Sunday, April 30, 2017

Early Indications April 2017: A Great Deflation?

In agricultural and industrial economies, price inflation has historically been a major concern. High interest rates make borrowing money, for everything from housing to highways, unappealing or impossible. Rising prices for essentials force more and more people on society’s margin to choose between heating oil and food, literally or figuratively. Business planning and government administration become difficult when the future picture is fuzzy. In extreme cases like present-day Venezuela, where prices rose 741% in the year to February, the country becomes nearly ungovernable.

In the U.S., the official inflation rate has been 2.1% or lower seven of the past eight years, including years of -.4% and .1%. My starting point for this newsletter was a chart of prices over the 1996-2016 span by the economist Mark J. Perry of the American Enterprise Institute. He shows that college tuition far outran any other economic good in its 20-year cost increase, while new cars held pretty steady and televisions got significantly cheaper. 

If we look back to about 1985, wages for middle-income U.S. earners have been stagnant, so low overall inflation is not a surprise. One reason companies can re-shore factories is that U.S. labor is pretty cheap, by global standards, especially if health benefits are somehow removed from the calculation. One way to do this is use automation, getting more work per human (and insured) employee. Thus the current boom in US manufacturing plants benefits from a lot of advanced manufacturing technology: over the past five years, Rockwell Automation (which makes assembly lines and related stuff) has seen its share price shoot from $62 to $157.


Moore’s law and technology economics more generally — such as mass production of smartphone camera sub-assemblies — are partially responsible for some of this price compression, but not all of it. One example: the Apple II sold in 1977 for the equivalent of 5100 current USD. Globalization (including low offshore manufacturing wages and the low costs of containerized ocean freight) is absolutely in play, but again, is only part of the answer. 

Consider toys. The original Barbie cost about $23 (2011 dollars) at its launch in 1959. Wal-Mart currently sells at least three different versions of the doll, without accessories, for $5 apiece. And while televisions have come down in price, cable TV service costs have skyrocketed, in part driven by rights holder fees: subscribers pay more to Comcast, which pays more to ESPN/Disney (and adds players like Food Network and other new channel providers), and ESPN bids up the price for sports rights from leagues and college conferences. The average monthly revenue per Comcast user in 2001 was $35; it’s now nearly $84.

Cars are complicated because apples-to-apples comparisons are impossible. A 2017 model has features including stability control, remote tire pressure monitoring, Bluetooth, and the like that have no counterpart on a 1967 or 1987 model. Also, even the same model is typically bigger and heavier over time: a 2017 Honda Accord is about 8 inches longer and 400 lb heavier than its 1990 predecessor. A standard-configuration Ford F-150 pickup in 1990 was a foot and a half shorter than today’s equivalent and had almost exactly half the horsepower. Are cars getting cheaper? Counting parking, insurance, and the like, most certainly not. But there’s increased content to the vehicle as well.

And the story gets even more complex, Energy, for example, was priced historically low in 2016 as natural gas far underpriced coal, with or without Obama-era EPA standards factored in. One estimate suggested a generation switchover point from coal to gas at about $2.50 per million BTUs of gas; in March 2016 the price hit a low of $1.64, but 13 months later, the price has doubled to $3.19. Power generators must balance a portfolio of generation and storage options, at the same time that alternative energy is quietly but rapidly making an impact. Last December, Texas used wind power for 40% (or more) of its power for 17 hours straight, while California met 40% of its power needs with solar for three hours on March 11 of this year. Electric rates momentarily turned negative on the wholesale exchanges, in part because a wet winter is helping hydro plants run at high levels of output. Thus it’s impossible to say there’s large-scale price depression in electricity, but clearly downward price pressure is a factor in specific locales.

Digital deflation

Moving back into digital markets, think of all the free content we get via the Internet. Each of the following is a source of deflation and, importantly, job loss:

  • news
  • investment information
  • music (compared to $16 CDs)
  • streaming video (Amazon’s Prime is not technically free, but psychologically Prime membership is a sunk cost)
  • tech support, training, instruction (how many things can YouTube NOT teach you to do?)
  • reference services
  • maps.

