Global Insights, Leadership, Risk Management

The Case for Low Interest Rates, Lower Taxes, and More Babies – Deflation!

7 Sep , 2017  

The economists and central bankers of the US Federal Reserve have a perplexing challenge. The US economy has picked up in terms of GDP growth, but inflation is below the Goldilocks target of 2%. How could economic models be wrong? What, if anything, has changed? It has spurred a serious discussion that suggests that US economy operates differently now. I think the answer is obvious – DEFLATION! We have deflation, just not in an absolute form. We have deflation in the economy like you might have bugs in your house. They are not everywhere, just in places. Overall, the house is mostly clean, but there are some bugs. Overall, the economy is growing but there are deflationary pressures (that are not going away). Why do I link deflation and bugs? Well, neither are especially welcomed. Deflation is good for people with lots of cash. The cash gets more valuable over time and currency appreciates with deflation. Prices fall, and you can buy more with less cash in the future. It also means you delay purchases, investments, and borrowing. For some, it seems good, but it is really bad for consumption-based economies like ours in the US, and deflation is especially bad for lending. Deflation is dangerous because lenders might decide that holding cash is better than lending, and borrowers might not want to pay in more valuable future dollars. Irving Fisher wrote a famous paper on the impact of deflation to credit risk and lending[1]. Economist and central bankers often make light of deflation, as it is rarely seen, but the big D is dangerous, and it was at the core of the Great Depression.

In a sense, inflation, as we measure it, is an average. It does not specifically capture that deflationary forces are at work. These deflationary forces might not be enough to make overall inflation negative (deflation) but they do hold back natural inflation. Indeed, some of the deflationary forces that we see are permanent, suggesting the assumptions of growth with inflation will need to be revisited. Here are the realities that I see as deflationary forces on our economy

Demographics: America is getting older. Consider the below population pyramids from the US Census Bureau. Baby boomers are retiring. Why does this matter? Well, older people consume less of many of the things that drive the economy. Retirees buy less vehicles, less food, and often even use less housing. Has your oldest uncle gone sofa shopping recently? Probably not. It might seem impolite to conjecture, but retirees on a fix budget more or less try to make that work. They spend less, because they have less to spend, but they often have many of the physical things that they need in life (housing, furniture, appliances, clothing…). Consider that 12,000 people are retiring each day in the US. That is a lot of reduced spending. Spend less, earn less – that is deflation. We need more people, more babies, really.

Median Household Income Growth has been Weak: Consider the below graphic. Just as the economists play their Prince CDs, reflecting on GDP growth, thinking it is time to “party like its 1999,” wait…it really is 1999 for over 50% of households! Real household median income is on par with 1999, having increased in the early 2000s, then having dropped dramatically in the last decade, and only recently is starting to recover. Can you and your family live on $55,000 (before taxes) a year? Half of America has been doing this since 1999. Consider that number, its impact on families, spending, politics, and distrust and disgust it has engendered for those who have seen prosperity. Low or flat household income = less spending. That means deflation (and it explains, in part, our divided country, rash politics, Brexit, and calls against the 1%). On the same graphic above, consider Real Disposable Personal Income, defined as the total amount of money available for an individual or population to spend or save after taxes have been paid. Since 2000, Real Disposable Personal Income growth has lagged that of GDP growth (green line has higher slope than purple line). This suggests surplus in GDP growth is increasingly being kept by firms or is captured in taxes, or otherwise not making it to workers and consumers. This is a bad omen for increasing prosperity. The amount that people have after taxes is lower, as a fraction of GDP growth, than we saw decades ago. Proportionally, this shows deflationary pressures. It is an argument for cutting taxes, raising wages, and getting more of our GDP growth into the pockets of Americans. Give more of the GDP growth back to the population! Lower taxes!

Globalization (Really China): Our largest single trading partner is China. Our trade imbalance with China was $347 billion in 2016.[2] That means we buy nearly a billion of stuff from China each day! Why does this matter? In a purely Milton Friedman approach, open borders are good, right?

Consider the excellent graphic, above, from Anthony Cohen, that shows trade imbalances in 2011. Our trade imbalance is largely with China. Well, in 2000, our trade imbalance with China was 84 billion a year.[3] China was then our 5th largest trading partner.[4] So, in 16 years, we went from 84 to over 347 billion. That is a change of over 4X! Look in your house at all of the things made in China. Dishes, pots, pans, furniture, food, electronics, toys, shoes, clothes, and even many parts of your car, and the drywall hanging from your walls are made in China. As economically fair as we might see globalization, we have moved production to lower salaried workers in China. This has multiple deflationary pressures. First, it removes salary and jobs from US workers (less salary = spend less = deflation) and it means that producers can drive cost of goods lower and compete on price (good for the people with lower salaries too). Look at those prices at Wal-Mart. How do they do it? Importation of course! Lower prices mean people spend less, which means more deflation. We even now import a lot of food from the likes of Mexico and South America. And in 2016, the last Oreo factory in Chicago shutdown as the new Mexican Oreo factory came on line. Like it or not, we enjoy low prices on goods, like Oreos, because we have outsourced production to even lower salaried countries. That is deflation!

