Deflation Nation

Business Week ^ | May 26, 2003 | Brian Bremner and Irene M. Kunii

[oceanview]

you will never alter that cycle. the real estate market is not "fair".

[supercat]

you will never alter that cycle. the real estate market is not "fair".

No, but that doesn't mean I want to get on at a bad time.

[supercat]

I would submit to you that the catastrophic injustices envisioned by you will not come to pass should such a reform be carried out. Entrepreneurs today are far more responsible than the left gives them credit for.

It's important also to consider that those injustices could not have been maintained without (1) a steady flow of immigrants, and (2) a government willing to let companies violate existing laws by doing things like bodily assault people attempting to unionize.

The proper balance of power between unions and management is when unions have the right to organize, but management has the right to fire the lot if the costs of training new workers (including the oportunity cost of the time the factory is unproductive) would exceed the cost of going along with union demands.

In such an environment, unions could command a small price premium from management if they could also provide added value, but unions would not have the ability to make the extortionate demands they can make today.

[spokeshave]

America has a much more efficient labour/capital market....deflation is just another opportunity....

Bring it on

[solzhenitsyn]

I think I'll be renting for awhile, until the bubble bursts.

That's precisely what I'm doing. I owned a wonderful 1400-square foot condo down in Raleigh, but I sold it when my job moved up to the Boston area. I could afford to buy something up here, but I just don't see reasonable value offered for one's money. Don't really know how long I'll be up here, and my rent is reasonable enough, so I don't care to pay hundreds of thousands for something that could suddenly end up being worth far less.

I think everyone now is buying on the "greater fool" theory. Prices have gone up so fast for so long that folks have it cemented into their heads that real estate is bound to keep appreciating that way in the future. That's silly. When real estate keeps appreciating faster than wages and prices in general, at some point, it outruns fundamentals (such as rental incomes and the cost of building new structures), and real estate prices collapse.

[The South Texan]

The sky is falling, the sky is falling!!! Help!! Please Save us Democrats!!!

If I had a nickle for every sky is falling article I have read the past three years I would be rich!

[fso301]

read later

[Starwind]

America is not Japan

And the S&P 500 Index is not a SPDR. Maybe you should stick to geography - the different shapes seem help you.

[hove]

"America is not Japan"

You are correct. The coming deflation/depression will be much harder on America...a severely debt ridden economy. There will be no way for America to escape her fate. Any attempt by the FED will result in a period of hyper-inflation....to be followed by the inevitable deflation/depression. Americans should be warned...and prepare.

[logician2u]

Typical Business Week article, and they're good at predicting events that never happen and missing the larger stories that did.

Deflation, or lowering of the general price level, is not likely to happen in the US as long as we have a Federal Reserve bent on priming the pump with billions in newly-printed greenbacks, many of which go strait overseas to sit in some sheikh's vault.

For a saner perspective on the "threat" of deflation, read Hans Sennhoz's essay, "The Biggest Myth about Money " at the Ludwig von Mises Institute's web site.

[L_Von_Mises]

I think that most of the discussion on deflation is overblown. If you look at the CPI, the only categories that are showing falling prices are apparel, automobiles, and technology items like telecommunications equipment and computer equipment. I will conced that apparel prices are down but they are almost all imported goods from low-cost countries. Automobiles and high-tech both have a quality component to them. This is the source of much of the "deflation" in these categories. If cars this year tend to have for example, side air bags and those last year did not, then BLS considers that a greater quality good and adjusts the price accordingly. Now, if you have to pay an addtional, say $500 for that feature whether you wanted it or not, the cost of the automobile went up by $500 to you but BLS might more than offset that price increase with their quality component of the index yielding a decrease in the index. In high tech those quality components are even greater. There you see double-digit percent decreases in their indexes year over year.

They do the same thing when they measure capacity used in the capacity utilization rates. Most of the increases in capacity took place in the high tech sectors and most of that was simply adjustments for quality. If a company makes processors that are 1ghz and then uses the same plant to produce 2ghz processors instead, their capacity just doubled. (Well, probably not doubled but increased significantly). In the government data it would show a sharp decrease in capacity utilization for that plant. This would occcur even if they had the same size factory, running the same number of machines, putting out the same number of chips, and having the same number of workers. Aggregate that out to the whole economy and you have some serious errors in the data.

