One of the interesting things about the most recent flutter in financial markets is that investors sold some gold. Gold had been in a buy-crazy mode for so long now that the rush of sell orders undoubtedly took some analysts by surprise.
The reasons why investors sell off stocks are somewhat different from the reasons they sell off gold holdings, although liquidity needs and market psychology play an important role in both. Stock prices are generally tied to estimates of future earnings. Gold prices are more closely tied to estimates of future prices of other securities and everything else in our economy; in other words, the purchasing power of our money.
When investors’ general expectation is that prices will rise — in other words, inflation — gold prices will usually go up.
What spooked the gold market most recently was a gloomy outlook of slow economic growth that opened the possibility of long-term deflation, a period of years in which prices generally decline.
While many of us would welcome some relief from constantly rising prices, most economists talk about the arrival of deflation the same way that Romans talked about the arrival of the Huns. In fact, one of the few things that policy makers, economists, investors, financial market professionals and gold investors agree on is that deflation is not a good thing.
It is not an accident, then, that most economic policy targets set by central banks, including our own, include a modest level of inflation, under the “better safe than sorry” principle that a little inflation is better than falling into the deflation tar pit. That is one reason for the relentless onward and upward price spiral we live with.
Why is deflation such a bad thing? The answer is all about money, time, and the uneasy relationship between them.
Much of our economy is dependent on business and commerce, and these, in turn, are dependent on credit. There is almost always a delay between the development and production of goods and services and their translation into revenue for the business. That time interval has to be financed somehow.
The business sector relies on credit to finance the costs over that time interval. In a deflationary period, though, two things happen and neither of them is good. First, deflation means that the purchasing power of money goes up — and that means that the business has to pay back its loan with money that is worth more than it was when it was borrowed.
Second, if prices are declining, then the sale of the product or service will bring in less revenue than the business planned on. The business model may have been counting on selling its new model computer for $500, but because of falling prices it might now sell for $450.
That’s fine for the consumer, but the resources, including labor that went into designing and making it, were paid at the higher price levels of six, 12 or 18 months ago. With profit margins eroded by deflation, business owners and entrepreneurs begin cutting back, which tends to lock the economy into a slow-growth or no-growth pattern.
Manufacturing and retail businesses are particularly hard hit by the effects of deflation because they generally have to maintain inventory as part of their normal business operations. If prices decline, the asset-value of that inventory declines, too. Those of us who own or owned homes during the recent sector-deflation in the real estate market know just how much fun that is.
When economics was young, money was viewed primarily as a medium of exchange. There is still some truth in that, but we have come to realize that money’s other function — as a “store of value” — is very important, too. And its effects in a deflation period are quite strong.
The psychology of money cannot be ignored either. Few of us would get really enthused about taking a pay cut even if prices are declining. Money psychology also makes traditional economic policy tools less dependable in efforts to reboot the economy in a deflationary period.
How likely is deflation to become a problem for the U.S. economy? The probability is real enough to keep some people worried but shouldn’t keep all of us awake at night. The incessant discounting of some consumer goods has not seemed to be spreading to other sectors. Rather than deflation, unless we have another global financial crisis it seems more likely that things will go the other way.
When our huge public debt collides with the continued economic growth of our trading partners, there will be tremendous upward pressure on interest rates, then resource prices, then wages — in other words, inflation. Either way, it looks like we’re in for interesting times.
James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.
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