Deflation on the Horizon
The next phase in this great unraveling is deflation. Deflation is when you go to the supermarket and things cost less. Deflation is when prices go down--but in our present situation that is nothing to cheer about.
If everyday life is hit by a deflationary wave, it will bring extreme hardship to millions. This will not be a gentle dropping of prices, as when safe and competent hands are running the Federal Reserve Board and those in charge are simply steadying the value of money. This, if it comes, will be a brutal and jarring drop in prices.
We have just experienced one example of a deflationary drop when the stock market took a nose dive and share prices went down at a sickening speed. In one day pension funds, 401(k)s, college savings accounts, charitable foundations, college and university endowments collectively lost $1.3 trillion. That's deflation of the brutal kind.
And, of course, housing and real estate. It is hardly news at this point but until now, at least, it has been seen as an isolated catastrophe. Now, as things have developed, it is beginning to look like part of a major deflationary pattern. (Home prices have dropped more than 16 percent in the past year.) The world of business is too interlinked for a major sector to have a stand-alone price crash for any length of time without the other sectors getting on the down elevator too.
Deflation is hard at work on once hugely valuable businesses. We have seen gigantic outfits like Bear Stearns, AIG and now Wachovia sold off for a pittance. It won't be long now before somebody will buy Citigroup for three marbles, a shiny nail and a toad--the contents of Tom Sawyer's pants pockets.
The jaws of a destructive deflation have not yet clamped tight on us. Personal incomes are wobbly but they haven't hit a tailspin. The price of automobiles has fallen, but most retail prices haven't collapsed--and will not, if incomes don't fall and if people aren't so frightened by what's going on that they refuse to buy.
Nothing is more deflationary than increased unemployment. People out of work have little to spend, and the fewer the customers, the greater the pressure on retailers to cut prices.
Should the liquidity situation continue to get worse and keep people from getting credit to buy goods, the deflationary pressure will increase, affecting retailers, shippers and on down the chain, causing businesses big and small to lay off employees.
In a deflationary situation, pay raises go out the window and pay cuts become common. Unfortunately, debts contracted in the good old days of cheap and plentiful dollars do not get smaller; borrowers are stuck making payments on old loans with fewer dollars. That leaves them with less money to spend on restaurants, going to the movies or buying clothes, all of which contributes to increasing the deflationary pressures.
The nation took a deflationary punch similar to the one described here in the early 1930s. The effects were devastating, but history ordinarily does not repeat itself. The deflationary threat is at work, but it is still over the horizon and there is time to beat it back. To do so, something has to be reflated--and that something is real estate. Up to now we have been waiting for the real estate market to hit bottom, which it has not done. Housing prices continue to slide downward, bringing with them the prices of everything else.
There are a dozen ways to build a floor under real estate prices. They all have one thing in common: they require a lot of taxpayer money--but it is better to pay higher taxes on your income than to pay no taxes because you have no income.
The Paulson-Bernanke real estate reflation plan is the only plan on the table. It is clunky; it favors those who are already rich, but it is better than no plan--which is what the members of the House of Representatives who voted against it have to offer. Either they come up with a plan of their own, or give in and pass this one.
It may fail anyway, but if the Paulson-Bernanke plan or another is not quickly enacted, deflation will come and, with it, the worst of times.