JAPAN vs. USA: The Raw (Sushi) Facts on Deflation Demystified

Whatever happened to the eternal war against inflation?  We won...I guess.  Our economic forefathers taught us to run from inflation; which we did, like schoolgirls being chased by a monkey infected with Ebola.  We kept running and didn't stop until Alan Greenspan jumped in front of us with a stop sign in the early 80's.  Poof!  Like a magician making a penny disappear, Alan waived his wand and inflation vanished.  Where did it go?  Along with his radical supply-side theories, Alan had the magic ingredient to fight inflation - nothing.  That's right, nothing at all.

Alan Greenspan understood that a free-market economy, combined with a rich money supply, would yield tremendous investment, growth, productivity, and efficiency.  Keeping short-term interest rates relatively low would provide the necessary fuel for this growth.  Unlike what's written in dogmatic economic textbooks, significant economic growth need not result in inflation.  Technological advancements consistently yield greater productivity and efficiency and, thus, lower prices.  An economy flooded with money will spur healthy competition and a demand for greater efficiencies in order to compete.  Whether it's DirectTV's advanced satellite network developed to deliver high quality digital television or Eli Whitney's cotton gin invention of 1793, technological advancements increase efficiency while driving down the costs of goods and services.  As long as capital spending exists to promote and develop these technological efficiencies, consumers will be able to purchase more, while companies watch its bottom line grow.

Great, so we solved the inflation riddle; just give the economy the resources and freedom it needs and price levels will remain stable.  It appears to be clear economic sailing from here on out.

Well, not so fast.  Just as economists were waiving goodbye to inflation, they seem to have grown hysterical about deflation, almost like paranoid schizophrenics.  We have all seen the headlines about how we are doomed to follow Japan into the miserable clutches of deflation.  Deflation is the economic blackhole; once it shackles you, it is virtually inextricable.  Price levels plunge and profits dwindle, while the burden of debt rises.  The effects of deflation are greatly magnetized for companies holding heavy debt loads.  As prices fall, companies have a harder time repaying debt.  The end result is not pretty - layoffs, wage cuts, and even bankruptcy.  This is why - at a time when America has the highest levels of corporate and personal debt - the thought of deflation is particularly troublesome.

However, this should not typecast all deflation as evil.  Any deflation we have experienced thus far in recent years, as discussed above, was due in part to technological progress.  Prices for many consumer products were able to decrease as productivity and efficiency outpaced the rate of the price decline.  In fact, this sort of positive deflation has occurred before.  Between 1865 and 1879, manufacturing output rose 6% a year while prices fell by 3% a year - a positive net growth.

What really scares Americans is the type of deflation that Japan has lived through for the past four years.  Prices keep declining and there is nothing the central bank can seem to do about it.  The Bank of Japan has cut interest rates virtually to zero.  Money in Japan is practically free!  However, banks can't seem to find any takers.  Companies have no incentive or desire to borrow and invest, and individuals would rather hold on to cash as prices decline.  What's worse, the few companies that are actually borrowing money from the banks are using it to invest abroad.  With no capital spending or investing within Japan, its economy slowly dwindles away.

With inflation-adjusted interest rates now at or below zero, the Fed seems to have very little maneuvering room left.  Mr. Greenspan demonstrated little concern about the likelihood of deflation with the surprising 50 basis point rate cut on November 6.  He believes that Americans will take the cheap money and go on a shopping spree.  It's no small coincidence that the rate cuts come on the heels of the holiday shopping season - Greenspan wants to be certain the money supply exists to ensure a robust holiday season. 

But why will Americans take Greenspan's cheap money when the Japanese refuse?  Because Americans can't resist!  From the day we are born we are conditioned by the Visa's and GM's of the world to spend it all.  And with the extensive and intricate financing opportunities that exist, Americans can spend it even if they don't have it.  Our entire lives are quantified into one simple, small monthly payment.  As short-term interest rates decline those monthly payments shrink, allowing us to exponentially keep on spending!  The Japanese love to save; it is their nature.  Japanese have the highest savings per-capita in the world.  By contrast, the average annual savings per-capita in America is $0!  (But who do you really think has more fun!) As long as we keep on shopping, the economy will keep on sailing without the risks of deflation.