The Black Swan of Deflation

For the world’s central bankers the blackest of black swans is deflation.

While we thrill to the collapse of oil prices and look forward to having extra disposable income, we fail to recognize the threat that deflation poses.

For the record, we also fail to ask ourselves how much debt is involved in oil exploration and production. Last I heard the number was north of $5 trillion. A deflated oil price is bad news for those who hold the debt.

When the mortgage crisis hit the economy in 2007-2008 there were approximately $1 trillion in bad loans.

Bloomberg News has offered a brief primer on why deflation is bad news.

First, it chokes off spending.

If you believe that prices will be higher tomorrow you will be more likely to buy today. If you believe that prices will be lower tomorrow you will be more likely to defer all but essential purchases.

The same applies to spending by corporations. Company officers who believe that prices will decline will spend less on raw materials and will make fewer investments in plant and equipment.

Next, companies lose pricing power. Competing with other companies that are lowering prices, companies must also lower their prices. Thus, their profit margins vanish. (One might also note the decreased prices offered by internet vendors.) And employees don’t get raises. In the worst cases they accept lower salaries.

Finally, lower prices do not change the amount of debt you owe. If your salary decreases and your mortgage remains the same, you have a problem. If economic activity diminishes and the interest on the national debt stays the same or increases, we have a big problem.

Bloomberg notes that central banks often fight deflation by lowering interest rates.  At the moment, however, interest rates are close to zero.

It’s potentially a very threatening black swan.