Why You Should Worry About Japan Deflation?

 

Japanese Deflation – Is the U.S. becoming Japan?

Japan has long been known as an example of what can happen when you allow deflation in an economy which is highly reliant on sustained inflation. What is happening in Japan is one of the reasons that the Federal Reserve is trying so hard to avoid deflation in the US. But is Japan really in the same position as the US?

There are some economic similarities between Japan and the US. However, there are two main factors that differential Japan from the US which may outweigh the similarities. The Japan has a shrinking population where the US does not. Second, Japan is currently stuck in a deflationary trap, where the US is not. These are strong deflationary forces that are hard to overcome.

Japan Deflation Causes – Population Shrinkage

Japan is in a challenging economic situation. This is mainly due to their demographics. They have an aging population, the number of elderly people is quite a bit larger than the younger generations. Anecdotally, in 2011 sales of adult diapers exceeded the amount for baby diapers. The chart below shows the demographics of Japan during 3 periods of time with approximately 50 years in between. A shrinking population can become a problem for an economy because it is a strong deflationary force. Japan has an aging population which will only continue to shrink over the next few decades. While other developed nations have stagnant or slow-growing populations, this is not ideal for an economy to expand.

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Japan’s demographics show a strong deflationary force

Japan Deflation Causes – Deflationary Trap

Another problem Japan has, partially due to its demographics, is it has fallen into a deflationary trap. A deflationary trap is when a country enters an economic period where the typical central planning solution of lowering interest rates and printing money does not cause inflation. These are the two primary tools central banks use to create inflation. A deflationary trap is a self-reinforcing cycle, which is not easily corrected. It happens when the population changes their psychology towards money. Changing a person’s psychological attitude towards money is not easy to do. Once it happens, it becomes reinforced by the actions of other people. Central banks around the world have a fear of allowing their country to fall into this deflationary trap. This is one of the reasons that their initial reaction to deflation is to use monetary tools such as printing money in order to restart inflation.

Ben Bernanke made a point at one of his speeches in November 2002 at the National Economists Club in Washington DC that throwing money from a helicopter would effectively eliminate deflation (based on Milton Friedman’s “Helicopter drop”). This may be true in theory, but once people have been conditioned to a certain environment, it is hard to change their mindset. As the astute philosopher Yogi Berra said,

“In theory there is no difference between theory and practice. In practice there is.” -Yogi Berra

As radical as this idea of throwing money from a helicopter is, it might be under consideration at the moment. The Council on Foreign Relations, the power brokers of the US, published a paper in their periodical, Foreign Affairs, recently discussing how we needed to give tax paying citizens cash rather than giving it to the banks to stimulate the US economy. While the article was full of holes in how it describes the benefits of such a policy, it shows the powers that be in the US are afraid of becoming Japan and will consider even the most extreme policies to avoid that outcome.

Should you be worried about deflation?

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“Helicopter” Ben Benanke’s solution to deflation

Why is the US so afraid of deflation with the S&P 500 at all-time highs? If you look at the numbers in the Inflation Monitor, you can clearly see that the Federal Reserve has not created the inflation it desires. While you might think of the S&P 500 as an indication of whether inflation exists in the US economy, you are not seeing the whole picture. You have to ask yourself is this question, If the US is experiencing inflation, why has the Federal Reserve continued with its Quantitative Easing (QE) measures for five years? Why have interest rates been kept low for 7 years?

As of the end of October 2014, the Federal Reserve has taken a break from their quantitative easing program. Coincidentally, shortly after the Federal Reserve concluded its most recent round of quantitative easing, the Bank of Japan surprised the markets (sort of) and started up their own version of QE. The European Union has also started their version of QE as well. Globally, there are massive money printing efforts taking place and may continue into the foreseeable future.

Why are countries around the world embarking on a massive effort to spark inflation? Primarily because it doesn’t currently exist in a sustainable form. Creating inflation can be done at any time. The problem is creating sustained inflation, as has existed in the US for the past 60 years. Creating sustained inflation is hard to do since it requires changing the population’s psychology about money. When people are saving, instead of spending – when they are paying down debt instead of investing – when they don’t generally assume that they could easily earn more money in the following year or get a higher paying job, that is a deflationary psychology. With this deflationary mindset rooted firmly in the psyche of the public, it is very hard to create inflation by “throwing money from a helicopter”.

The average person’s view of money would have to change. If the Federal Reserve or the US Congress decided to give people cash rather than giving it to the banks, and the psychology of people is to save, or pay down debt, all this will do is to allow people to pay down their debt or save it for a later date. If you want proof that the US is experiencing deflation, this is how you could easily make that determination. Give people cash and see what happens.

“Printing money does not lead to prosperity. If it did, Zimbabwe would be the strongest economy in the world.”

Why should we care about Japan deflation?

Japan’s problems aside, they are not the only ones experiencing a deflationary period. Europe entered a period of deflation a few years ago with the global economic crisis, and they have had a hard time ever since. Each country of the European Union has its own economic problems, which collectively weigh down the entire union. While the PIIGS (Portugal, Italy, Ireland, Greece and Spain) of Europe are having a challenging time with high unemployment and slow economic growth, the EU has effectively been supported by Germany. However recently we have seen that Germany is also experiencing its own economic challenges.

