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September 24, 2012

The Case For Deflation

It has become evident over the past three years that the Federal Reserve’s easy monetary policy is not working.  By government observations, inflation remains tepid along with growth and the economy is not creating enough jobs.  While reviewing all of our economic statistics, I wondered; are prices too high?  It’s common knowledge in economics that, all things equal, a decrease in prices increases demand for goods and services.  I began to wonder if such a price decrease would be beneficial to our economy and I made some intriguing findings.

For some reason, people (like our Federal Reserve Board of Governors) believe that by creating more money, you can create demand.  In our economy, we’ve created billions (if not trillions) of new dollars, but have yet to see sufficient growth.  Additionally, we’ve seen prices of food and energy jump in response to this policy.  Has the Federal Reserve propped up prices beyond “normal” levels and thereby hurt growth?  The total revenue curve provides some strong insight into this topic.

The Total Revenue Curve

The total revenue curve states that if prices go too high or too low, total revenue in the economy will suffer.  It’s very similar to the behavior of the Laffer Curve and tax collections.  In examining a model of the total revenue curve, if prices were 10% higher than they should be for the amount of goods and services in an economy, the chart would look like below.  The green point represents the optimal point and the yellow represents a 10% price increase. 

 The issue of higher prices means that for any inflation that occurs beyond that point, growth could potentially be hurt more, but in order for this theory to be true, we need statistical evidence.  Last month, Bloomberg reported that revenues for S&P 500 companies were falling.  Out of the 349 companies that had reported, only 116 had upside surprises and seven of ten sectors were under their revenueexpectations.

Don’t confuse corporate revenues with corporate earnings/profits.  Profits are outstanding right now because corporations are focusing on productivity and cutting costs including labor.  This brings me to my next point.  Distressed total revenue caused by propped up prices is hurting the ability for American businesses to hire.  All of this ties together, higher prices hurt demand, which hurt revenues, which hurt hiring, which hurts consumption, growth, and the overall economy.

How can we create 5-10% deflation without causing a credit crunch or an economic depression?

First, the Federal Reserve must be transparent in announcing what its intentions are.  This is to abate any fear that could occur when prices begin to fall.  We will also later show how the Federal Reserve can do this without creating a crunch of credit.  This method would be very similar to what the Fed did under Paul Volcker in 1980.

The Fed’s next move would be to end quantitative easing and begin allowing the Fed’s balance sheet to wind down via allowing securities to mature without re-investment.  Whether or not the Fed should begin selling these assets to the financial markets would be up to the Fed as the economy goes.  However, I believe that they should wait until they see positive results before taking it a step further.

Keep in mind that such a move should not decrease the money supply, but slow its growth.  This is something that would be necessary to keeping inflation tame once growth starts picking up.  One way to demonstrate how the money supply could still expand is to look at the year over year growth in M2, the broadest form of money that the Fed currently measures.

As prices begin to fall, demand should start to rise.  If the government can combine this with definitive tax policy and less regulation (I know, wishful thinking), sales and revenues should begin to increase.  As those revenues grow, so will the need to add capacity and with that jobs.  All of this leads to economic growth.  It would be important to add that the total revenue curve will likely shift upwards with increased capacity, thus adding another layer of growth potential.

Additional benefits that we would likely see would be increased capacity utilization (you can read about how capacityutilization has suffered for decades here), a stronger dollar, and (with that stronger dollar) lower commodity, energy, and food prices.  This should also increase tax revenues, decrease entitlement spending, and an improved deficit.

Why is the Federal Reserve not considering this strategy?  The reason is fear.  The crisis of 2008 remains fresh in their minds along with their experience studying the Great Depression and the Fed’s role.  They would rather be seen as doing too much than “tightening.”  Some force of deflation is going to eventually be needed, so why not start now?

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