Deflation is set to wreak havok
It seems that just a few years ago the most closely watched “flation” was inflation. But now it seems apparent that that particular flation has been pushed aside – or maybe steamrollered – by the other flation, deflation.
Considering the fears that existed about inflation for decades, deflation seems as if it’s inflation’s more benign cousin. Nothing can be farther from the truth. Just like inflation, deflation is a contagion, that could wreak havoc with the world economy. It will affect every component of it, from your job to your investments.
The Benefits of Deflation are Only in the Beginning
In some quarters deflation is seen as a positive force. But that’s mostly because the benefits are all felt upfront. For example, the price of gasoline fell by roughly 50% between the summer of 2014 in the summer of 2015. That has put more money in the hands of consumers, where it has been used it to boost spending on retail, restaurants, and entertainment.
Deflation also keep interest rates low. The absence of inflation – or the fear of deflation – was almost certainly the reason why the Federal Reserve didn’t increase the Fed Funds rate in September. Low rates are seen as an additional stimulus to the economy.
The initial effects of inflation can improve the economy – or at least mask underlying the decline due to the darker side of deflation, at least for a short while.
Unfortunately, the effects of deflation are not uniform. For example, necessary expenses, such as healthcare, insurance, education, and even utilities continue to rise. Hardest hit are commodities, as we’ve recently seen with the price of both oil and gas.
Eventually however, deflation in commodities is likely to spread to financial asset classes, as well as to entire national economies.
Declining Revenues and Job Eliminations in Resource Companies and Sectors
Deflation in the commodity sector is having a negative impact on the revenues of companies engaged in that business. That affects employment. Fuelfix.com recently reported that employment in the energy sector is down by 220,000 jobs globally.
The complication is that many of those jobs pay salaries that are well above average. That means the loss of such jobs has an exaggerated impact on the economy.
Since commodity production tends to be regionally centered, entire regions experience economic decline. This is already happening in the oil patch regions of the United States, and anywhere in the world where oil is a primary revenue source.
This tends to have a multiplier effect, since eventually jobs will be lost by people who were employed in businesses and industries that service the energy sector. This can include shipping companies, rail transport, pipe suppliers, drilling rig suppliers, and a host of other support industries.
No one will be immune from the business failures and job losses that will merely start in commodity dependent regions. The decline of the economy in specific regions and industries will eventually spread to the general economy.
Recession and Depression in Resource Producing Countries
The negative effects of deflation will hit some countries harder than it will others. Certainly countries that are more dependent upon commodities and commodity exports will be more severely affected.
Examples are beginning to stack up. Canada – one of the world’s major commodity suppliers – is already officially in a recession. And word is that Australia is close behind. Russia is also seeing steep declines in its economic output.
These are all major counties that will have an effect on the global economy, that will include the US. Virtually any country in the world that is a major commodities provider is flirting on the edge of disaster right now.
Deflationary Debt Collapse
We had a front-row seat to the effects of a deflationary debt collapse during the Financial Meltdown that began in 2007. Once house prices and stocks began dropping in value, the ability of borrowers to repay the debt they borrowed during better times became increasingly doubtful.
Nowhere was this more apparent than in the real estate market. Since the entire market is fueled by mortgage debt, declining house prices caused a stunning amount of mortgage indebtedness to go sour. It took the widespread purchases of mortgage debt by the Federal Reserve, and the US government takeover of mortgage giants Fannie Mae and Freddie Mac (both still under federal control) to stem the tide.
We may not be so lucky this time around. We are now seeing the effects of a deflationary collapse in in Spain, Greece and Cyprus. Each of those countries needed bailouts by the European Union just to avoid total collapse. The current pattern is to simply refinance national debt that everyone knows cannot be repaid by the debtor countries. None of those countries is in any better shape than they were before the bailouts started.
Debts of all kinds are becoming uncollectible in the most troubled countries, but it’s highly likely that the same pattern will snowball into countries currently deemed to be “safe”, particularly the US.
Currency and Asset Price Collapse
For the most part, the US stock markets and the dollar have been relatively unaffected by the rolling global contagion. But the dominoes are increasingly lining up in the wrong direction.
It was reported just a few days ago that Saudi Arabia has withdrawn $70 billion from global asset markets to deal with domestic fiscal issues. This of course has everything to do with the collapse in oil prices. But traditionally, Saudi Arabia has been a major creditor nation, investing in the currencies and financial assets from other countries. If they’re withdrawing funds from the global system, that will not bode well for stocks, bonds, or real estate.
China – the world’s largest creditor nation – is currently undergoing sudden and significant decline. As its financial fortunes fall, it will not be in a position to lend to or invest in other countries, particularly those dealing with financial turmoil.
On the other side of the coin, Brazil’s debt rating was recently cut to junk status. This situation already exists in several European countries, but for the fact that those countries are operating on ECB bailouts.
The combination of the repatriation of international reserves by creditor nations, with the decline in quality of debtor nations, is almost certain to result in a financial contagion that will both collapse currencies and torpedo the world’s asset markets – including those in the US.
Real World Examples: US in the 1930s and Japan Since 1990
These are perhaps the most prominent examples of what a deflationary collapse can do to an entire nation.
The effects of the Great Depression of the 1930s, which was driven by deflationary forces, are a matter of historic record. The stock market fell by nearly 90%, hundreds of banks closed, and millions of jobs were lost. By the peak of the cycle in 1932, nearly 25% of the US workforce was jobless.
Japan has been wrestling with a perpetual deflationary economy since 1990 when the previous economic boom in the country topped out. Economic and financial conditions have never gotten as bad as they were in the US in the 1930s, but the country has been dealing with economic stagnation for a quarter of a century. In fact a recent report confirms that Japan’s economy continues to contract.
Deflation is very much a contagion. Once it starts, it has to run its course, and nothing can be done to stop it from doing just that. In its essence, a deflation is the undoing of the damage done by a prolonged period of inflationary activity.
The US and the world have been stoking inflationary bubbles in real estate, stocks and bonds since at least the early 1980s. When that begins to unwind – as now appears to be the case almost across the board – the damage will be severe.
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