According to the IMF (International Monetary Fund) the top 20 economies ranked by Nominal GDP are:

Japanese deflation

If we look at countries in the top 10 (2010), the only countries which are growing at a reasonable pace are: the US, China, Russia, and United Kingdom. Of these, Russia is slowing sharply since much of their economy is based on oil and commodities and commodity prices have been weak. China has also been showing signs of significant slowing as well.

So if the largest economies in the world are not expanding at a strong and consistent pace, then how can the US expand its economy?

Are global economies connected?

The short answer is yes. The long answer is… well, long. A lot longer than the space here allows for a reasonable explanation. The simple way to explain it is that economies are no longer isolated. Large corporations are global and because of this global nature of their business, recessions and poor economic conditions globally affect their profits and this filters down into the other country economies. The well-used phrase: “When the US sneezes, the world catches a cold.” also works in reverse. While the US and other developed nation economies may be growing now, if the growth is only limited to those countries, eventually that growth will slow and force the US back into a recession. While the US economy is currently one of the only ones showing signs of strength, that cannot continue for long, especially with a strong dollar which will hurt our exports.

Can the US economy decouple from other global economies?

This is a myth that is prevalent when emerging markets and other developed markets enter recession before the US and while the US isn’t showing signs of recession. When other economies begin to enter a recession, the US is usually not far behind. I heard the talk about decoupling in 2007 right before the global financial crisis appeared. This was while the US had an inverted yield curve which is never a good sign. Now with interest rates virtually at zero, it would be impossible to have an inverted yield curve unless interest rates went negative.

What should you do about deflation?

  1. Change your point of view – The first thing you need to do is to change your view of money, investing, debt, and saving. In an inflationary environment, the optimal consumer behavior is to use debt to your advantage. Over time debt is inflated away. Inflation also causes assets prices to rise encouraging investing over saving. Inflation deters people from keeping cash in an unproductive form. Deflation is the opposite. Deflation causes consumer behavior to prefer cash over debt, thus people pay down their debt, because deflation makes debt more expensive over time. Deflation discourages investing and spending because over time goods and services will get cheaper. Consumers know this, so they don’t buy items today, they will buy tomorrow because they assume it will be cheaper tomorrow. When too many consumers think this, it can actually cause this deflationary force to happen.
  2. Pay down debt – Debt becomes more expensive over time in a deflationary environment, so you should consider paying down debt.
  3. Save your capital in cash – In a deflationary environment, cash becomes more valuable. Its value increases vs. the goods and services it can buy. During these periods of time many people don’t have cash, so it makes it more important to have it.
  4. Find secure sources of income – In a deflationary environment, having a strong source of income is important. These are not times where you should take high risks in order to try to earn a higher income from investments. Being more risk adverse than normal should be in your best interest.

Conclusion

While we experienced a deflationary episode in mid-October, The US economy is still showing signs of strength. The US is actually one of the few places in the global economy which is showing strength. In the short term, this is a good thing. This may continue for a while, however, it cannot last for long. The world is too connected to allow for an outlier economically. A stronger US dollar will hurt exports, and although this may take a few quarters, it will eventually show up in corporate earnings. Oil prices have dropped significantly in the past few months. This should help corporate earnings due to lower transportation costs. However, this also reduces the profits from the energy sector, which will put a drag on the US economy as well as other oil producing nations.

The Inflation Monitor has started to show us signs of deflation creeping into the US economy. We expect this deflationary force will not be apparent to most people at the moment, however in a few quarters if these trends continue, it should be obvious to most people. Now is not the time to take big risks on over-priced assets. The next few months may provide some interesting opportunities, but these opportunities will be limited. Take some time to build up cash for future opportunities, and try not to spend it all during the upcoming holiday season.

If you want to learn more about inflation, deflation and how they currently stand in the US economy, read our monthly report, the Inflation Monitor. Click the button below to subscribe, and you will automatically receive your monthly issue when we release it.

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About Innovative Advisory Group: Innovative Advisory Group, LLC (IAG), an independent Registered Investment Advisory Firm, is bringing innovation to the wealth management industry by combining both traditional and alternative investments. IAG is unique in that they have an extensive understanding of the regulatory and financial considerations involved with alternative investments held in self-directed IRAs and other retirement accounts. IAG advises clients on traditional investments, such as stocks, bonds, and mutual funds, as well as advising clients on alternative investments. IAG has a value-oriented approach to investing, which integrates specialized investment experience with extensive resources.
For more information, you can visit: Innovative Advisory Group
 

About the author: Kirk Chisholm is a Wealth Manager and Principal at Innovative Advisory Group. His roles at IAG are co-chair of the Investment Committee and Head of the Traditional Investment Risk Management Group. His background and areas of focus are portfolio management and investment analysis in both the traditional and alternative investment markets. He received a BA degree in Economics from Trinity College in Hartford, CT.

Disclaimer: This article is intended solely for informational purposes only, and in no manner intended to solicit any product or service. The opinions in this article are exclusively of the author(s) and may or may not reflect all those who are employed, either directly or indirectly or affiliated with Innovative Advisory Group, LLC.