Deflation hurts the economy like hydrochloric acid burns through steel. Falling prices destroy corporate and household balance sheets and make it impossible for the financial sector to function normally. Demand is destroyed by deflation which in turn leads to more deflation. The weakest sectors are hurt first, but deflation quickly burns through healthy industries. This week’s economic news is a real life lesson in what deflation will do to the economy and why it must be stopped at all costs by the Federal Reserve and the incoming Obama administration.
The morning’s business headlines stated “10 Percent of U.S. Homes in Financial Jeopardy”. The fall in housing prices, i.e., housing deflation, destroyed the balance sheets of millions of households which in turn caused mortgage delinquencies and defaults. The catastrophic losses in the banking sector are a ripple effect of housing deflation. While households were financially over-extended and should have had less mortgage debt, deflation’s first victims are always the weakest and sub-prime borrowers are by definition on the economic fringe of solvency. Consumer demand was destroyed by falling home prices which hurt family wealth and made individuals unable or unwilling to continue spending.
The ripple effect of housing deflation hit the overleveraged financial sector like an economic tsunami. Even with high delinquencies and defaults, if house prices hadn’t declined, lending losses would have been much lower because lenders would have recovered most of their investment when they sold foreclosed homes. Home price deflation made foreclosure a losing proposition and made the losses bigger. The banking sector’s past year would have been a bad dream if housing deflation hadn’t occurred.
The Big 3 automobile manufacturers’ problems are a “ripple effect” of the housing crisis and falling consumer demand. Of course decades of mismanagement made the Big 3 vulnerable. But, even without their well documented shortcomings, the Big 3 would be in big trouble. Automobile manufacturers have large fixed costs and can’t survive the 35% drop in sales (domestic and imported) that has occurred. Without sales to offset fixed overhead costs, it is inevitable that the Big 3 will fail sooner or later. In fact, few manufacturing companies can survive both collapsing sales and falling prices. If the trend continues, the next “shoes to drop” will be suppliers to the automobile industry including logistics companies, parts suppliers and raw materials producers.
Retailers are dropping like flies after the first frost. November retail sales were posted this week and showed the biggest monthly drop in 30 years. Falling retail sales are evidence of collapsing consumer demand that started with housing deflation. Prices are falling and traffic is down at most retailers. If retail sales don’t pick up in the near future, many more retail bankruptcies will occur. Retail bankruptcies will destroy other industries such as commercial real estate, logistics, manufacturing, advertising, media and packaging. And, of course, the banking sector will face more losses as retailers go broke and lay off workers.
Oil prices closed the week at around $40 per barrel which is a 4 year low. Assuming the current trends continue, soon bankruptcies are going to start in energy and energy related industries. And, since many farm commodity prices are tied to energy prices, large scale business failures in the food supply chain are likely. This week’s bankruptcy of Pilgrim’s Pride, a poultry grower, is an example of what happens when prices and demand collapse. Pilgrim’s Pride paid for feed during the summer at record prices and then when it tried to sell its chickens and turkeys in the late fall it was hammered by falling prices and collapsing demand. Every turkey that Pilgrim’s Pride sold this thanksgiving was probably sold at a loss. Of course Pilgrim’s Pride was financially weaker than its competitors, but that is how deflation works; it picks off the weakest first as it burns its way through the economy.
Other sectors of the economy that are being destroyed by falling prices and weak demand include education, leisure, transportation and anything relating to discretionary spending. It won’t be long before everyone feels the corrosive effects of the deflationary spiral.
The problem is that deflation tends to create a self perpetuating and reinforcing cycle. As new rounds of bankruptcies and business failures occur wealth is ruined, workers are laid off and demand for goods and services are destroyed. Falling demand causes falling prices which starts a new round of bankruptcies and business failures.
The Federal Reserve is working overtime to break the cycle and stop deflation. They are increasing money supply at a very rapid pace as seasonally adjusted measures of money supply (both M1 and M2) hit new all time records. For the last 13 weeks seasonally adjusted M1 increased at the blistering pace of 22.6% and seasonally adjusted M2 increased by an amazing 9.2%. Normally, this rate of money supply growth would create hyper demand, hyper growth and hyper inflation. However, the economy is in recession because banks and households are hoarding cash. Demand for goods and services is falling, growth is negative and deflation is accelerating.
The cure for the deflationary spiral is large scale spending by government. The Federal Reserve by itself can’t stop the hoarding of money and cannot force demand to increase. Bernanke needs the President to be his partner by stimulating the economy through Federal spending. The spending needs to be targeted at increasing demand by having government purchase goods and services and doing it quickly. Soon we will find out if the Obama Administration is going to rise to the challenge and be the partner that the Fed needs to stop the corrosive effects of deflation.