in the marketplace as was once commonly accepted. The next step is for tuition to fall.
What will cause tuition to decline (re: deflation) is that students will find and have found that they cannot repay their student loans.
Students and parents will begin to question the value of the degreee. Schools are already being audited because they allegedly failed to accurately reflect opportunities for students upon graduation. This action is just the beginning. It will follow that schools either reduce tuitions or lose students. However, the fixed costs at universities are so great that schools will have no alternative except to reduce tuitions to keep enrollment up.
Housing and academia are but two examples of what happens with deflation.
Deflation has devastating effects in every aspect of life.
First, anyone with debt will find it more difficult to repay the debt in a deflationary cycle. Incomes and prices will fall making debt repayment difficult or impossible.
Second, organizations with high fixed cost such as airlines, hospitals, automobile manufacturers, drug and pharmaceutical companies, governments, and sports teams to name just a few will find that they must reduce prices in order to cover their fixed costs or lose customers. While this strategy works in the short run the economic consequences of the lower prices will ultimately translate into lower pay.
Third, once the deflation cycle starts, the ability of a society to pay for things such as Social Security, retirement benefits, unfunded obligations, and any type of retiree healthcare cost will be impaired. The deflationary spiral will prevent any of these organizations from increasing prices.
Deflation hits all aspects of your life. Pay will decline, property taxes become more difficult to repay, food prices gyrate, and life as you used to know it becomes unsustainable.
Chairman Bernanke is using the Federal Reserve. Quantitative Easing and a cheap monetary policy to dampen the effect of the recession we are currently in. His doctoral thesis however clearly indicates that it is the uncertainty that is causing the economic dislocation.
To avoid all of the negative issues of deflation it is essential that our elected leaders and the Federal Reserve work immediately to eliminate uncertainty and reduce wasteful spending within our economy. Failure to do so will lead to substantial deflation.
The time to act is now. Decisive action must be taken to end the uncertainty. The Federal Reserve and our federal government must understand that no decision and gridlock is, in fact, a decision.
Col. Frank Ryan, CPA, USMCR (Ret) and served in Iraq and briefly in Afghanistan and specializes in corporate restructuring and lectures on ethics for the state CPA societies. He has served on numerous boards of publicly traded and non-profit organizations. He can be reached at [email protected] and twitter at @fryan1951.