Winner Take All Works (Really Well): With the exception of pharmaceutical and healthcare, just about every industry I can think of has been hit with the “Winner Take All” phenomena. This is the constant race to lower prices in order to win market share. Amazon, Costco, Google, Walmart, Southwest Airlines – and the list goes on and on. All of these firms are examples of those that have won by driving prices down. I recall paying $15,039 for a new 1997 Honda Civic. Today, one can buy a 2017 Honda Civic for $18,000. That increase of $3000 does not even correct for inflation. The 2017 model is decked out, too. That, my friends, is deflation in the price of econ-box cars. In 1992, I got a student-discounted rate on a United flight from Tampa to Chicago. The fare was just over $300. Today, I can book that flight on United for $97.01. Wow! That is a great benefit to passengers. It is another example of lower prices and deflationary pressures. “Winner Take All” business models have been all the rage in business schools. Everyone wants to corner the market, as the path to wealth is paved with examples of others who have done the same. In this regard, markets are finding a new equilibrium – efficiency matters. Take costs (and workers) out of the system to lower product prices. All of this leads to deflation!

Digitization: I greatly enjoyed reading the Wall Street Journal in paper form each day. I have not touched one in 9+ years. I get it all online, and so do millions of others. The Chicago Tribune still delivers a paper to my house, even though I have not paid them in years. I asked them to stop repeatedly. They must be dreaming (or is it a nightmare?). In any case, digital businesses need less people than conventional ones. No paper means no need for trees, trucks to haul the paper, mills, plants, ink, presses, etc. Digital business models require well-trained professionals, but the impact of one editor at the paper has high leverage over the business. Uber is another great example of how drivers are digitized. Prices go down, and it the end drivers make less. Workers and even whole sections of the economy are made redundant by digitization. Be careful, the next digital model may be looking at your job. So, less workers via digitization = less salary = deflation!

Automation and Bots: Automation is the most absolute sense of worker removal. We replace the hundreds of workers not with a single digital chief, as in digitization, but we replace the workers with machines that have no salaries, benefits, health costs, or even feedback loops. More work is being done without people involved. It is great for keeping costs down! Less cost = less inflation and the less salary growth. More signs of deflation!

Greedy Firms: This might make some people feel bad. One explanation of the low growth in salaries is that older people, with higher salaries, are being replaced with younger people with lower salaries. It is as if the economy is replacing older, higher-waged people, with younger, lower-waged people each time a Boomer is replaced with a Millennial. I think there is something to this and, frankly, if the younger person is doing the work of the older, he or she should get the same salary. Age and the related salary growth have always seemed unfair to me. This cause would make a great protest and march. In any case, there are lots of younger, lower-salaried people doing the work of higher-salaried people who have left the workforce. That is unfair! Young People Matter, Too! This form of reverse age discrimination means less salary growth, higher profits for firms, and yes, deflation!

Conservation: This is sure to raise people’s eyes and be controversial. Consider the insulation that I put in my house in 2009. I paid once (actually the power utility paid me to install it, which was great, plus there was a tax credit, which was even better). The insulation is there now for decades. I will use less fuel. That is good for me, the environment, and presumably the power utility. It is not good for the millions of people that make energy, transport its forms, or service devices that use energy. I am all for conservation for its ethical and environmental grounds, but using less means we spend less in the major market of energy and that leads to deflation! Maybe this is a good form of deflation, but I’m not yanking the insulation out anytime soon. That form of deflation is here to stay.

Labor Unions: Much has been written about the demise of labor unions in the US and how this has impacted salaries. There is clearly something to all of that. Workers have reduced abilities to negotiate salaries. Jobs have gone away and are unlikely to return. Unions will say that greedy firms broke unions. Or, maybe unions were not effective in protecting jobs in the long-term. Politicians (of both parties) were happy to increase trade and see jobs leave for China, Mexico, and elsewhere. Sending jobs to other countries has been good for keeping the price of cars, TVs, and Oreos down and controlling cost. Losing jobs = less salary growth = deflation, too.

The Sharing Economy is a Real Drag: It is certainly hip to be frugal. Share a ride, room, or an air mattress. It is great for the consumer. It is bad for producers. Of course, Uber first comes to mind. Airbnb is, perhaps, a better example. Why build new hotels, when there are thousands of rooms, apartments, and couches available? Utilizing slack resources means new resources are not produced. The demand is not for new items. It is for sharing existing items. That is like conservation in a way. Reuse, reduce, recycle – all good things, but when you share your neighbor’s lawn mower, you have taken a lawn mower, and its maintenance out of the economy. Sharing shows our economy overproduced in some sectors, like automobiles, housing, and even yachts and executive jets! Lower production from lower selective demand yields lower spending = deflation!

