Forget inflation: Is deflation the real threat?
— -- Ask most investors what they worry about, and they'll tell you it's inflation — specifically, a period of soaring prices that destroys the value of the dollar.
But a growing number of economists and money managers are starting to worry about the opposite of inflation: deflation, a period of falling prices and declining incomes.
Sure, the government's consumer price index has gained 3.5% the past 12 months. Even stripping out food and energy, the CPI is up 2.1%, the Bureau of Labor Statistics says. And anyone who lives in the real world knows you can't live without food and energy.
But other prices have been moving relentlessly downward, from refrigerators to stocks to houses and salaries. Economist A. Gary Shilling argues that many of the factors for deflation are already in place, and that people overlook falling prices because they are so focused on the items they use the most.
In the meantime, everyone's looking for lower prices, either from one of dozens of deal sites, such as LivingSocial and Groupon, to low-price specialists such as Walmart, Target and Costco. "We have become obsessive to chase the lowest low prices," says Marian Salzman, trend-spotter and CEO of Euro RSCG Worldwide.
That's a deflationary attitude — something policymakers fear. In deflationary periods, consumers put off purchases as long as possible, believing that prices will get lower. Fewer purchases mean lower economic activity — which, in turn, leads to lower salaries and higher unemployment. While deflation doesn't necessarily mean another Great Depression, climbing out from a deflationary pit is tough — arguably, tougher than whipping inflation.
Chain reaction of debt defaults
Debt — specifically, the inability to repay it — is one contributor to deflation. As a simple example, consider what happens when your neighbor can't pay his mortgage. Eventually, the bank forecloses on the house and sells it at a cut-rate price. When potential buyers look at other houses in the neighborhood, they base their bid on the last price — your neighbor's discounted foreclosure price — and home prices on the entire block fall.
When enough people and businesses default on their debt, they set off a chain reaction. Banks, hurt by loan defaults, have to raise capital to cushion against further losses. That means selling profitable divisions, because those are the only divisions they can sell. As profitable divisions get chopped off, bank stock prices fall, banks lend less, and the economy grinds to a halt.
Already, European banks such as Banco Santander and Deutsche Bank are peddling highly profitable ventures, such as Deutsche Bank's asset management business.
And your neighbor's foreclosure may be part of a larger trend. "Any surge in debt-repayment problems are a byproduct of a deflationary trend," says John Lonski, chief economist for Moody's Analytics. "The inability to pay off debt usually flows from two things: Either your cash flows are less than anticipated or the value of the collateral declines precipitously."
Most individuals have seen their income tumble. As unemployment has soared, businesses have discovered that they can get away with paying employees less or withholding raises. Median household income (half were higher, half lower) fell 2.3% in 2010, according to the Census Bureau. And many of those who have been laid off have to take a lower salary than the one they had before.
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