The Deflation Delusion Is the Phillips Curve In Reverse
“…we must never lose sight of this maxim, that products are always bought ultimately with products.” Jean-Baptiste Say, A Treatise on Political Economy
The Phillips Curve economic model is based on the notion that if a nation’s economy exhibits a great deal of strength, the end result is inflation for demand allegedly outstripping supply. Federal Reserve vice chairman Donald Kohn embraces this view along with the vast majority of academic economists, including our present Fed chairman, Ben Bernanke.
In a 2003 speech made while vice chairman at the Fed, Bernanke spoke of looming inflationary pressures thanks to high levels of U.S.-based capacity utilization, and in a July 2005 op-ed for the Wall Street Journal, Bernanke asserted that there is a “highest level of employment that can be sustained without creating inflationary pressure.” Intriguing thoughts at first glance, but Bernanke’s very assumptions are quickly disprovable once we consider the real-world impact of economic strength.
When labor shortages in a nation’s economy reveal themselves such that wages rise, the latter is a signal to sidelined workers to offer up their services in order to capture higher wages. And since economic strength in one nation is rarely uniform (compare employment rates in Detroit vs. Las Vegas), rising wages in one region of a country also attract workers from areas where jobs are less plentiful. In the end, labor shortages are always moderated by new entrants to tight labor markets.
It should also be remembered that U.S. firms are not solely reliant on workers within these fifty states. As CNN’s Lou Dobbs frequently reminds us, companies with an American address regularly access the world’s abundant labor supply in carrying out their operations. And if that’s not enough, the next time readers pump their own gas or buy gifts and plane tickets on the Internet, they should remember that innovations of the mind allowing self-service are the market’s way of working around labor shortages.
When we consider capacity utilization or what some economists call the “output gap”, the same scenarios apply. If manufacturing capacity is running low in Tennessee, unused capacity in Flint (MI) can be accessed. More importantly, Nike has never manufactured its myriad products stateside, so when Bernanke suggests high capacity utilization in the states could lead to inflationary pressures, he ignores the basic truth that U.S. firms aren’t limited to the available capacity within our nation’s borders.
But of greatest importance is the certain reality that demand is simply the flipside of supply. We can only consume after we’ve produced first. And if we’ve not produced, we must have collateral based on past production so that we can borrow the capital of the productive to facilitate our own consumption.
So while it’s an appealing thought among academics that demand can outstrip supply, the logic is easily disprovable. Our productivity in the workplace is our demand, which means supply and demand in any economy balance. Inflation is always and everywhere monetary in nature, so absent monetary disturbance, demand spikes are by definition preceded by supply spikes.
But with the U.S. economy presently struggling, many are suggesting that deflation is now what ails us. The problem there is that just as strong economic growth cannot cause inflation, flagging economic health can in no way cause deflation. Indeed, all it takes to show why this is the case is to reverse the above scenarios.
If a slowing economy leads to an increase in the supply of available labor, this at first could lead to lower wages and salaries offered by employers. If so, and we’re seeing this already, the number of workers that sideline themselves in response to falling wages rises. There’s also less labor migration from weaker regions, which means falling wages are moderated by a reduction in the supply of workers.
And if wages are falling stateside, there’s less economic incentive for U.S.-based firms to access labor not in these fifty states. “Outsourcing” is the certain result of strong economic growth, but if growth is less than robust, it’s marginally easier for companies to limit their hiring to the states. Lastly, if labor’s plentiful, technological innovations meant to work around labor shortages become less essential.
When the “output gap” is considered, if due to slower growth the alleged gap rises, this simply means unused capacity will no longer be accessed. There would be no pressing need to put mothballed factories in weaker U.S. regions into operation, not to mention production slated for overseas venues would more likely remain stateside.
Most important, however, is the basic truth that supply and demand are one and the same. If discretionary spending among Americans declines, that also means their supply has declined too. And for those who say fear of the future has producers saving more, it can’t be stressed enough that saving in no way detracts from demand. Money saved is merely lent out to others; some with near-term demands. So while it might be appealing to assume that economic declines are deflationary, simple logic tells us that a falloff in demand is nothing more than a decline in supply.
Some of course would reply that clearance and going-out-of-business sales that bring prices down are deflationary, but these examples too don’t pass the most basic of tests. Indeed, falling demand that is met with fire sales is yet another market signal transmitted to producers telling them to manufacture or offer less. So while retail sales are the “deflationary” seen, the unseen is the reduced production that eventually moderates retail pricing. Think the various airlines, and the number of planes they have and will continue to remove from the skies.
In 1992, this writer placed a 30-minute “long distance” call from Austin (TX) to Houston that cost $15. Today, long distance calls anywhere in the U.S. are mostly free. But is this deflation? Not in the least. Thanks to competition making long distance essentially costless, Americans have been able to demand other goods previously unattainable, thus driving up their prices.
And if the theoretical is not enough, we can look at the empirical. If the Fed’s logic were remotely true, recessionary periods in the U.S. would have been deflationary, while strong periods of economic growth would have been characterized by rising prices. In truth, the opposite has always been the case. The U.S. economy experienced no less than four recessions from 1965 to 1982, but far from a deflationary era, there’s a general consensus that we experienced massive inflation. Conversely, from 1982 to 2000, the U.S. economy pretty much grew without interruption, and while the CPI is faulty at best, it registered in the teens in the early ‘80s versus a 2.7% reading at the end of the millennium.
In the end, today’s deflation warnings are a perversion of the concept. Inflation results when the currency is debased, and deflation is the result when the currency’s value rises above a non-inflationary level. With the dollar still testing all-time lows, deflation only exists if we’re willing to completely redefine the notion altogether.
So with the dollar very weak, inflation is our problem, and it’s one that has the potential to get worse if the Treasury and Fed continue to communicate to the markets their nonchalance when it comes to the dollar’s value. Put simply, the Treasury and Fed are presently fighting non-existent deflation with more inflation.
For investors, this is a very bad signal indeed, because stocks despise inflation for it eroding real returns on investments. In short, the deflation delusion foretells many years more of subpar market returns; all this thanks to a misreading of what is a very basic concept.