Workforce Participation is Low: Consider the following graphic.Total Civilian Labor Force Participation is nearly 63%. That means 37% of the population does not work at all. This includes children, the disabled, and, of course, retirees. In 2000, the civilian labor force participation was nearly 68%. We have 5% more of the population that is just not involved and not counted in unemployment. Total unemployment is a better measure of the state of employment. It is around 9.5% and not the championed <5% mentioned in the news. There are lots of Americans that don’t work. That is a drag on the economy in many ways. Not working = not earning = spending less = deflation.

People Don’t Like Inflation (Even if Economist Like Some of It): In reflecting on all of these deflationary forces, it made me realize that people don’t like inflation and price increases for the sake of price increases. Many industries have moved to unbundled fees. Airlines lower ticket prices (deflation) and then move to various fees. Taxi cab firms might lower mileage rates but charge an energy surcharge. People look at the price, decide based on it and reward business that have not driven up prices. People are on the look-out for inflation and work around it. The Federal Reserve might like inflation, but the consumers don’t! That is more deflation!

The causes of deflation are problematic for the Federal Reserve because it lacks the tools to reduce, control, or remove these deflationary pressures. Of course, devaluing the currency and or lowering interest rates are options, but the Federal Reserve has been on a warpath of rate increases, almost as a mandate that the economy has recovered. But they did not consider the persistence of deflation. Want to change demographics? That requires immigration and tax incentives for having larger families. Want manufacturing jobs to come back to the US? Apply tariffs. Want more consumption? Limit conservation measure and reduce sharing in the economy. Sounds crazy, but the energy rebates are a thing of the past and many cities are trying to limit Airbnb and Uber. Countries like Japan and Singapore, which have similar demographic challenges, are offering families financial incentives to grow. The tools to limit the deflation we see come from the lawmakers, not the Federal Reserve. The solutions can be brash, uncomfortable, and even unpopular (like curtailing conservation, say).

Deflation is here to stay, even if it remains hidden in the economy. Don’t believe me? Banks are happy to lend at low rates at long terms, and many experts are expecting low (as in sub $50) oil prices for decades in the future.  Economists feared that inflation would spiral out of control as economic growth returned, but the real the fear is that we are in an economy that will have stronger deflationary pressures for decades to come.

Keep rates low, Yellen. Lower Taxes, Congress. And have more babies; the economy needs them!

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Professor Russell Walker helps companies develop strategies to manage risk and harness value through analytics and Big Data. He is Clinical Professor of Managerial Economics and Decision Sciences at the Kellogg School of Management of Northwestern University. His most recent book, From Big Data to Big Profits: Success with Data and Analytics is published by Oxford University Press (2015), which explores how firms can best monetize Big Data. He is the author of the text Winning with Risk Management (World Scientific Publishing, 2013), which examines the principles and practice of risk management through business case studies.

Professor Walker has developed and taught executive programs on Enterprise Risk, Operational Risk, Corporate Governance, Analytics and Big Data, and Global Leadership. He founded and teaches the Analytical Consulting Lab, Risk Lab, Global Lab, and Digital Lab, all very popular experiential learning classes at the Kellogg School of Management, which bring Kellogg MBA students together with corporate opportunities focused on data and strategy. He also teaches courses in risk management, analytics, and on strategies in globalization. He was awarded the Kellogg Impact award by Kellogg MBA students for excellence and impact in teaching.

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[1] http://www.jstor.org/stable/1907327?origin=JSTOR-pdf&seq=1#page_scan_tab_contents

[2] https://en.wikipedia.org/wiki/List_of_the_largest_trading_partners_of_the_United_States

[3] https://ustr.gov/archive/assets/Document_Library/Reports_Publications/2001/2001_Trade_Policy_Agenda/asset_upload_file485_6497.pdf

[4]https://ustr.gov/archive/assets/Document_Library/Reports_Publications/2001/2001_Trade_Policy_Agenda/asset_upload_file485_6497.pdf

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Russell Walker helps companies develop strategies to manage Risk and harness value through Analytics and Big Data. As Clinical Professor at the Kellogg School of Management of Northwestern University, Russell Walker has developed and taught leading executive programs on Big Data and Analytics, Strategic Data-Driven Marketing, Enterprise Risk, Operational Risk, and Global Leadership. He founded and teaches the popular Analytical Consulting Lab and Risk Lab, experiential classes, which bring Kellogg MBAs together with real-world projects in Analytics and risk evaluation. His is the author of the book From Big Data to Big Profits: Success with Data and Analytics (Oxford University Press, 2015) which examines data monetization strategies and the development of data-centric business models in the new digital economy. He is also the author of the award-winning text Winning with Risk Management (World Scientific Publishing, 2013), which examines the principles and practice of risk management as a competitive advantage. Dr. Walker consults with firms on the topics of Big Data and Analytics, Risk Management, and International Business Strategy. Russell Walker can be reached at: russell-walker@kellogg.northwestern.edu @RussWalker1492 russellwalkerphd.com



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