Deflation more of a threat than inflation this summer

The US should shortly announce that prices have fallen for a third month in a row, the only time this has happened since the 1930s. It is hardly a bullish indicator though you could be forgiven for thinking it might be from the condition of the stock market.

This level of disjunction from reality reminds us very much of the summer of 2008. We were accused of being far too pessimistic then, although most of our critics took a big fall in the fall.

Good thing?

What does it mean if price levels are falling? At first sight it might not appear a bad thing. Your money buys more. You feel richer. The problem is the knock-on impact on the economy.

For one thing why buy today if something will be cheaper in a few months? Then again falling prices will begin to hit the bottom line. What happens to the hotel in the UK where I paid 15 per cent less this year than last year’s discounted room rate?

If rates carry on going down while the hotel carries a huge debt then it could be driven out of business simply by falling prices. It also does nothing to encourage investors sat on cash to invest, after all they are winning by doing nothing.

Eventually deflation will surely spur a return to quantitative easing. For printing money is the easiest way to cause inflation. Governments can do this sort of thing. The problem is that the austerity mongers want deflationary spending cuts, and that cancels out the money supply increase.

Money supply falling

Indeed, that is what is happening now. Deflation is a result of a shrinking money supply, something else we have not seen since the 1930s. For all the stimulus packages this has not actually been enough to offset the decline in private credit.

Deflation is also about overcapacity in many sectors of the global economy, and demand is either falling or at best static. Too much supply and too little demand sends prices down.

Now what we do not want to see is a deflationary debt spiral. That happens when incomes are cut – either directly or through taxes – while debts remain unchanged. Then people have less disposable income and spend less and less, while the debt burden may become unsupportable.

And the stock market rises on this, welcome to the summer silly season!