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  Posted on: Thursday, July 7, 2005
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Cycle of Deflation Revisited
Written: 07/07/05

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We have been strong believers in the deflation theme since these comments began in February of 2000, and even before.  We are attaching the chart showing the "Cycle of Deflation" at the end of this comment, so you might want to scroll down and print out the chart as you read this. 


As you can see on the chart, the cycle starts with typical economic investment which during the "bubble" of the late 1990s evolved into over-investment (or malinvestment) and excess debt.  This logically winds up with excess capacity and weakness in pricing power.  This has been evident since the bursting of the bubble and continues to show up today (witness the GM incentive plan which allows the public at large to get the same discounts as the GM employees).  Although there are remnants of the beginning and middle of the cycle as it evolves, the place on the chart that is the most dominant is Devaluation, Competitive Devaluation and Protectionism & Tariffs.  We have had a few instances of some "beggar-thy-neighbor" policies (selling products to trading partners below cost in order to keep plants open and people employed).  We can go back over a year to see the dumping of TVs below cost by the Chinese to the USA, as well as dumping of steel in which we retaliated with tariffs.  The last stages of Plant Closings and Debt Defaults are by far the most onerous and painful stages of the cycle.


To understand the consequences of attempting to promote lower currencies than your trading partners we will explain by an example.  If the US dollar rises relative to the Euro currency or Asian currencies our goods would become more expensive and it would drive the current trade deficit to higher and higher levels as the dollar grows stronger.  In other words if our currency declines relative to the Japanese Yen the Japanese goods become more expensive to Americans.  The US dollar would have been able to purchase close to 400 Yen 35 years ago, while now it can purchase just over 100 Yen.  The strength of the Yen from 400 Yen to the dollar to 130 Yen to the dollar in 1989 was, in our opinion, largely responsible for the depression and deflation Japan has been experiencing since 1990. 


Treasury Secretary Snow states in just about every speech he gives, that the USA is promoting a "strong dollar policy".  He has to stand for that, since it seems almost "un-American" to have a weak domestic currency policy.  On the other hand, why are our congressmen threatening China with close to 30% tariffs if they don’t de-link the Renminbi from the US dollar?  Again, the competitive devaluations are more subtle than protectionism & tariffs, but just the same, the linkage of the Chinese Renminbi is a way to keep their currency low relative to the currency of their favorite trading partner (USA).  Just last week Secretary Snow and Fed Chief Alan Greenspan had a closed session meeting with Senators Chuck Schumer and Lindsey Graham, who were threatening to impose tariffs on imported Chinese goods unless they de-linked their currency.


The situation in Europe is very similar as can be seen by the gyrations of the Euro from 117 in 1999 to close to 80 in 2000 as their economies were prospering.  Then the strength of the Euro from 83 to 137 at the end of last year brought the European Zone economies to a screeching halt.  Now that the Euro has started down since the beginning of the year (which may stimulate their economies) makes you wonder if the reason for this is the free market working, or Euro Union policy.


Clearly, the relationship of competitive devaluations between our country and China (as well as Europe) can be seen in the middle of the "Cycle of Deflation".  If we are correct in our "cycle of deflation" theme, the Alan Greenspan "conundrum" would no longer be a "conundrum", but actually make sense.  

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