What About the Possibility of Deflation?
The Counter-Arguments to the Structural and Secular Inflation Thesis - Article 49
In this 15-minute article, The X Project will answer these questions:
I. What is The X Project all about?
II. Why this article now?
III. What is deflation?
IV. What is one argument for why deflation may occur?
V. What is Cathie Wood’s argument for deflation?
VI. What does Peter Zeihan think about deflation?
VII. What are Hugh Hendry’s views on deflation?
VIII. What does Vinod Khosla think about deflation?
IX. What does The X Project Guy have to say?
X. Why should you care?
I. What is The X Project all about?
I normally start every article with this first section, answering, “Why this article now?” I first need to set a broader context for this article before answering that question. To do that, the bigger question to answer is, what is The X Project all about? The short, easy answer is my tagline, “The X Project curates, summarizes, distills, and synthesizes knowledge & learning at the interseXion of economics, geopolitics, money, interest rates, debts, deficits, energy, commodities, demographics, & markets - helping you know what you need to know.” I provided a longer answer in article #11 back in early December 2023, “What is The X Project again? And why should you care and want to be a part of it?”
But those answers miss the “why?” Why did I start The X Project? Why did I pick those ten topics? The underlying thesis is that I believe for someone like me, a member of Generation X born in 1970, the broader world is at a major inflection point from several perspectives. Said another way, much of the world that I have come to know and expect over the past few decades will likely be very different in the next couple of decades and in ways that will have meaningful impacts on everyone’s lives. Those who are aware and prepared will be able to navigate these trend changes and benefit from them financially. Those who are not aware and prepared are at risk of falling behind financially. I started The X Project to help people see what’s coming and to see how to protect themselves financially. The ten topics covered by The X Project are areas to witness the changes taking place and where there are opportunities for financial gain.
What parts of our world are at “a major inflection point”? How will our world be different in the next couple of decades compared to the last few? Each article published attempts to answer those questions, directly or indirectly, in some way. I understand that most of my subscribers have joined recently, and I also understand that most of you read my articles via email as opposed to the Substack app or website (see article 11, linked above, to learn more about those). This is my 49th article. After I publish my 50th article next week, I will publish a list with links to all 50 articles so that everyone can go back and read any that you might have missed. For now and for this article, I still need to answer the question, “How will our world be different in the next couple of decades compared to the last few?”
In broad terms, starting with geopolitics, the relative peace and prosperity experienced in the past few decades will be far less peaceful and prosperous in the next decade or two. The trend of growing globalization is reversing. Demographically, much of the developed world (notably Japan and Western Europe) and developing worlds (notably China, Russia, and South Korea) have populations that are or will soon be shrinking. And, shrinking populations usually mean shrinking economies unless there is some productivity miracle. Macroeconomically, the nearly 40-year trend of declining interest rates has been broken and is unlikely to return. Higher interest rates indicate higher costs for more scarce capital. Higher interest rates also end the sustainability of the prior trend of ever-increasing debt.
Higher incidences of wars and international conflicts, deglobalization, aging and shrinking populations, the end of declining interest rates, and the reckoning with debt growth and loads becoming unsustainable are some of the biggest changes that will have major and broad impacts on our lives. One of the biggest impacts of these macro-trend changes, which is also one of the biggest threats to us financially, is the “printing of money,” the continued and accelerating debasement of our currency, and inflation.
II. Why this article now?
Long-time readers, and especially paid subscribers, know I expect structurally and systemically higher inflation for longer. Many, if not most, of the articles I have published, conclude with the potential or likely inflationary outlook based on the topic being discussed.
So… why this article now? In February,
published an article titled “Cogent Analysis,” in which the opening paragraph states:“How can you tell the difference between an analyst and an advocate? It is all in the handling of data that runs counter to assertion. To an analyst, being wrong is disappointing, but it is primarily an opportunity to learn—an expected element in a feedback loop of continuous improvement. When knowledge is your only objective, there is no such thing as a bad fact, only one which you do not yet understand. Not so for the advocate. The advocate has tied their hopes (and often their livelihoods) to a specific outcome and feels compelled, whether consciously or not, to rationalize away or attack inconvenient realities.”
That passage resonated with me as I strive and consider myself to be an analyst. I am certainly not advocating for more currency debasement and higher inflation. I have always believed an analyst considers all sides of an argument, and I aim to do that as I continue my own journey of learning and acquiring knowledge and information. However, I realize - especially after Doomberg’s article - that I haven’t been writing about the arguments that I considered but with which I don’t agree. In article #23, “Navigating the Tides of Black Gold - Exploring the Bullish and Bearish Perspectives in the Crude Oil Market,” I wrote about both sides in that article mostly because I concluded they could both be right and that it is probably more a question of timing and sequence than one being right and the other wrong.
In any event, I realize that I have been concluding that higher inflation for longer is a dominant expectation in many, if not most, of my articles. Therefore, it is time to let readers of The X Project know that I am aware of and consider the counterarguments to my thesis in my analysis.
