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The sudden fall in the price of oil provides a unique opportunity to
examine the widely held belief that deflation is economic
poison. As many governments and central banks have vowed to fight
deflation at all costs in 2015, the question could hardly be more
significant.
While falling prices may strike the layman as cause for celebration,
economists believe that it can kick off a nasty, and often inescapable,
negative cycle, which many believe leads inevitably to a prolonged recession,
or even a depression. However, these same economists acknowledge that falling
energy prices may offer a stimulus, equivalent to an enormous "tax cut,"
particularly for lower and middle income consumers for whom energy costs
represent a major portion of disposable income. They suggest that the
money consumers and businesses no longer spend on gasoline and heating oil
could be spent on other goods and services thereby creating demand in other
areas of the economy. Even Fed Chair Janet Yellen, a staunch advocate of the
economic benefits of rising consumer prices, has extolled the benefits of
falling oil prices.
After considering these competing tensions, most economists agree that
falling energy prices are a net positive for an economy (except for oil
exporting countries like Russia and Venezuela). But the fact that there is
even a debate is shocking. It should be clear to anyone that consumers
individually, and an economy collectively, benefit from lower energy prices.
As I mentioned in a column late last month, no
one buys energy for energy's sake. We simply use it to do or get the things
that we want. The lower the cost of energy, the cheaper and more
abundant the things we want become.
But if we all can agree that lower energy prices offer a benefit, why can't
we make the same conclusion about food prices? Wouldn't consumers get a huge
"tax cut" if their grocery bills fell as dramatically? How about
health care? Wouldn't we all be better off if our hospital and insurance
bills fell dramatically from their currently insane levels? Come to think of
it, why wouldn't we be better off if the price of everything fell? When
does too much of a good thing become too much?
Modern economists tell us that while it's okay for one or two sectors
to see price dips, the danger comes when prices decline across the
board. Their theory is that if consumers believe that prices will fall over
time that they will curtail their purchases to get better deals
down the road. Even if the overall dip is relatively small, just 1% annually
for example, they believe any amount of deflation will eviscerate demand
and kick off a cycle where depressed demand leads to weak sales, which leads
to business contraction, layoffs, and further depression in demand thereby
renewing the downward cycle.
But the truth is that deflation is not the menace to consumers and
businesses that governments would like us to believe. Common sense and
basic economics tell us that prices fall for two reasons: Either an
excess of supply or a lack of demand. In both cases falling prices are
helpful, not harmful
For much of our history, increased productivity increased the supply of
goods and forced prices lower. Falling prices made former luxuries affordable
to the masses, and in so doing made possible the American middle
class. Based on data from the Historical Statistics of the
United States, the many periods of sustained deflation did
not halt American economic growth in the first 150 years
of the Republic. (Sustained inflation did not become the normal state of affairs
until 1913, when the Federal Reserve was created).
Prices can also drop when demand falls due to economic
contraction. Any store owner will tell you that if customers stop buying
and inventories get too high, the best way to create new demand is to mark
down prices. This is basic supply and demand. Demand rises as prices
fall. In this sense, falling prices are not the cause of economic
contraction, but the market solution to depressed demand.
But today's economists are rewriting this fundamental law. In their eyes,
demand rises as prices rise. This is the equivalent of a physicist
suggesting that the law of gravity forces objects to repel from one another,
and that a stone dropped from a rooftop will fall upward. They further
stand logic on its head by concluding that falling prices are the
cause of the reduced demand. (It's like blaming rain on wet
sidewalks, and concluding that the showers will stop if the sidewalks can be
dried.)
Economists also argue that falling prices will harm business and lead to
unemployment. They forget that falling prices
also mean falling costs and increased sales, which lead to higher
profits, more capital investment, greater production, and higher real
wages. Henry Ford succeeded, and his workers prospered, not
because he raised prices, but because he lowered them. Cheaper
Model T's did not impose a burden on the public or compel Ford to lower
wages. More recently, the tech industry has prospered, and has paid
its workers well, by consistently lowering prices.
As a result of these ideas, economists advocate for policies that push up
prices. But all this does is kill off more demand and prolong the slump they
are trying to cure.
Since Janet Yellen acknowledged the beneficial effects of falling gas
prices to consumers, I wonder if she could name even a single
category of goods that would impose a burden on consumers if it were to fall
in price? My guess is that she can't. If a decline in the price of any
individual product is good, then a decline in the price of all products simultaneously
is even better. Am I the only one who notices the inconsistency in this
logic?
Perhaps this disconnect can shed some light on a topic that central
bankers are desperately trying to keep hidden in the shadows: Falling
consumer prices are good for the consumer and the economy, but they are bad
for central banks looking to maintain asset bubbles and for governments
looking for a graceful way to renege on their debts.
If we continue to insist that falling prices are the cause of economic
malaise, we will continue to produce economies where malaise is the only
possible outcome.
Best Selling author Peter Schiff is the CEO and Chief Global
Strategist of Euro Pacific Capital. His podcasts are available on The Peter
Schiff Channel on Youtube
Catch Peter's latest thoughts on the U.S. and International markets
in the Euro Pacific Capital Fall 2014 Global Investor
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