Deflation: You Can't Have Your Cake and Eat It Too

"What's so bad about deflation? I'd love to pay less for the things I buy." I'll admit, that thought has occurred to me lately. I'm glad that gas costs half as much as it did a year ago. I'd be singing a different tune, however, if I were in the business of selling gas. The trouble with deflation is that almost everyone is in the business of selling something. For every buyer who benefits from lower prices, there is a seller who suffers. It’s clear, therefore, that a general reduction in prices is not an unqualified boon.

The concept of deflation is difficult because few of us have ever thought about it. So let's start with inflation.

If inflation is running at 2% when you buy your house, you'll probably pay about 6% interest on your mortgage. If inflation increases to 10%, your lender will increase the interest rate it charges on new mortgages to 14%. The extra 8% interest is intended to compensate the lender for the additional 8% erosion that it expects (annually) in the real value of its principal.

What happens if you get your loan when inflation is running at 2%, and then inflation increases to 10%? In that case, you get a windfall. Your salary will start increasing at a higher rate, in accordance with the higher rate of inflation. (You'll spend more money for haircuts, but the barber will have more money to spend in your store.) Your mortgage payments will remain fixed, however, so they’ll take up a lower percentage of your income than you had counted on.

Of course, your salary increases aren't 'real'. After all, they ultimately result from the Federal Reserve's decision to print more money. We know intuitively that putting more money into circulation won’t make us all richer, but it can make some of us richer. We just saw that an increase in the inflation rate will make it easier for you to service your loan, so you'll be a clear winner. On the other hand, your lender will lose out in the deal because your 6% interest payments won’t even compensate for the 10% annual erosion in the real value of your loan balance.

In short, a sudden increase in inflation results in a significant transfer of wealth, from your lender to you.

Now let's consider the opposite case, where the inflation rate falls from +2% to -10%. As before, there will be a transfer of wealth, but this time, it will be from you to your lender. Your salary will decline at a 10% annual rate, making it increasingly difficult to service your mortgage. Conversely, your lender will be receiving 6% interest on its principal, even while the real value of that principal is increasing at 10% per year.

The problem gets worse. Because the value of your home is likely to be falling (just like everything else), your lender will be getting anxious about its collateral. If you default on your loan (an increasingly likely outcome considering the circumstances), the proceeds from a foreclosure sale may not be enough to pay off the principal. That will make your lender increasingly reluctant to extend new credit against your home. In short, while your creditworthiness is deteriorating and your likelihood of default is increasing, some banker will be losing his job because his employer isn't doing enough mortgage business.

And so on. There's more to the story, but by now it should be clear that deflation means more than discounts at Wal-Mart.

Don't Count on Foreign Buyers to Rescue San Francisco Real Estate

When the housing crash started grabbing headlines last year, real estate insiders were hopefully espousing the theory that foreign buyers would prop up demand for San Francisco housing. The idea was that the declining dollar made US real estate cheaper for foreign buyers, who naturally preferred world class cities like San Francisco and New York. Unfortunately, the theory makes little sense. The reason for any sudden drop in the dollar is that foreigners are trying to reduce their holdings of US assets. Why, then, should they suddenly increase their demand for San Francisco real estate?

The dollar has indeed declined over the last several years, but the decline has been gradual and modest. A careful look at the facts suggests that the resulting impact on foreign demand for San Francisco real estate has been marginal at best.

Currencies rarely move in lockstep with one another: while one currency is appreciating relative to the dollar, another one might be depreciating. In such cases, how can we say whether the dollar is getting cheaper or dearer? Economists address this problem by using trade-weighted exchange rates. The idea is to create an index whose value is adjusted from period to period by applying a weighted-average of the percentage changes in a representative group of exchange rates. The weights are chosen to reflect the amount of trade that each country does with the United States.

Take a look at the chart, below, which shows the inflation-adjusted value of the dollar, measured against a trade-weighted basket of foreign currencies.

Remember that this 'exchange rate' is actually an index: a 10% increase in the level of the index indicates that the dollar has appreciated by 10%, but the level of the index itself is meaningless. (I obtained this series from the Federal Reserve. I re-scaled it so that the average of the index over the last 20 years is 100.)

The index reached its peak value of 117.7 in February of 2002. It reached its recent low of 88.6 in March of 2008. The peak-to-trough change was approximately -25%, which is indeed a sizable decline. Keep in mind, however, that most of this decline happened gradually, over a six-year period. In other words, it's not as if San Francisco real estate suddenly went on sale. The index did fall at an accelerated rate beginning in late 2007, but the cheap-dollar/foreign-buyer theory had taken root long before then. And when the sudden fall did occur, foreign buying slowed, just as I suggested above. (The National Association of Realtors reported that fewer Realtors were working with foreign buyers in August of 2008 -- when the dollar was near its low -- than in August of 2007.)

The latest index value is 98.6. That represents a discount of 16 percentage points relative to the 2002 peak. Again, that's a sizable discount, but it's not exactly a half-off sale. I'm not saying that foreign demand for San Francisco real estate has not increased, but a discount of that size seems unlikely to have had anything more than a marginal impact. And once you reject that simplistic explanation, the notion that foreign demand will prop up San Francisco real estate starts looking like wishful thinking.