III. What is deflation?
Before we examine the arguments for deflation, let’s ensure everyone understands what deflation, disinflation, and inflation are. In article #9, “An Introduction to Inflation: What is its relationship to interest rates, government debt/deficits, and fiscal dominance?” I provided the following definition of inflation:
“Inflation is an economic term that refers to the rate at which the general level of prices for goods and services is rising and, subsequently, purchasing power is falling. As inflation rises, every unit of currency buys fewer goods and services. It is typically measured as an annual percentage increase.”
What is disinflation?
Disinflation refers to a slowdown in the rate of inflation, meaning that the general level of prices is still rising but at a slower pace than before. It indicates a deceleration in the increase of the price level of goods and services over time. Disinflation is often seen as a positive sign when an economy is experiencing high rates of inflation, as it suggests that inflationary pressures are beginning to ease. We have experienced disinflation from inflation’s peak at 9.0% in June 2022 until June 2023, when it bottomed at 3.1%.
What is deflation?
Deflation is an economic condition characterized by a general decline in the prices of goods and services within an economy over a period of time. It is the opposite of inflation. Deflation occurs when the inflation rate falls below 0%. This is a pretty rare occurrence, and it has only occurred four times in the past seventy-five years.
As you can see by the red circles in the chart above, the four episodes of deflation since 1948 were:
May 1949 - June 1950
September 1954 - August 1955
March 2008 - October 2009
January 2015 - April 2015
Is deflation a good thing? Actually, no. Economists and policy-makers fear deflation far more than inflation, mainly because deflation is associated with depressions like the Great Depression. But another reason Peter Zeihan articulates well in the video referenced below is that inflation is self-regulating, whereas deflation is self-reinforcing.
By self-regulating, Zeihan explains that when prices get too high, demand will eventually fall, and/or producers will increase supply, reducing the upward pressure on prices. Conversely, deflation is self-reinforcing because when consumers expect prices to fall, they delay purchases. As inventories increase due to delayed purchases, producers slow production and lay off workers. As more people become unemployed, they further reduce their purchases, which gives producers more reason to further slow or stop production, laying off more employees. A deflationary spiral is underway and can become difficult to stop and reverse - as occurred in the Great Depression; that is why policymakers prefer a low level of stable inflation and why the Federal Reserve targets 2% inflation.
IV. What is one argument for why deflation may occur?
A “hard landing” or deep economic recession
Not too long ago, there was a lot of debate regarding the economic outlook as the Federal Reserve embarked on its most aggressive interest rate hiking campaign ever, hiking rates a total of eleven times between March 2022 and July 2023 for a total of 5.25%. A year ago, the general consensus seemed to be that we would get a recession as a result of these rate hikes, and the debate was whether it would be a “hard landing” or a “soft landing.” As we saw in 2008-2009, a deep recession can lead to deflation.
As we approached the end of last year, the consensus seemed to shift to a “soft landing” or “no landing,” meaning we would either have a short and shallow recession or avoid it altogether. The Federal Reserve meeting in December 2023 seemed to validate this consensus, with board members suggesting three rate cuts were likely later in 2024.
By January 2024, a “hard landing” scenario was considered a low-probability event, and not many forecasters were calling for one. However, it was still within the realm of reason and possibility. And so The X Project wrote article #29 on January 28, covering the expectations of one of the most highly regarded and well-renowned economists, “Forecasting the Economic Storm: Dr. Lacy Hunt's Dire Predictions for a Hard Landing in 2024 and Beyond.”
In that article, I stated:
“Whenever I see a broad consensus, I naturally think of Bob Farrell’s rule #9: “When all the experts and forecasts agree - something else is going to happen.”
Since then, the economy has continued to be very resilient, and consensus has shifted even more towards a “no landing” scenario. Dr. Lacy Hunt has been relatively quiet lately. Still, another highly regarded and well-renowned economist continues to predict a recession, and I will cover David Rosenberg and his outlook in the next article or two.
V. What is Cathie Wood’s argument for deflation?
Cathie Wood, the CEO of ARK Invest, presents a deflationary thesis centered around the impact of rapid technological innovation and the macroeconomic environment shaped by monetary policies.
She has appeared in two YouTube videos towards the end of last year:
The economy will be in a period of deflation next year, says ARK's Cathie Wood
December 22, 2023, with 114,974 views
"Deflation is Next" - Cathie Wood, CEO Ark Innovation Funds
November 21, 2023, with 53,776 views
Her argument highlights several critical factors contributing to a prospective deflationary period:
1. Technological Innovation and Productivity:
Cathie Wood emphasizes that technologically enabled companies, especially those in innovation sectors, inherently drive costs down due to the efficiencies and productivity enhancements they introduce. She suggests that companies focused on innovation are more adapted to survive in a deflationary environment and can thrive as they continue to push the boundaries of cost reduction through technological advancements.
2. Deflationary Pressures from Macro Trends:
Wood points out several macroeconomic indicators suggesting deflationary trends. She mentions specific sectors where prices are beginning to decline, such as commodities, airlines, and automobiles. Furthermore, she references general consumer reticence in spending as reflected in company earnings and sectoral revenue downturns, indicating broad deflationary pressures across the economy.
