Deflation, Not Inflation, Is Your Worst Enemy

Some of the most common questions and comments we get concern inflation and the money supply. Many feel that a fixed or tightly controlled supply of money would prevent inflation. One email predicted chaos due to rampant "double digit" inflation "sure" to come next year because of the Fed and Treasury's recent actions. There is a hidden danger to a lack of inflation that is not readily apparent.

In any business, there are a certain amount of costs which are fixed, while others are variable. Take the production of any widget for example (cars, hamburgers, airplanes, or even loans). Workers can be hired, fired or their compensation adjusted based on production. The volume and price of raw materials also varies with the volume of production. These costs are mostly variable. However, the factory, store or building in which they work is a fixed cost. Rent must be paid; energy consumed for heat and power; taxes on the land, etc. These cost are largely fixed- they must be paid whether the business outputs 100 or 1000 or 10,000 units.

Let's say a business has revenue of $100 million, variable costs under normal circumstances of $40 million and fixed costs of $40 million. On normal output, this company would earn $20 million. Now say demand falters and sales fall to $80 million. Variable costs ought to fall roughly with sales after adjusting for needing less labor and materials. So, variable costs fall to $32 million, but fixed costs remain at $40 million. The business now earns just $8 million. A 20% fall in revenue translated into a 60% fall in profit.

Consider that debt is also a fixed cost in the short to medium term. Those interest payments must be made regardless of sales for that is the nature of a debt covenant. Imagine that same business as above, only they had borrowed $40 million at 8% to build the plant. That $8 million barely covers the $3.2 million in interest, nevermind the reduced ability to actually repay the principal.

What does this have to do with inflation? If prices rise say 3% per year on average (moderate inflation), after a few years this results in about 10% more revenue for the same amount of production. Those sales in our example ought to go to $109.3 million, variable costs to $43.6 million while fixed costs remain at $40 million = profits of $25.7 million, more than enough to pay any interest or reduce the debt load. Mild to moderate inflation creates a safety net of sorts with respect to the safety of making loans.

When deflation sets in, what incentive do you have to buy now, instead of waiting a little longer? After all, that tv/car/home/clothing item/etc will be cheaper in a few months. That delayed revenue (falling sales) crushes the ability for the economy to cover its fixed costs. It becomes a self-fulling cycle: You wait to buy, more businesses go under. This creates excess capacity, so new stores or stores renewing leases get to lower their fixed costs. Slightly lower fixed costs allow them to lower prices more. You wait longer. This is the simplistic version of a deflationary cycle, but in the real world it looks like the Great Depression.

It gets even worse when sales fall because of lower prices, but not necessarily lower units. If production volume remains about the same, the variable costs don't necessarily decline as much as prices. This squeezes margins even further.

All this is timely because today's CPI (consumer price index) plunged 1% this month. That doesn't sound ominous, but consider this is the worst since records began in 1947 (and translates to an annual rate of 12%). One month does not a trend make, however it is certainly not a good data point given the current state of the economy and markets.