Michael Dell famously lowered prices across the PC sector 20 years ago when his company applied supply-chain efficiencies to the segment. His successor in margin destruction, Jeff Bezos, has affected the value and service expectations of tens of millions of shoppers (including those in the market for Dell’s servers who now buy cloud computing instead). Publishing and bookstores are obvious victims; now the focus is on mall retailers, who are dropping by the wayside on a nearly weekly basis.


Again, it’s not a simple story. The U.S. has substantially more retail real estate, measured on a per capita yardstick, than any other country on earth: at about 24 square feet per person, that’s twice as big as Australia (#2 on the list) and six times the space of the UK. Correction was inevitable, and enclosed malls are a common starting point. With department store consolidation, there are fewer potential anchor tenants, especially as Sears, a common standard-bearer, publicly expresses doubt it can remain afloat. Sporting goods has been hit hard as Sports Authority closed 423 stores while shutting down operations and outdoor specialist Gander Mountain filed for bankruptcy in March. In apparel, Bebe will close all stores by the end of next month, following the lead of Payless Shoesource. Credit Suisse projects a total of 8,600 U.S. store closings this year, which would be an all-time record.

Consumer electronics is an already-difficult category to win in, with the luxurious high-touch Apple Store at the top of the segment and Amazon and Wal-Mart hammering prices downward at the bottom. If you’re Best Buy or Staples in the middle, what can you do? After they reset the electronics market, Amazon has emerged as the #2 U.S. apparel merchant, barely trailing Wal-Mart according to Morgan Stanley estimates. The company is adding its own brands of men’s and women’s clothing, I’ve noticed, following its Amazon Basics electronics accessories and store-brand snack foods. In the stationary store category, Office Depot already merged with Office Max, while Staples lost half a billion dollars last quarter and is closing 70 stores on top of 242 locations shut down in the prior two years. As big as Amazon is, and as fast as it is growing, there are still many categories where it could increase its imprint. Thus far it has only scratched the surface of grocery, and big-box home centers seem, for the moment, to be faring reasonably well: a gallon of paint is a tough item for online retail, as is a wheelbarrow or sheet of plywood.

The big picture

Thus we have a story with very different messages for different populations. Amazon investors continue to bid its share price up at the same time that truly good local bookstores are continuing to survive and thrive long after Borders went away. As mobile telephony replaced wirelines, AT&T and Verizon shed tens of thousands of jobs while nobody seemed to notice. And when L.L. Bean wants to increase production of its signature leather/rubber boots in the U.S., finding both skilled labor and onshore suppliers constrains production: 50 years ago, 98% of shoes worn by U.S. consumers were made here. 

Yet as Noah Rothman notes in a recent article, job losses in declining industries sometimes make for potent political theater. President Trump has focused on coal mining, which employs only about 16,000 “extraction workers or helpers,” according to BLS data quoted in the Washington Post. More generally, the St. Louis Federal Reserve Board counted 65,000 coal workers in 2015. Whatever the number, consider how much more potential political attention might be devoted to disappearing retail clerks and salespeople, whose ranks number in the 14 million range — about one job in ten in the U.S. Like miners, many retail workers — about a quarter of hourly retail employees, according to one estimate — live close to the poverty line. What will be the dominant narrative? A) Efficiency and convenience benefit enough people that a lost Circuit City or Bebe or Sears isn’t widely mourned. B) The enclosed mall was an American social center (rather than a blip in the long history of public space), and the shopping experience deserves to be propped up somehow even as demand for that experience is plummeting.

Deflation is a complex business. The customer benefits of falling prices or “free” stuff often have a social cost, in part of inefficiently designed business processes populated by working people who lose their jobs through “structural dislocation” or some such abstraction _that isn’t their fault_. In some cases, technological improvements deliver a free lunch, saving time, money, and worker dignity or some version thereof. Elsewhere, we see very long cycles in play: Britain recently witnessed its first day with no goal-generated electricity since the 1880s. 

Who’s next? As Mark Perry noted at the beginning of this note, higher education is prime for a reset. Local teacher and police pensions are bankrupting some municipalities. The common thread is government involvement: how often have we seen public goods be disrupted, with significantly lower costs passed through to customers, the same way that commercial innovations like containerization, Moore’s law, or air travel have lowered prices of formerly expensive goods or services? Should it actually happen, the deflation of the bureaucratic state could be one of the biggest stories of the 21st century.