As we count down the days until the Obama administration, we are getting a clearer and more frightening picture of the extent of the economic problems facing us. To give our fellow MOMocrats the tools to participate in the conversation, I will be starting an Econ101 series. Once a week, join me as I pluck a timely economic or econ-related topic and try to dissect it, without the jargon or gooey innards.
Today, the Dow droped over 400 points, closing at its lowest level in six years. The newspapers have attributed at least part of the drop to new reports released that suggest we may be experiencing deflation, a scary word that literally strikes fear in the heart of economists, and was one of the defining attributes of the Great Depression.
What exactly is deflation, and why is it so bad for the economy?
Deflation is, superficially, a general and sustained decline in the price of goods.
On a personal level, deflation may seems like an awfully good thing right now. After weathering this past summer, when we were seeing gas prices above $4/gallon and food prices climbing in the supermarkets, the recent drop in gas prices, as well as retail prices (as retailers try to entice us back into their stores) probably seem like a welcome change for all of us, especially as we furiously try to cut back, pay down debt and increase our savings so as to ride out this economic downturn.
As I mentioned, deflation is superficially a general decline in the price of goods. But hey, you might ask, we've been seeing the price of certain goods, like clothing and computers, fall for years now. And that's been great. What's the difference here?
The difference is the cause of the price decline. Over the past few decades, falling prices have largely been due to globalization. As companies started to produce abroad, they were able to reduce the cost of production - and some of those savings were passed on to the consumer. In those cases, the decrease in prices actually increased demand, since Americans took advantage of the fact that they could buy more with their dollar by... buying more.
We have a distinctly different situation today. Today, prices are falling because there is not enough demand. This kind of falling price started with oil. When oil climbed up to $140 per barrel this summer, it was being driven by increasing demand from developing countries (China and India specifically) to feed their growing industry (and cars) at the same time that it was looking as if the overall supply of oil was decreasing (disregarding potential new strikes). But when the financial crisis hit the US and then hit the rest of the world hard, that demand quickly disappeared. Same amount of oil available, but suddenly not as many people who want to buy it. Prices fell rapidly (oil is currently hovering in the $50-$60 per barrel range).
We are seeing a similar situation with cars, clothes, electronics, and really everything. Retailers have started to discount, and fairly steeply, all of their goods because they have seen a sharp drop in the demand for their goods. This may seem counter-intuitive, but most retailers will tell you that it is more important to move inventory than to maximize profit.
But here is the problem - unlike normal times, where such steep discounts might actually stimulate spending, economists are afraid that we may be caught in what is called a "deflationary spiral", where the dropping prices are actually just inducing more dropping prices.
Part of the reason for this is that one of the biggest things that is dropping in price is housing. Home prices have been falling across the world. Besides the obvious implication (increasing foreclosures), it has a more immediate impact of making homeowners feel poorer. So even though things may be dirt cheap right now, many Americans are feeling on net too poor to take advantage of those dirt cheap prices.
As we get further into the deflationary spiral, however, other forces come into play.
Think of it like this. You really want a diamond ring. In fact, you know the exact ring that you want. It costs $3000 today. If you knew for certain that the ring would cost you only $2000 in a year, would you wait? For most people the answer would clearly be yes.
Well, this is what happens in a deflation, except that on top of it happening to us, it also happens to all of the investors and business people in the world. For example, you own a factory that would work more efficiently if it had new machines, which cost $100,000 today. If you think those machines will cost only $80,000 in a year, you will probably wait a year to buy them. But if in one year, you realize that the machine will cost only $60,000 in one more year, you would probably wait one more year. Investors are reduced to investing in only that which is absolutely necessary.
When the factory owner puts off buying machinery, the spiral continues since the machinery company does not make the sale. If enough factory owners do the same, the machinery company may have to cut costs and layoff workers. Laid-off workers don't have money that they can put into the economy (and contribute to the unemployment rate). They too, start to sit on any cash they have, not because they can buy things cheaper tomorrow, but because they can't afford to spend money on anything but the bare necessities.
If enough workers are laid-off and not purchasing goods, then the factory won't need to produce as much, which means the factory manager will have even less incentive to invest in machinery. And so on, and so on...
Recently, we've all heard about Ben Bernanke's steady reduction of the target federal fund rate from about 5% a year ago to 1% today. Without going into detail about what the federal fund rate is, what you should know is that this target rate, in some way, affects most interest rates you see from banks (such as the interest rate you are paid on your savings accounts or your certificates of deposits (CDs)). The reason for the drop in rates, as we've progressed into recession over the past year, is to stimulate growth.
The theory is pretty simple. If interests rates are really really low, so you get only 2 or 3% returns on the money that you save, you're far more likely to take that money and invest it in riskier ventures that will give you better returns. Riskier ventures like new companies, or even old companies.
Lowering interest rates has also been a tool for fighting deflation. Although more complicated than this, when you have extremely low interest rates, you have less incentive to hold on to money, which may at least counteract against your lack of incentive to spend it.
Unfortunately, there is a limit to how far you can lower interest rates, zero to be specific, and we're awfully close to that.
Kady is NOT an economist, and DOESN'T play one on TV, so she welcomes comments on anything that may be incorrect. She also welcomes any questions readers may have on deflation, which she will try to answer, to the best of her ability. She blogs much more existentially at Wonkess.
Thank you, Kady. I love it when you talk econ, baby!
Posted by: Lawyer Mama | November 20, 2008 at 06:03 PM