3. Federal Reserve's Policy Impact:
Wood argues that the Federal Reserve's aggressive rate hikes to curb inflation will eventually slow down the economy significantly. She suggests that these hikes have been so rapid and extensive that they will likely lead to economic contraction or a "hard landing" rather than a gentle adjustment or a soft landing.
VI. What does Peter Zeihan think about deflation?
In his recent YouTube discussion, Peter Zeihan highlights several key concerns and insights into how deflationary pressures might manifest and impact global economies.
Things I (Do) Worry About: Deflation || Peter Zeihan
March 22, 2024, with 364,998 views
Here's an exploration of Zeihan's deflationary concerns:
Great Depression and Japan
Zeihan references the Great Depression in the United States and the lost decades in Japan as examples of deflation's severe and long-lasting impacts. During the Great Depression, a spiral of falling wages and prices contributed to economic contraction, while Japan's prolonged period of deflation beginning in the 1990s resulted in stagnant economic growth for decades.
China's Deflation Risk
Zeihan expresses particular concern about China, pointing out the country's aging population and reliance on exports. With a declining consumer base and increased export dependence, any significant policy change in major economies like the United States or Western Europe that restricts Chinese exports could trap surplus production within China, leading to deflationary pressures.
The Chinese real estate sector, representing a significant portion of private savings and characterized by a surplus of housing units, is identified as a potential deflationary trigger. This overcapacity in housing, unmatched globally, could contribute to a deep deflationary cycle if not managed carefully.
Simultaneous Inflation and Deflation
Zeihan highlights China's unique risk of experiencing inflation and deflation concurrently. Given China's high dependence on energy, food, and raw materials imports, the country could face inflation in these areas while simultaneously experiencing deflation in consumer demand and manufactured goods. This situation, unprecedented in scale, would present complex challenges.
VII. What are Hugh Hendry’s views on deflation?
Hugh Hendry, a.k.a the Acid Capitalist, is an eccentric and provocative retired hedge fund manager who is known for making bold, contrarian, non-consensus calls and bets. He appeared on YouTube not too long ago to share his views:
Madmax Deflation is Coming
January 24, 2024, with 102,347 views
He believes we are in the midst of the last bull run before a deflationary shock, and here is a summary of what will cause deflation:
China's Pivotal Role: China has been a significant driver of global growth, heavily investing in infrastructure and real estate. Hendry's prediction of a cataclysmic event in China, potentially a property market collapse, would slow down China's economy and significantly impact global demand for commodities and goods. Given China's major consumer and producer role, any substantial slowdown would lead to decreased global economic activity, fostering deflationary pressures as demand falls.
Global Financial Linkages: The global economy is highly interconnected, with financial markets and banking systems closely linked across borders. A crisis in China could rapidly withdraw global liquidity as investors seek safer assets, leading to falling asset prices and deflationary pressures elsewhere.
Interest Rates and Bond Prices: The bond market has experienced a prolonged period of bull runs, largely due to declining interest rates around the world. Lower interest rates make existing bonds with higher yields more valuable, hence the bull market in bonds. Hendry suggests that we're nearing the end of this trend. If interest rates bottom out and start to rise, or if confidence in the ability of governments to manage their debts wanes, the bond market could face significant downward pressure, contributing to deflation as the cost of borrowing increases and economic activity slows.
Market Distortions and Asset Bubbles: Policies by the U.S. Treasury and the Federal Reserve, including quantitative easing and low-interest rates, have been aimed at preventing deflation and stimulating growth. However, Hendry argues that these policies might lead to overvaluation in various asset classes, creating bubbles. These bubbles could lead to deflationary outcomes as asset prices collapse and debt levels become unsustainable, prompting deleveraging and reduced spending.
VIII. What does Vinod Khosla think about AI and deflation?
Vinod Khosla is a billionaire venture capitalist who invested $50 million in Open AI in 2019. He believes “AI should be hugely deflationary over twenty-five years.”
Is that a good or bad outcome?
Well, we don’t know yet. Some believe AI could be so productive that it causes massive unemployment, which would be hugely deflationary and, therefore, a bad outcome.
Others believe AI is the productivity miracle needed to grow our economy faster than our debt is growing, advancing other deflationary technologies like robotics and fusion energy and creating many other new jobs in the process. Thus, keeping unemployment low and unleashing a new era of abundance would be a good outcome.
In the next section, I will explain what I think about all of this, and then in the final section why you should care and, more importantly, what more you can do about it. However, I have just hit a new paid subscriber threshold, so you must now be a paid subscriber to view the last two sections. The X Project’s articles always have ten sections. Soon, after a few more articles, the paywall will move up again within the article so that only paid subscribers will see the last three sections, or rather, free subscribers will only see the first seven sections. I will be moving the paywall up every few weeks, so ultimately, free subscribers will only see the first four or five sections of each article. Please consider a paid subscription.
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