DIY investor: Rethinking deflation

Well known investors usually say they ignore the macroeconomic backdrop because good companies can prosper whatever the conditions. I tend to agree: the link between the economy’s performance and stock markets is tenuous. However, I’ve found it harder than usual to ignore economic commentators recently—because I find their explanations of what’s been happening in big parts of the world economy so profoundly unhelpful, not to say misleading.

If we’re unlucky, one of the “words of 2015” is going to be deflation. The appearance of mild price declines in the eurozone has prompted commentators to trot out the stock explanation of how deflation works, namely that it induces people to postpone purchases in the expectation that prices will fall. To my mind this formulation is glib but it seems to be repeated ad nauseam by clever people running on autopilot.

How can it be true in practice? The idea that I would put off buying food because it will be cheaper next week is absurd. If prices were falling by huge amounts per day, I might postpone my morning shop until the afternoon but we are thankfully a million miles from that situation, which in any case could not persist for long. Equally, although I’m used to the idea that the prices of technologies such as smartphones tend to fall, it has never yet induced me to put off buying.

If you’re a professional economist, you’re probably pretty well off. You have the means to make lots of discretionary purchases, so maybe you do indeed put off replacing your second car in the expectation of a better deal later on. But most of us just shop around more energetically, use the internet to compare prices, buy second-hand instead of new, search for voucher codes online, trade down to budget brands or simply decide that we can do without whatever it is, or that our credit card can’t stand the strain and the purchase will have to wait. If you put off buying, is that really because you’re an empowered consumer cannily playing a falling market? No, it’s because you’re feeling stretched.

In many parts of the eurozone people face high unemployment, lots of debt and stagnant wages. Not surprisingly, this makes them very cautious. They’re extremely price-sensitive, they force companies to offer them keener deals and where they can get away with it they don’t buy at all. That’s what deflation in the eurozone looks like to me. And when, as is the case in much of Europe, working-age populations are static or shrinking as well, the pool of people with the greatest propensity to spend is steadily diminishing; no wonder prices are under pressure. The classic description of deflation suggests that people don’t buy because prices are falling. I suspect it’s mostly the other way round: prices are falling because people aren’t buying.

Why does this matter to investors? In these conditions companies see their pricing power vanish, they cut back investment plans, hold down wage increases as far as they can and squeeze their suppliers, all of which helps to spread the pain far and wide. In every industry there will be companies that thrive in this environment and others that suffer: the point is that there will be clear winners and losers as market shares shift within markets that overall are hardly growing.

Economists see a world of rational agents that maximise their own utility but the limits of this model are very obvious when you think for a minute about how people actually behave. When economists are no longer able to describe the world in ways that reflect the experiences of real people dealing with everyday challenges, they become a luxury that most of us can no longer afford.