Deflation or Disinvestment?

When diagnosing our present malady, I think there has been too much focus on the technical definition of "deflation". A number of economists have lazily said "Well, CPI isn't falling yet so we can't be in deflation". Fair enough, but why do we care about deflation in the first place? We care about deflation because of its effects, not its tell tale symptom. Its symptoms can be best described as "disinvestment".

Now, disinvestment has another definition that's related to economic boycotts where those who disapprove of the actions of a country or region such as what happened to South Africa under the apartheid regime. In this case, we mean a more literal definition which is the dimunition of investment and its various manifestations. In a deflationary environment, conditions are such that the owners of capital feel little need to earn a high rate of return and indeed they perceive that a high rate of return is not possible to earn. As such, they do not replace depreciating capital investments, place new equity capital into their businesses, or increase the human capital of their labor force. With low or non-existent rates of inflation, the real value of their money is not under pressure and as such there is little cause to take risks. As such, they just draw down on their existing capital, having great profits and cash flows for a little while, but their lack of investment hurts their productivity in the long run.

Further, consumers expect that goods will be at the same prices as they are now or potentially lower while they don't expect their incomes to rise so they see no reason to take on more debt. What's more is that because existing debt burdens are hard to pay down with stagnant wages, debt service becomes comparatively more onerous. While debts get paid down, they are only paid down slowly. As consumers also expect asset prices, principally house prices, to be moribund, they sit on their hands and wait for prices to drop before buying new houses and they also don't deploy their money to the capital markets.

To one extent or another, we are seeing all of these symptoms even while we still technically have some inflation. While weak consumer spending has been evident for some time, some of the business investment indicators that had been turning up are beginning to look a little soft to put it mildly. Now, we had a similar set of data disappointments in 2002 and the economy still resumed growth thereafter so it doesn't mean that we will fall apart here. Still, I think the Fed may be adopting policies with far too narrow a definition of deflation. If they paid attention to these symptoms of disinvestment, perhaps they would adopt more rigorous and also more creative approaches toward stimulus.

End of the Brief Hiatus and on to the Deflation

Now that I have finally moved into my new abode I can recommit myself to blogging.

A general issue that I have talked to a number of people about is what to do in the event that there is persistent and nagging deflation in the economy. I will say that the one good part about the onset of deflation in the variety that we see in Japan is that you have plenty of time to recognize it before the market actually punishes you for missing it. It isn't as though "the market" wakes up one day and goes through this logical exercise "IF CONDITIONS = "DEFLATION" THEN "40% SELL OFF"".

One will have ample time to first recognize the onset of persistent deflation and then adapt policies to it. I would say that we are seeing definite signals in the equity and credit markets that market participants are quite concerned about the prospect of slow and grinding deflation. With the 10-year at approximately 2.7% and stocks seemingly rangebound, we may be getting some early signals, but there is no sense in acting harshly on this as the effects of equity and credit markets are gradual enough to allow for a very thoughtful and gradual reallocation. As of right now, as the dynamic allocation model will show when I update it later today, a healthy allocation to equities is still warranted.