In recent years, monetary and fiscal stimulus across the world have led to the assumption that serious inflation, if not hyperinflation, is on its way. I believe chronic deflation is more likely.
The expectation of rising prices is reasonable. Most people have only experienced inflation. The last meaningful episode of deflation was in the 1930s. That’s also the last time the U.S. was truly at peace. Deflation is a peacetime phenomenon.
The U.S.’s bouts of inflation, however, have historically occurred during wartime. That applies not only to shooting wars, but to the Cold War and the War on Poverty. These are periods when vast overspending by the federal government is combined with a robust private economy. These aren’t the conditions we have today, when government stimulus can’t offset private-sector weakness.
In the 95 wartime years since 1749, wholesale price increases averaged 5.7 percent. In the 168 peacetime years, they fell 1.2 percent annually on average. As the U.S. withdraws from Iraq and Afghanistan and as defense spending declines, peacetime conditions are likely to prevail.
Furthermore, we tend to have biases that cloud our perception of inflation. When we pay higher prices, we think inflation is at work, but we believe lower prices are a result of our smart shopping and bargaining skills.
Even though deflation has been forestalled in the past decade, disinflation -- declining rates of inflation -- has prevailed since the early 1980s. Indeed, the consumer-price index fell in November and December and was unchanged in January. For February, the cost of living in the U.S. was up 0.7 percent, the first increase in four months and the biggest since June 2009. Nonetheless, expectations for inflation over the next 10 years are for a continued drop.
Deleveraging: In a normal economy, chronic deflation would already be well established. Our global economy, however, is dominated by deleveraging in the private sector and financial institutions, and is highly deflationary. These actions are overpowering the effects of stimulus programs since 2007. Even with all the government measures, the U.K. is in a recession, as is the euro area. China’s gross-domestic-product growth has slowed considerably and the U.S. reported a mere 0.1 percent annual increase in real GDP for the fourth quarter of 2012.
The liquidity created by central banks is tiny compared with the destruction wrought by deleveraging financial sectors. The decline in securitizations is just one aspect of this contraction. Banks are eliminating or writing down off-balance-sheet vehicles substantially. Governments are increasing capital requirements even as banks dump assets to raise capital ratios.
Increased Saving: The U.S. household-savings rate fell to 1 percent in 2005 from 12 percent in the early 1980s. This decline of about one-half a percentage point per year meant that consumer spending rose on average around a half percentage point faster than GDP, adding about the same growth to total economic activity once multiplier effects are included. U.S. imports drove growth in Asian and other export-led economies.
Americans are now being forced to save more. First, as a result of the volatility in stocks since 2000, and especially since 2008 because they no longer trust their equity portfolios to substitute for savings when it comes to financing their kids’ college educations and their own early retirement. Home equity that once was used to finance spending is no longer available, a casualty of withdrawals and falling house prices. Job insecurity encourages saving for contingencies.
In the years ahead, I expect the half-percentage-point annual drop in the savings rate to be replaced by a one-percentage-point annual gain. This would slice 1.5 percentage points off consumer-spending gains as well as GDP growth, after multiplier effects are accounted for. That alone would drop aggregate growth to 2.2 percent from the 3.7 percent annual increases in the period from 1982 to 2000.
Other Deflationary Forces: Fertility rates are below the replacement level of 2.1 in most industrialized countries, and populations around the world are aging. As a result, the ratio of working-age people to total population will shrink, retarding economic growth. Substandard education systems, especially in the U.S., restrain productivity growth, employment gains and economic advances. Instead of investments in education, research and productivity-enhancing capital equipment, the emphasis has been on consumer spending, housing and financial assets, which do little to enhance productivity and can curtail growth.
Deflation also is a result of the huge gap between U.S. annual real GDP and its potential long-term trend growth. Excess supply is the root cause of deflation. Declining real median household income, even in this recovery, is depressing consumer-spending power. The same is true of income polarization because high earners are less likely to spend their money than people with lower incomes. According to the Federal Reserve’s Survey of Consumer Finances, real median net worth fell 39 percent from 2007 to 2010, the latest available data, yet income polarization caused the mean to fall just 20 percent. In 1989, mean consumer net worth was four times the median. It jumped to 6.5 times the median in 2010.
