The New Conundrum – Deflation versus Consumption

As we head further into 2015 with the US economy on solid ground and building momentum, an interesting tug of war is taking place in economic circles. Economists and other market participants are debating whether or not declines in the prices of some goods and services, especially those in the energy sector, are good or bad for the economy. The argument is basically a debate on the ramifications of deflation. To begin, I’d like to get us all on the same page with how we are defining deflation which is a decline in the prices of goods and services. Now, in and of itself, this definition does not carry a negative connotation. Deflation does not become a negative occurrence until it’s viewed in what some economists see as a situation where consumption halts in anticipation of lower prices. While it is true that an economy would suffer as people postpone purchases, it’s unlikely to happen because of a natural human tendency to consume. This brings me to the crux of my disagreement with the deflationary economic collapse scenario which is that consumers, who find themselves with stable employment and discretionary income, will consume regardless of any potential future price declines. Furthermore, deflation when coupled with both steady employment and incomes can induce greater consumption of goods and services which will ultimately lead to rising prices as firms seek to maximize profits. The question now becomes, what drives consumer behavior?  The answer comes from three areas: basic human psychology, economics and common sense.

To frame the discussion in an academic sense for now so that we can address consumer behavior, we will begin with Maslow’s Hierarchy of Needs. The hierarchy acts as a psychological framework made of up of tiers which begins with the most basic necessities for life and then progresses up to the final level in which people have become essentially all that they want to be. The section which I will draw attention to is just before the final tier and is called the “Esteem” tier. It is in this “Esteem” tier that a person’s innate desire to consume lies. Maslow describes this tier as one that “is soundly based upon real capacity, achievement and respect from others.” Translation: A person will consume to fill personal desires and / or the desire for attention from others. Maslow also succinctly captured consumer behavior in his Theory when he stated, “Man is a perpetually wanting animal.” In general, if we believe in Maslow’s hierarchy or other types of motivation theory, we believe that people will always have a need to consume. It is this need to consume that will create greater utility for consumers as prices decline which in turn will create more consumption.

From an economics standpoint, there are a couple of concepts at work that also support rising demand from lower prices. While these concepts are some of the most basic and often first lessons learned in finance, it appears that they are also some of the first to be forgotten. If we go back to basic demand curves and elastic goods, economic principles dictate that as prices fall demand goes up, all things being equal. From a common sense standpoint, I’m pretty sure that as consumers we have all been in a store and bought more items because they were on sale, right? Going a step further, I have found myself more hesitant to make additional purchases of a discretionary item if the price has gone up.

Another economic concept at work was introduced by J.M. Keynes in his seminal work The General Theory of Employment, Interest and Money and is referred to as “propensity to consume” or PC. PC looks at changes in consumption as changes to income occurs. Interestingly enough, Keynes was kind of a predecessor to Maslow as Keynes also looked at the psychological factors of consumption which he referred to as the “subjective” factors. The primary and rather intuitive relationship Keynes established was that as incomes rise so does consumption. Keynes primarily focused on increases in income as a function of labor expended; however, that focus can be built upon to look at an increase in income as a function of expended labor as well as decreasing costs (deflation). Today, consumers’ incomes are rising through a combination of nominal wage raises, lower nominal prices in many goods and finally through savings from a drop in energy prices. All this being said, we can see PC manifesting itself in one of the most elastic/discretionary of goods categories which is the restaurant and food services sector (RFS). The year over year growth rate in RFS sales for the three month period ending February 2015 was 8.97%. The same metrics for 2014 and 2013 yielded an average growth rate of just 3.49%. The significant increase in sales is a function of a decline in energy prices (increase in income) and RFS being a readily available outlet for spending. I expect in 2015 that as energy prices stay muted and more companies follow the lead of retail giants like Wal-Mart and Target in increasing wages, we will see PC driving up consumption across the entire retail goods spectrum. The bottom line is that people want to consume, and consumption is the fuel that will drive our economy to new heights and achieve greater prosperity for all.

I’d like to now shift gears to a more market focused discussion in which we will look at the possible reasons behind falling prices. This is of great importance because if prices were falling because of a lack of demand, then we would actually be in a negative deflationary scenario. I would argue that we are in a natural period of deflation that is a result of dramatic advances in technology. These advances have had the knock on effect of suppressing prices. To be specific, there have been two key structural changes to the production of goods and services which have led to deflation. The first was a change to the labor force as a result of technology. This change has resulted in increased productivity and reduced costs at the firm level through a reduction and rebalancing of the labor force. A basic example of this would be software programs that have replaced almost entire human resource departments in large organizations. Then on a smaller scale we can look to “smart” technology in portable devices which have eliminated the need for sales support roles and other administrative positions throughout many businesses. This streamlining has allowed firms to be more competitive in pricing without harming margins and ultimately create more jobs through business growth. The second structural change comes from the renaissance in American energy production. America has gone from being the world’s largest consumer of oil to the world’s largest producer in less than a decade. This rapid change has completely altered the dynamics of international energy markets and reduced input and operating costs for many domestic companies. What used to be a massive transfer of wealth to foreign oil producers has now become a savings for domestic consumers on a retail and commercial level. In fact, based on 2014 gasoline consumption, consumers have saved roughly $148 billion from the drop in gas prices. To put this into perspective, the economic stimulus package of 2008 provided by the government and paid for by tax payers was $170 billion. The $148 billion in gas savings is essentially a no cost stimulus to US consumers. Of course this is just the savings on retail gasoline; one has to look across the entire energy complex to gauge the complete savings.

To conclude, depending on its context, deflation is not a bad thing. Deflation as a result of changes from supply side dynamics is just as natural an occurrence as changes in inflation from demand side factors. Every day we are bombarded with headlines from central bankers and economists about the perils of deflation and what the latest macroprudential policy rabbit out of the hat will be to stop it, when in fact all that is necessary is to let economic nature take its course. With that, I think when we look at the current unemployment rate of 5.5% and the structural changes temporarily suppressing inflation, I believe the economy has recovered. The reason people are having such a difficult time recognizing the recovery is because they are looking for this “break out” moment and are forgetting how far we have travelled from the financial abyss of 2007/2008. The new recovered state of the economy is not going to look like what we had before because of all the changes that have occurred. The sooner we come to this realization, the sooner we will be able to focus on the future and finally leave the great recession behind.

4 thoughts on “The New Conundrum – Deflation versus Consumption

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