Deflation 2003

After decades of sometimes hating, sometimes loving, but always living with inflation, this month we hear financial gurus like Federal Reserve Board Chairman Alan Greenspan talking about fears of falling prices sending the U.S. into a dangerous spiral of deflation.

Deflation has held one of the top three global economies, Japan, in a death-grip since approximately 1989, which has contributed to its perennial economic malaise ever since.

But in America, following the end of the Great Depression of the 1930s, deflation has been a shadowy economic dinosaur, long extinct. Now, it turns out, if it is a dinosaur, it's a coelacanth.

The coelacanth (pronounced see la canth) is a 400 million year-old species of fish thought extinct since the Cretaceous period 65 million years ago. That is, at least, until one was caught off the coast of Africa in 1938.

Webster says deflation is a lessening in value. But in economics, "value" is a relative term, depending on whether you're buying or selling, when you got in, and how much inventory you have.

In a recent Wall Street Journal article, R. Glenn Hubbard, former chairman of the Counsel of Economic Advisors to President George W. Bush, defined deflation as, "a persistent decline in the price level, it weakens borrowers' balance sheets, and reduces consumption, especially business-investment spending." Hubbard further states that deflation, "is costly -- potentially much more so than modest rates of inflation."

The Good And The Bad
Our friend and Brain Trust member, Gary Shilling, has been warning about deflation for over 20 years, and has written several books on this topic. Gary tells us that there actually are two kinds of deflation:

1. Bad deflation. This is the kind Webster and Hubbard defined, where real estate values decrease, for example. The kind that happened during the Great Depression, and now in Japan. Bad deflation diminishes wealth across the board. A healthy economy floats all boats, while an economy with broad deflation lowers all boats.

2. Good deflation. The best example is in the technology industry. A cell phone purchased 10 years ago cost $500 and was just a phone in your car. Today, you can get a features-rich model for free, just for signing up for the service. Good deflation is a product of productivity, and typically creates opportunity, unless you're too invested in the old paradigm.

Good deflation also begets productivity. As a result of good deflation, technological advances have become affordable for Joe and Jane Entrepreneur, whose operations have become more productive and efficient through the leveraging of technology.

In the same speech where he commented on the fragile nature of our current economic recovery, Mr. Greenspan also marveled at the excellent productivity numbers we're producing. We can thank good deflation, at least in part, for those numbers.

Dealing With Deflation
But deflation is a Jekyll and Hyde phenomenon, and Gary reminds us that we have to be careful when we play with it.

In his book, Deflation: How to Survive and Thrive in the Coming Wave of Deflation, Gary lists 25 strategies that we should consider as we move our businesses ahead in this split-personality marketplace, which may be inflationary in one sector (healthcare insurance and energy), and deflationary in another (cell phones and long distance service). I'm going to summarize a few of the items from Gary's list, which are critical for small business owners.

1. Cut costs and push productivity
One way to accomplish this strategy is to embrace and employ technology in your operation. Remember, technological innovation, delivering affordable capability and increased productivity, is often one of the best examples of good deflation. Finding enough people to work is going to be a long-term challenge. Therefore, look to technology first for solutions, and then hire people.

2. Keep inventories down
In modern day materials management, you MUST use just-in-time inventory practices. It's much easier to train your customers to take delivery tomorrow, just-in-time, than it is to explain to your banker why all of your cash is tied up in deflated inventory, just-in-case.

3. Explore niche opportunities
The opposite of filling a niche is selling commodities. Things that are most vulnerable to deflation are those that are, or can become, a commodity. Leave that stuff to the Big Boxes; they can afford to hedge. Fight for your niche like a terrier, service your customers within an inch of their lives, and focus on your core business like your life depends on it.

4. Understand the challenges and opportunities of deflation
Check your products and services to see if they are at risk for a deflationary trend. Even if you are finding opportunity in selling a particular item that is part of a good deflationary trend, if you own too much of it, that can become bad deflation to you.

Shifting Paradigms
Paradigms are shifting all over the place as increased productivity spawns good deflation, which then begets more productivity. Small organizations are doing things today at an acceptable expense that, a handful of years ago, would have cost so much as to have been prohibitive. Think about that: from cost prohibitive to full implementation and full control in less than a decade. In macroeconomics terms, that's good deflation at light speed.

Are we headed toward wholesale deflation resulting in widespread financial collapse? It depends on whom you talk to. But you don't have to be an economic visionary to see plenty of deflationary evidence creating both challenges and opportunities. The lack of pricing power by businesses is one elementary indicator we amateur economists can watch as we track the phenomenon of deflation.

Here's my prediction: I think we're in an extended period of low annual inflation, less than 2%, but where the value of goods of certain industries will experience deflation. We're going to continue to have an economy where new innovations combine with globalization to create intense competition, where the forces of natural selection will not be very subtle.

For decades, our monetary authorities, primarily our central bank, the Federal Reserve Board, have been fighting the last war, inflation. But now, there seems to be the possibility of this new enemy. Deflation is enough of a reality that you should make sure you know where the deflationary challenges and opportunities are for your business.

And if you think deflation is extinct, did I mention the coelacanth?

Write this on a rock... Your good deflation is someone else's bad deflation. The trick is to be on the good side of this dance as much as possible. Forewarned is forearmed.