Increasing protectionism also slows global economic growth. A recent survey of 3,000 business executives in 25 countries commissioned by General Electric Co. found that 71 percent wanted governments to protect and encourage domestic innovation. Global trade-liberalization deals have been largely abandoned in favor of bilateral agreements and narrow compacts in environmentally friendly technologies and other areas.
Competitive devaluations are now a serious threat to global growth and cooperation, as shown by the actions of Prime Minister Shinzo Abe’s new government in Japan.
In periods of prolonged economic pain, notably the global recession of 2007-2009 and the subpar revival that has followed, international cooperation gives way to an every-nation-for-itself attitude that often takes the form of protectionism. Many countries are now pursuing competitive devaluations to spur exports via a cheaper currency and to impede imports.
When all nations competitively devalue, they all lose because foreign trade is disrupted and economic growth is depressed. But that doesn’t stop countries from trying to get an edge. Most, however, will probably end up devaluing against the U.S. dollar, the premier currency.
Commodity Deflation: On balance, commodity prices have been falling since early 2011. They will continue to drop, especially if a shock, such as a Middle East crisis, drives up oil prices. Prices for industrial commodities should be further depressed by rising inventories. After the earlier drought-related surge in grain prices, farmers in the U.S. and elsewhere will plant more, and can expect record harvests in 2013, weather permitting. This may help explain the recent decline in grain prices.
As for crude oil, I believe the “peak oil” devotees are far too pessimistic. High prices are the best predictor of increasing supply. Technological improvements are making it easier to discover new fields and to increase production from existing ones. Hydraulic fracturing and other new technologies for extracting natural gas from shale have increased supply and lowered prices.
Wage and Income Deflation: The continuing decline in purchasing power produced by shrinking real wages and real incomes is also putting downward pressure on prices. Nominal pay is dropping, too. For about a third of those who find jobs after being unemployed six months or more, the new position pays less than the last job held. This is primarily the result of the recession and the sputtering recovery that slashed demand for labor. Globalization, which moves production to lower-cost locales, also plays a role. Furthermore, U.S. businesses are using cost cutting to improve profit margins rather than using pricing power and sales-volume growth.
The downward pressure on compensation is connected to the rapid erosion of labor-union power. In 2012, unions lost 400,000 members, or 2.7 percent, and their representation in the labor force fell to 9.3 percent, from 9.6 percent in 2011 and more than 25 percent in the 1960s. In the private sector, unionization fell to 6.3 percent, with the sharpest declines in manufacturing and construction.
More states are passing right-to-work laws, which allow employees in unionized workplaces to opt out of paying union dues. In the past year, private-sector employees in right-to-work states earned 9.8 percent less than workers in other states. Manufacturing jobs pay 7.4 percent less in right-to-work states. On the other hand, the number of jobs in such states grew 4.9 percent in the past three years, compared with 3.9 percent in non-right-to-work states.
Municipal governments are under pressure to cut costs. Local tax collection is subdued because of earlier declines in property assessments and taxes, which account for 79 percent of revenue. State tax collections have revived, thanks to increases in corporate and personal income taxes and in sales taxes. Yet many states still face budget problems because of the fading effects of the federal stimulus enacted in 2009, which was used for infrastructure projects and to preserve teachers’ jobs. In addition, the Medicaid costs borne by the states are ballooning, and temporary taxes instituted during the recession are expiring. Vastly underfunded defined-benefit pensions are also fueling state and local government retrenchment.
In response, many states continue to cut spending and jobs. Labor costs, which account for half of state and local spending, are being targeted because of their total size and because government employees are paid 44 percent more on average than private-sector workers, 32 percent more in wages and 71 percent more in benefits per hour worked. In terms of income, this implies that the loss of two state and local jobs is equivalent to almost three layoffs in the private sector.
(A. Gary Shilling is president of A. Gary Shilling & Co. and the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the first in a five-part series. Read Part 2 and Part 3.)
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