Thursday, November 04, 2010

I Thought QE2 Was the Queen Elizabeth Luxury Liner

So the Fed embarks on Quantitative Easing II in order to try to pump the economy. They are doing this to avoid "deflation", which apparently is worse than the hyper-inflation they are planting into the system (and if this word seems alarmist, take a look at the price of gold, wheat, oil, or any other commodity over the past six months. These price increases are starting to be factored into food, gas, and anything else that uses raw materials, and these price increases haven't led to increased employment).

Why does the Fed think that a lower dollar and lower interest rates will boost business spending? Businesses are sitting on giant cash hoards and not investing. Why would lower borrowing costs change this?

And why is deflation so bad? I have been working in an industry where deflation is a part of life: technology. Anything we sell today will be selling much less a year from now. In fact, our customers expect to see a "cost down" roadmap of 15% per year MINIMUM, sometimes much higher. We work with it, factor it into our planning, and of course it inspires us to do more with our products, to put more things into them so we don't have to reduce prices so much (which is why you get so much more for a laptop for the same price today as you did five years ago - the price has deflated, but more memory, larger disk storage, etc. was added to keep the price even).

We hear about how the poor spend everything they get, and how an increase in benefits goes directly into their spending. So if there is deflation, doesn't that mean they get to buy more things for less? So deflation helps the poor. The only people who spend less during deflation are people who can plan their purchases, so the better off supposedly delay purchases, but the big ticket items that group already buys - TVs, appliances, anything with technology - already has deflation, and has for years.

"Required" inflation is a theory from Keynesian economics, but that theory was put forth for increasing populations pushing for more goods. But what if the population is decreasing (like Japan)? Or what if people are just tired of buying crap (including housing) like we have now? The theory is silent in these conditions, but that doesn't stop the Central Bankers from using the only tool in their box instead of letting things work themselves out.

This will be a case of the cure being worse than the disease.

3 comments:

The Arthurian said...

Gee, Mitch... Hello, by the way; the Next Blog button brought me here.

#1... When prices fall in a rapidly-advancing high tech industry, this is not "deflation." I can't explain it any better than that, but it isn't deflation.

#2. You write:
Why does the Fed think that a lower dollar and lower interest rates will boost business spending? Businesses are sitting on giant cash hoards and not investing. Why would lower borrowing costs change this?

These are excellent questions. Personally, I think they misunderstand the problem.

#3. And why is deflation so bad?

Inflation reduces the income with which we must pay our debt. In a time when U.S. debt reached 350% of GDP (and has yet to drop much from that level) deflation is a superhighway to economic collapse.

But it seems to me that you must know these things.

Art

Director Mitch said...

Yes, I know, in theory, why deflation is bad. This was more of a post to throw out things to create discussion (like you have here, so thanks for the inputs).

You're right - technological innovation is not "deflation", the same that productivity isn't, and it too gives more products or services for the same amount of input. Both technology and productivity create "wealth" by allowing people to get more stuff for less money. Theoretically, this allows people to save more, which creates investment for jobs, which creates more technology creation, and so on in a virtuous circle.

"Real" deflation is when the value of goods and services are going down due to monetary phenomena (theories range from consumer sentiment to currency valuation). Companies see that a product they produce today will be sold tomorrow for less than they make it for, so push out production and slash workers, who spend less, which lowers the demand for goods, which creates a vicious downward cycle.

Right now we have deflation in the housing market (prices are not going down due to better house technology or faster construction), but many other price declines in the economy are from efficiency and technology (Wallmart delivers more stuff to market more efficienty, the cost of toys is cheaper due to being made in China, TVs and computers do cost less).

So basically the Fed is doing QE in order to keep one asset class from deflation - housing. In order to do this they are starting inflation (see commodity prices).

The thinking here is that trying to do "something" is better than doing "nothing" and just letting housing take its lumps and clear the market.

I am in the "do nothing" market, but the Fed and others are not mainly due to the vast market of mortgage-based securities that are held worldwide. If the entire housing market implodes, it would take a lot with it. So the Fed is doing everything in the book - ZIRP, QE, etc. - to prob back up housing.

And if housing doesn't come back and now with ZIRP and QE in place, what happens? We still have housing deflation plus other problems to deal with. Like I said I think the "cure" is worse than the disease, but we'll know for sure in about 3-4 years.

The Arthurian said...

Hello, DM. It is the curse of interesting times, isn't it.

"Do nothing" makes me uncomfortable. But "do the wrong thing" is worse. I'm still waiting for an analysis of the problem that rings true to me.

Hey, I'm glad you didn't take it wrong when I said 'it seems you must know these things'... Probably I should have known by the post title that you were doing some tongue-in-cheek.

Art