Consequence of Innovation: About Twenty-First Century Deflation

By: Wojciech Kic

What is deflation?

Deflation is an economic term generally associated with decreases in pricing and spending.

When and how did the current deflation begin?

The introduction of the internet in the early ‘90s triggered deflation by rapidly increasing innovation. In the pre-internet world, the return of capital invested in a new gadget was protected by the time it took to invent, and organize the production of a better model. For example, it took humanity over 4,000 years to build the very first telephone.The first cell phone was built some 100 years later; and today for only the purchase price of a “smart” phone, users even acquire global free video link when paying for basic voice service. The internet breaks down barriers to new ideas, and it accelerates innovation beyond the time necessary to return the investment, which exposes investors to unacceptable risk.

Why is the shortage of acceptable risk translating into decreasing prices?

Increasing financial competition for the decreasing availability of acceptable risk is decreasing interest rates. For example, when two investors vie for one opportunity to invest in a newly created “” their competition results in lower cost of investment capital. The remaining, seemingly idle capital is lying in wait willing to work for the smallest returns. In turn, to defend, existing companies must decrease prices to discourage future competitors from entering the marketplace.

But wouldn’t lower prices increase spending?

When customers spend, they engage in profit maximization activity. During inflation, for example, customers spend more, because the future will cost more tomorrow. Because during deflation customers expect decreasing prices, profit maximization to the customer means spending less.

OK, but then why are so many products going up in prices?

Inflationary prices on some products are caused by reduced supply which is a hedge against increasing risk for existing businesses. For example, car making is profitable today only because production is reduced just below the level of pent up demand, as opposed to excess demand only a few years ago. During deflation, profit maximization model equals to pent up demand less one; the rate of deflation controls the difference.

And what about prices of commodities?

It is through the price of commodities that we can measure the rate of deflation.The shortage of viable investment opportunities is causing commodities, especially gold, to absorb excess cash. In terms of value of gold all goods and services dropped in price by some 20% in 2011 alone. Conversation over the uselessness of gold is but an effort to protect the value of cash.

OK. But what about the cheap dollar?

Twenty-first century deflation is global. In a world flush with cash it remains for the most competitive currency to get the job done, and price out the others. Thus, just as an investor wins by providing the least expensive capital it is the “cheap” dollar that is now the strongest currency, even when declining overall, and not the other way around.

If an increasing risk depresses interest rates, and causes deflation, then what exactly causes high interest rates, and inflation?
During inflation increased competition between borrowers increases interest rates, and it silences lenders. Deflation shuts up the borrowers.

Lets’ bring it to the terms of Main Street.

Twenty-first century deflation ends trickle-down economics. The defensive corporate profit hoarding, some 3 trillion using 2011 as a base line, has far worse socio-economic impact than an economy dominated by money losing enterprises. While individually money losing is undesirable, collectively, it has a positive social impact because a business loss enters the economy as someone else’s gain.

While in the Keynesian non-growing economy the government simply spends more money to stimulate it, more government spending today worsens it, because it only increases the pool of idle cash and decreases interest rates to below zero.The suddenly diminished ability of traditional fiscal tools to leverage our way out of deflation seemingly transfers power over the economy to corporations. “Occupy Wall Street” is a spontaneous social response to government’s inability to counterbalance corporate interests.The successful effort to disperse it is the paradox of the twenty-first century deflationary governance.

Are there other examples?

Twenty-first century deflation is about extreme competition. It demands a frictionless, waste free economy. It is a permanent process that demands concessions not only from companies but also from individuals. For example, the ongoing decreasing highway fatality rate and the crime rate in America have been reducing collective cost, and it represents a personal change in response to the economic forces at play. Regrettably, less competitive societies will take longer to adapt, their breakdown is evident, and likewise it’s been ongoing. Afterall, we did not get here overnight.

Can we stop deflation?

Deflation now brings the future forward. It is a natural outcome of the quantum speed of progress which cannot be put in reverse. Physical production of new gadgets has necessarily retarded progress in the past.The absence of physical production will remove the last economic bottleneck. However, since the future economy will play out in the virtual world, valuation models must be invented to pay for new ideas that become pieces of the future. But for these models to exist, we must start the debate about the future, and only then, with the end in mind, progress will absorb excess cash capital, and create widespread prosperity.

When do we start?

Dealing with twenty-first century deflation is new, and accepting it will take some getting used to. The sooner we accept deflation’s permanence, the sooner we can manage its message, the delay of which grows at an increasingly negative compound.

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