Thursday, April 13, 2006

Getting a handle on inflation and deflation

This isn't the "upcoming post" of last post's mention. Instead it's an attempt to educate - myself as well as any readers. Inflation and deflation are confusing, and a lot of people mix cause with effect with, well, an inability to grasp what's happening. I'm going to start with analogy, but I'll try not to stretch it too far.

Instead of money, we're going to consider shares in a company. There are 100 shareholders, each with 100 shares for a total of 10,000 shares. Each shareholder's worth is 1% of the total

If we inflate the number of shares available - say, we add another 10,000 shares - the practical value of each share is less. It used to take 5001 shares to win a vote. Now it takes 10,001. Now it's possible that things will balance - that each shareholder will get 100 additional shares for a total of 200 shares. It still takes 51 voters to win the vote, but they need to use 10,200. That's inflation - still the same share, but more actual pieces.

Let's say that we cut the shares in half - deflating the total. Now the win needs just over half of 5,000 shares, which if everyone has equal shares means it needs 'only' 2,550 shares. The price of a victory is now 2550 instead of 5100 - we've had a 50% deflation.

Now that doesn't look to bad, does it? Unfortunately it's not that simple. The first complexity - and in my opinion the greatest one - is that we have more than one thing, and these things change at different speeds. I won't bother stretching the above analogy. Instead we're going to jump to the 'hard' one to understand - deflation - and how it hurts.

We own a business. It makes widgets, and we have a 10% net income margin. That 90% is (for ease of this exercise) broken into nine elements each costing 10% - 1 set of wages (production staff and sales staff), 1 for each of 5 parts, 1 for building and 1 for equipment, and 1 for utilities (power, water, gasoline for transporters, etc.) My wages are an annual contract, three of my parts are ordered and billed quarterly with the other two are monthly, the building and the equipment are long-term payments (greater than five years), and the utilities are can adjust with 30 days notice. For simplicity, we've started the clock for all these at the same instant. And each adjustment is going to be for full deflation - that is, each of the above parts of 10% become 9% at the appropriate time.

Deflation of 10% strikes - people are only willing to spend 90% of what they were spending per widget.
The first month I make 0 - I'm still spending 90 but only getting 90. Month 2 (perfect world) all the monthly expenses adjust. That's two of the parts and the utilities. Expenses of 87 means I make 3. Months 2 and 3 are each another 3 profit. Starting month 4 I get to adjust the other three parts - 84% expenses make profit up to 6. I have no more increase till next year when I get to try to persuade my employees to take a cut. It's a perfect world, they agree, and I'm making 7. That's 7 on a gross of 90. If I was rolling half back into the company and living on the other half, I've gone from 5 to 3.5 - still more than my employees make, but a 30% cut in pay for a 10% deflationary period.

And that's a simple example with everyone agreeing to adjust in timely fashion.

Now, a key thing to point out above is that eventually everything adjusts. Reality is that the adjustments are going to vary in time and degree. Conventional wisdom is that those to whom money is owed (and yes, this includes employees owed wages) benefit from a deflation. Reality is that this is true only until the adjustment occurs AND so long as the person owed is able to retain the difference. In other words, let us assume George makes $2000 per month (after taxes). If George is paying $1000 in rent and $200 in utilities and $250 for a car plus $50 for gas and $400 in groceries and (finally) $100 in entertainment, he's spending it all. It's likely the purchasing power of his income toward entertainment will increase more, which means he can buy more for the same $100, the same for a bit less, or save for rough times. Rough times? What if his income is adjusted before the rent and car are adjusted? Using the easy 10% math, he got a whopping $1 from utilities, then his wage went and dropped to $1800, and even if he buys NO entertainment he's looking at $1900 in out-flow. Yes, cut the groceries - hopefully they'll adjust soon so he can get $330 worth for his $300, but that may not be soon.

Do you begin to see the pain? It hits the business, and it hits the wage-earner. And some folk have such a narrow margin, or they've too much in costs that can't or won't be adjusted for the change, that they lose money. Something has to give, whether it's George just selling the car or giving up and declaring bankruptcy.

Know what? I'm not going to do this exercise for inflation. We've been living with that for, well, since before WWII. It's been with us so long we take it for granted - cost of living just goes up a bit, and our wages keep pace, and so we spend about the same proportion of our wage on the same stuff more or less, and gripe at the lag from cost of living increases to wage increases.

There are more complexities and issue, but I think I'll stop there. That's deflation and its ills. And, subtly, the good - if you're holding or owed a non-adjustable amount more than you owe then your relative wealth (purchase power) increases. Big if there.


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