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When is deflation real and when is it imagined?

One of the few things that scare economists more than inflation is deflation.  Inflation insidiously transfers wealth from lenders to borrowers, freaks everyone out when prices rise faster than wages, spirals out of control when wages have to go up to keep up with higher prices, etc.  “We” who work always feel like prices rise faster than our wages, but to some degree they go hand in hand over the long run.

Deflation transfers wealth from borrowers to lenders.  That can put borrowers into default.  It also forces companies to lower prices, which reduces their profits until and unless they can lower the wages they pay.  Companies can do this in two ways.  One thing they can do is toss people onto the unemployment line.  This reduces demand for goods and services and creates deflationary spirals.  Worse luck, companies can come to workers for salary give backs instead of raises.

People don’t like prices going up.  People do like raises.  People do like prices going down.  But people really, really, really, hate unemployment and getting rewarded for their effort with pay cuts.  When these things happen, people shift money rapidly from consumption to savings, which causes demand to plummet… and more deflationary spirals.

In line with economists’ distaste for deflation, a number of people have been decrying the loss of value of stocks, the loss of value of commodities, etc.  They are essentially saying that the price of gas going down is not a good thing.  I’m fine with that to a degree.

I think all of our markets have been so distored for the past couple of years, though, that it is really hard to tell what the real price of things ought to be.

For example, the chart below shows US prices for regular gasoline since 1990.  Prices have fallen drastically since September and are at levels that haven’t been seen since about the beginning of 2004.  But to call this deflation seems misleading.  We know that China and India increased their oil consumption significantly over the last decade.  And we can kind of see the increased price due to increased global demand start to take hold around 1999.  Then there is a pause after 9/11 and then steady upward pricing pressure.  Until about the end of 2004.  Starting in 2005, or maybe even as early as 2003, it certainly looks like something aberrant was going on.  Prices shoot up, then plunge down, shoot up again, plunge down again, and then by 2007 they go stratospheric.

US Regular Gasoline Prices Since 1990

US Regular Gasoline Prices Since 1990

This isn’t inflation.  What has happened since 2005 results from a speculative bubble in the oil market, I think largely the result of artificially low interest rates.  Investors used massive amounts of debt to leverage their own capital, speculated on oil futures, and drove prices way beyond where production and consumption would have had them.  Then in 2007, with the debt markets starting to rumble, I think a tidal wave of money flowed from investing in mortgage backed securities to commodities in general, and oil in particular.  This giant slosh of money sent the price through the roof, and then the bubble finally burst with all the other bubbles this Fall.  The astronomical gasoline prices we saw did have an inflationary effect on lots of goods and was starting to have an impact on services… but it really all happened too fast to be reflected in wages.

So… can we call it inflation at all?  What seems to have happened is that gasoline consumers got royally shafted for a couple of years, the oil companies benefited beyond any rationality, and now things are getting back to “normal.”  Consumers should not expect pay cuts as a result of gasoline prices falling from levels that were artificially high to start with.  This isn’t deflation, it is a market correction.

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