Sunday, June 27, 2010

Inflation vs Deflation.

Mainstream economist or rather Keynesian economists who believe in “spending” as economic driver are always concerned about deflation. On the other hand Austrian economists (Which is very similar to our Indian traditional style of saving based economy) are worried about inflation. 

            In Simple terms today what central banks, governments and even major banks think that if Stock market crash, Real Estate tumble we can have deflation and that can cause economic catastrophe. Hence they stimulate (or rather try to stimulate) the economy by inflation (Printing money out of thin air and lowering interest rates).

Prima-facie their concern appears very genuine. The sequence of event that they believe then is ..
1)      If stock market crashes, it creates panic on main st.
2)      Businesses become very conservative in spending, resulting in job cuts.
3)      Real estate market crash.(This is more relevant only for this time as it is the root cause of 2008 panic from which we are not out yet.)
4)      In other words say if you have Rs 5000 /- per sq ft as rate in certain area, because of slow economic operations and uncertain future, no one buys new homes.
5)      Obviously that led to lower prices say Rs. 4000/- Sq ft.. Now when prices start going down, that itself becomes a reason for “not to buy” as people think it will go down further.
6)      This creates even less demand and prices drop even further.
7)      People who have bought at say 5000 Rs / Sq ft realize that it was way overprized and then “buyer turns into seller”
8)      Suddenly in system there are “all sellers and no buyers”.
9)      If no one buys people may opt to default on loan and give estate to bank.
10)  This create ”toxic asset “ on bank’s balance sheet.
11)  Banks possibly go under pressure and might collapse.
12)  Keynesian economists explain this as “uncontrolled deflationary spiral”.
13)  This obviously leads to very strong recession.

Well ..Doesn’t it make a sound business case to do something by government? Obviously everyone think yes.. but if we think more we realize that it’s really not required as there is always an auto corrective mechanism to this “Natural Recession”

Let me explain how.

For a common man.. If a home of Say 50 Lakhs becomes available in lower and lower price, is that not a great News. For common Man deflation is good because prices go down. His worry on the other hand was during boom time say 2002 – 2007 he was just not able to afford it. I agree that if there would have been no Stimulus spending, prices can go even down say 30 Lakhs or even 20 Lakhs  or 15 Lakhs ..… No Buyers …

However this co called “uncontrolled deflationary spiral” has a natural way of “auto correction” and at certain stage people find the cost rational (Say a flat worth 50 Lakhs if you say get in 10 Lakhs. Isn’t that a good buy then for common man). Obviously it is and  that is where deflation stops. In system we have buyers now. This obviously leads to a very cautious market in beginning and then possibly a big bull market down the road. That then becomes natural, robust and sound recovery.

Of course this is not painless way to recover though its natural way. We will have people who bought overpriced homes in deep water for few years. But if they have “bought home to live” it doesn’t matter. If they have bought it as investment then obviously you loose lots of money. But that’s risk that every investor takes and risk is risk.

Also it may mean collapse of few banks.. So what? Shouldn’t they have thought twice before giving loans of like 30 Lakhs / 40 Lakhs to individuals in their 20s for assets that goes up 30 – 40% every year. Shouldn’t their risk department experts should have thought that “something was wrong somewhere”. In our parent’s time, only government employees were entitled to Loans on home and private employees where not getting it (of course that was may be little too conservative but giving it to everyone was too risky and risk was that banks could have failed). In my opinion they should have failed.

Concluding. Deflation is not bad it’s a natural phenomena and an opportunity for people to buy. During periods of deflation getting money becomes very tough, many businesses that have weak fundamentals die. New strong businesses emerge as for new entrepreneurs deflation is golden time to buy assets, get resources at cheap rate. Also business that start in those times generally have strong and sound fundamentals as they remain cautious and realistic in their approach. Most importantly people realize incentive of "saving"

Added on Aug 06 2011: Long term Inflation vs Deflation for US.

US long term inflation Chart

Graph here clearly say that whole previous century was inflationary.

4 comments:

  1. Nice one! Touching the Jugular Vein again & addressing the million $ question - Deflation vs Inflation, thou I'll personally settle for latter ;)

    As random thought, isn't the deflationary cycle followed by inflationary one and vice-versa, as also implied by your article?

    So ultimately it boils down to what you want FIRST - Infla or deflation, takes two to tango :)

    ReplyDelete
  2. Amaresh Ashok GangalJune 28, 2010 at 7:37 PM

    Thanks for your comments. Yes you are absolutely right. " deflationary cycle followed by inflationary one and vice-versa". This natural cycle must continue. Things like Stimulus, expanding money supply distort this natural rhythm. End results can be very severe though.

    ReplyDelete
  3. or you get to keep BOTH, at times!

    You were a step ahead, before Reuters chipped-in w/ a Debate on this ;)

    Read on Reuters debate titled "Pick your Economic Poison -
    Inflation or Deflation, why settle for just one?"

    ReplyDelete
  4. Here's the link -
    http://blogs.reuters.com/great-debate/2010/07/01/inflation-or-deflation-why-settle-for-just-one/

    ReplyDelete