My own limited observations show nothing but price increases in my day to day purchases. I wish that what I pay for gas, utilities, food, health care, etc. were not constantly going up.

Regarding real estate, most of the significant increases in real estate prices are occuring in metropolitan areas where demand far exceeds supply. I live in the DC area and all the new housing construction is taking place farther and farther out. I can choose between a two hour plus commute each way and pay a nominal (relatively) amount or pay a significant premium to shorten that commute.

Also, when people make home purchases they look at what their monthly payment will be and if they don't their lender sure does. A lower interest rate means they can afford to pay a higher price for a home and vice-versa. Right now interest rates are very low so people are either buying more home or are offering more to beat out a competing bidder.

Combine these two factors - demand greater than supply and the ability to pay more and prices will rise. I believe that there will be some correction when interest rates rise again, but it certainly won't be a collapse in the market.

So, again, I am not very concerned about deflation. What I am worried about is us allowing China to be the world's manufacturer. Almost all of their growth in GDP is coming from investment. But very little of this investment is turning a profit, but that doesn't seem to bother them. In turn, they are flooding the world with cheap goods. If we end up relying too much on China (or any one country for that matter) it puts us at considerable risk due to potential hold up costs thus conceding a disproportionate amount of market power to them by making them potentially the sole provider of most of our finished or intermediate goods. It is analagous to having your entire portfolio in one stock.

[GOPJ]

bump

[Starwind]

If a company makes processors that are 1ghz and then uses the same plant to produce 2ghz processors instead, their capacity just doubled. (Well, probably not doubled but increased significantly). In the government data it would show a sharp decrease in capacity utilization for that plant.

Is that an example you made up to illustrate your point about BLS cap util stats, or does the BLS really think capacity increases when making a faster chip? Would GM's cap util increase by making faster cars? Larger cars?

[america-rules]

Here's the moral - high taxes and too much Gov't social freebies don't work !!

Here's why:

Two major facts are left out of this article:

Japanese Gov't spending was way out of control in the late 80's and they kept raising taxes so high that people stopped spending money because they got taxed to death on their income and then again when they bought something. They even added a national sales tax on top of a sales tax. They limited cheaper importets to protect their own businesses. Interest rates were still high and money lending was hard to come by. To buy a house you has to have a 50% down payment for a 40 year loan.

Social services were at an all time high and Gov't spending couldn't keep up.

They tried lowering taxes to jump start spending and they even gave away free money but people just Banked it. Too little too late !

[L_Von_Mises]

Is that an example you made up to illustrate your point about BLS cap util stats, or does the BLS really think capacity increases when making a faster chip? Would GM's cap util increase by making faster cars? Larger cars?

Yes they do. I was not aware of it until I began digging into some of the numbers and confirmed it with both BLS and the Fed. Regarding the cars, They do definitely factor in things like reliability (this would be factored over time), features (like climate control or power windows even if there is no added labor or cost to the builder), and fuel economy, among others. I would assume that horsepower or torque would also be a factor. My example about processors is better because it is more easily quantified and they told me so specifically. But I have had conversations with and read papers by someone who has been very influential in the implementation of this with BLS and automobiles and appliances were both cited as strong examples. I am not privy to all of the factors but I think what is important is the fact that they do use this in their calculations so it has to be considered when looking at the data.

[Starwind]

Stunning.

I knew they did this with GDP, CPI, PPI (for which I can see a small argument in their favor), but I see no basis to adjust capacity utilization for product features.

As an example, the wafer fab process to make processor chips is the same regardless of speed. The chips are built to run at max speed, and the clocks are retarded (post manufacture) on chips sold at slower ratings as per marketing plans. Obviously the fab line didn't run at half capacity because at the last step the CPU clocks are backed down.

I've also been digging deeper into BLS and BEA stats. Might you have a link to any BLS explanations about this stuff?

