Forget Deflation

Consumer and producer inflation indexes are both down. Consumer confidence is down. Employment is up. In a vacuum, this is a recipe for a deflationary cycle. Don’t be fooled. Unless you're a dust mite, you don't live in a vacuum.

We live in a world of interconnected national markets. Even though there is ample granite in the 50 states, we import granite countertops from India. Think of that, a boat full of rocks sailing the Pacific. All that fuel and overhead, yet it is less expensive to import the items than to produce them domestically.

I’m not worried about India. Like China and Brazil, it has a diversified economy. So, as the ass falls out of the commodities markets, India will be able to absorb the downturn over time.

Think, though, of Colombia. By natural assets alone, it should be one of the wealthiest countries in the world. Yet, we know that geopolitics prevent national stability. This instability (or chaos and butchery, if you prefer), prevents the country from reaching the market fantasy of maximizing wealth through comparative advantage (low labor costs + abundant resources = lucre from sales with countries with consumer and producer demand for raw materials).

Even with a free trade agreement, what happens when the prices of their exports drop? Farmers go back to growing cocaine. Shippers go back to shipping cocaine inside vats of coffee beans. Bureaucrats receive a higher concentration of bribes from cocaine producers. Military expenditures by the official government increase. Civilian deaths increase. Crime shoots up (so to speak). Instability foments into carnage. Again. Net effect: prices of raw materials will increase due to increased labor and transaction costs (in the form of physical security) and from scarcity as producers of raw materials flood back to the profits of the illicit drug trade.

Play this out in Kenya, Nigeria, Indonesia, Bolivia, Mexico, Egypt. What about Iran? As the demand for oil drops, the wealth dries up. What will the mullahs do to fasten their grip on a population hungry for economic modernity?

Net effect: we’re still sitting on an inflationary time bomb. Prices are correcting as a result of the bursting of the asset bubbles and as consumers feel the reckoning of their own over-leverage. There’s still too much money out there. It’s just not changing hands – yet.