Inflation, Deflation, or Nasty Hybrid?

07/16/2010 11:18 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

While we debate whether falling prices or rising prices would be worse, we could be in for a third scenario. The bright side: Investors might have a way out of the mess.

Inflation is a sexy worry.

We can photograph it. A photo of a billion-dollar bill next to a pile of apples from Zimbabwe's recent bout of runaway inflation stuns the imagination.

It's the stuff of national nightmares. The German electorate and German bankers are still traumatized by Weimar-era inflation.

And we know what to do about it: Raise interest rates, rein in the money supply, or, if worse comes to worst, send the economy into a recession.

Deflation isn't sexy.

It's hard to photograph money getting more valuable, and falling prices aren't terribly dramatic.

Japan has been sunk in deflation for years, if not decades, without violence in the streets or even noticeable anguish. The period doesn't even have a catchy name.

And we don't know what to do about it. Increasing spending, running big deficits, and subsidizing spending all work in theory, but they don't seem to have done much to solve Japan's persistent deflation problem.

About the best we can do is to use metaphors—"fighting deflation is like pushing on a string"—and pursue policies designed to keep inflation from establishing a beachhead.

That is why the possibility of deflation worries so many investors and economists right now. And why investors need to guard against both of these possibilities, as well as a third alternative that mixes some of the worst of both.

What Sliding House Prices Might Portend

If you look, you can see what might be signs of deflation.

Certain big categories of prices are falling or have fallen and look likely to keep on falling. I'm talking about housing. Prices for this big-ticket item are still falling in the housing-boom-to-bust economies of the United States, Spain, Ireland, and the United Kingdom. Economists predict that prices in some of these economies could keep on falling for five years. In the United Kingdom, for example, PricewaterhouseCoopers recently predicted that there was a 70% chance that the real cost of a house in 2015 would be below the price in 2007.

And you can certainly make the point from recent data that US consumers are following in the footsteps of their predecessors in Japan in putting off purchases. That's a hallmark of deflationary psychology: Money will be worth more tomorrow, because prices are falling, so the inclination is to postpone spending as long as possible in order to take advantage of that.

The Federal Reserve reported July 8 that consumer credit—the amount that consumers owe on credit cards and loans—decreased at an annual rate of 4.5% in May. Revolving credit—credit card debt—decreased at an annual rate of 10.5%. That contributed to a 1.2% drop in consumer spending in the second quarter of 2010.

I think you can make a case for a rising danger of deflation. Nobel Prize-winning economist Paul Krugman made just such a case in this New York Times column on July 12.

But I also think you can make a case for a rising danger of inflation. Some very large economies—China and the US, to mention just two—have vastly increased their money supplies in the past year. Neither has seriously begun to reverse those increases; just look at the Federal Reserve's balance sheet for evidence. True, the Fed has stopped buying some classes of assets so that its balance sheet isn't expanding at the warp speed of the months just after the financial crisis. But the Fed certainly hasn't yet begun to sell those assets back to the financial markets.

And then you've got the traditional inflationary trappings of massive government budget deficits, often an inducement to governments to inflate their way out from under some debt.

NEXT: Two Keys to the Deflation Debate

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Two Keys to the Debate

I think there are two important points to make in the current debate over whether deflation is a big danger.

First, though the data clearly show a drop in consumer debt, I think it's too early to say why debt is falling. It may indeed be a response to fear and uncertainty in the economy and a desire to regain control over family balance sheets. If that's the case, then the data are voting in favor of deflation as the bigger danger.

But it's quite possible that what we're seeing is just the lingering aftereffects of the financial crisis. Banks, as they usually do after a crisis, have tightened their lending standards, particularly for individuals and small businesses. As part of that, they've increased the hurdles that they're asking borrowers to jump and the strictness with which they're grading those borrowers.

For example, FICO scores, the credit rating metric that plays a major role in determining if a bank or credit card company will lend you money, have dropped to new lows. Roughly one in four consumers now has a score below 600. That's about twice the normal level. Some of that is because unemployment remains near 10%. But some of it is because banks, now that loose lending standards helped fuel a financial crisis, have cut grace periods and lowered credit limits. (A lower credit limit can sink a FICO score if a consumer is now using a higher percentage of his or her available credit.)

So one of the unanswered questions of the deflation debate is how much of the reduction in consumer borrowing is a result of the onset of deflationary psychology and how much is a result of today's stricter bank lending standards.

Second, you'll notice that almost all the (perhaps) deflationary examples come from the world's developed economies. For every deflationary tendency in the developed world, I can, I'm pretty sure, find an inflationary tendency in the developing world. If developed-economy consumers are cutting back, developing-economy consumers are demanding more goods in general and more luxury goods in particular.

If infrastructure spending is falling in Germany and the United Kingdom, it's still rising in Saudi Arabia, China, India, and Brazil. If real estate prices aren't in recovery after the boom and bust in Ireland, Spain, the United Kingdom, and the United States, China is still facing an acute shortage of affordable housing for a rising population of what are, by China's standards, middle-class families. (This isn't to deny the speculative boom in wildly expensive luxury apartments. Just to note that the boom in luxury real estate is taking place while middle-class families can't find affordable housing.)

The experience of Japanese deflation shows that the global economy can continue to grow while a major economy—what was then the second-largest economy in the world, or the third-largest if you count the European Union as one entity—goes through deflationary purgatory.

Declaration of “Indeflation?”

It's not impossible that the global economy could continue to grow—and even show inflationary trends in the prices of commodities such as oil, corn, copper, and the like that are in high demand in the developing world—even as the world's developed economies showed the slow growth and falling prices traditionally associated with deflation.

That wouldn't necessarily be any more pleasant for those of us who lived in those deflationary developed economies. We'd experience slow economic growth, falling prices for many of the things that our economies produced, and rising prices for goods and services that were in global demand.

I don't have any idea what we'd call the resulting mess. "Indeflation?” "De-inflation?” At this point in the economic cycle, I don't think we can rule out such a result. Nor should we rule out the possibility that deflation in the developed world could take down the entire global economy. Or that growth and inflation in the developing world would be enough to drag the developed world along.

We simply don't have economic models of sufficient complexity or sensitivity to give us a reliable answer.

My third way—indeflation or de-inflation—does at least offer investors a path through this mess. If that is the way the world economy will break, then that's one more reason to put money into developing markets. Those markets might be able to muddle through—or better—even if the developed economies struggle. (For other reasons to bet on developing economies, see this blog post on my Web site.)

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Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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