I've also wondered recently what our stats and reports would look like if they just reported the unadulterated numbers - maybe inflation adjusted, maybe constant dollars - but this philosophy of converting non-monetary aspects into some kind of 'cash-equivalent' is highly subjective, hidden, and they lack the judgement and background to do so (even if warranted) in all categories.

I would think GM, Intel, Phelps Dodge, etc would know their capacities better than BLS.

[A. Pole]

right, americans are going to work in slave labor camps like China.

Criminalize more things, support further growth of prison industry and you might get there sooner than you think.

[ExSES]

I'm no economist but if someone was living on their savings (I wish) which were mostly cash or near cash and had little or no debt, seems to me they'd be sitting pretty - in principle at least. A rather general scenario I know, but am I missing something ?

"Sitting Pretty"..., possibly but the facts are that most folks with little or no debt are retired and, unless they "locked in" high interest rate bonds (which haven't been redeemed yet), the return on their savings is not positive after taxes. I know folks whose entire retirement nest egg was in stocks which are down 60-70% due to their fallen for "expert advice".

Other folks who were very conservative, had their nest egg in money market accounts (now yielding 1-1.2%) and short term CDs (now yielding 2-3%) as opposed to 5-8% when they retired. Needless to say, with state/local taxes going up and all manner of services going up at annual rates of 4-7%, even these very conservative retirees are well behind the curve!

0% financing on autos and furniture and plummeting prices on ever more sophisticated electronic gizmos does nothing to help you when your monthly "net" keeps decreasing!

Reducing or eliminating one's debt is certainly good but it won't leave you sitting pretty, it will only leave you relatively better off than facing "official deflation" in a real inflationary situation while struggling to pay debts!

[L_Von_Mises]

I've also been digging deeper into BLS and BEA stats. Might you have a link to any BLS explanations about this stuff? Scroll down towards the bottom of this page and there is a series of articles on "hedonic quality adjustments" and "hedonic regressions."

Here is a brief excerpt from one of the article:
"Of the three different approaches or methods that use the results from hedonic regression models to quality adjust price indexes, BLS employs the 'matched model' method in its official indexes.2 This method controls for quality changes based on the difference in product specifications or characteristics between two items when a substitute observation, or quote, occurs in the price index sample. It is important to note that under the 'matched model' approach only substitution price changes, or quotes, are eligible for hedonic quality adjustments."

"As previously announced, the Bureau of Labor Statistics (BLS) is extending the use of quality adjustments derived from hedonic models in the CPI. A hedonic model decomposes the price of a consumer product into implicit prices for each of its important features and components, thereby providing an estimate of the value for each price influencing feature and component."

Link to CPI homepage is here

Regarding the Federal Reserve's use of quality to adjust capacity, I was unable to locate anything quickly, but I was doing some analysis on recent changes in capacity and the numbers just did not make sense based on my observations of recent trends in capital equipment. I contacted the analyst that assembles the industry indices and he informed me that most of the growth in capacity had occurred in high tech and most of that growth was based on quality improvements of the output rather than investment in physical capital.

Since capacity utilization is simply the IP index divided by the capacity index, the utilization rate gets impacted indirectly. Also, the capacity index is derived by different methods depending on the industry and its data availability. Their benchmark is the Survey of Plant Capacity, for which data has a two year lag. Then they attempt to make adjustments to that data to make it current. So you are really using a denominator based on today's output over a numerator that is based on capacity that existed two years ago.

I work with all types of government and private data every day and when I start looking into how the data is constructed, it can be a little unsettling. It is useful for analyzing trends if one asumes that in the long run and in the aggregate the errors cancel each other out. But to draw specific conclusions based on a snapshot can cause problems. Some data is better than others. The trade data is horrible. I have had more than one official tell me that anyone that uses it to obtain any detailed information is a fool. Pretty encouraging, huh? NABE (National Associaton of Business Economics) has been lobbying extensively to make the data more accurate but it is not easy. The People who put the data together are all very capable and serious about their work but the data they put out can only be as good as what goes in. I guess the main problem is a lack of funding.