Conventional wisdom indicates slowing global economy and increased production are the root causes behind the precipitous drop in oil prices since mid-2014.

In the Economist in December 2014, the explanation was succinct.  “The oil price is partly determined by actual supply and demand, and partly by expectation.” 

To limit the analysis of the decline in oil prices to something as simple as supply and demand is overlooking a potentially dangerous economic reality – deflation.  Deflation, if present, must be dealt with using entirely different tools than those presently used in fiscal and monetary policy.  In reality, current fiscal and monetary policy may be increasing the risk of a deflationary spiral.

Japan and the European Union have been dealing with deflationary concerns for an extended period of time.  Even in the United States, the potential for a deflationary spiral has been discussed by the Federal Reserve in its Federal Open Market Committee meetings.  The Federal Reserve’s primary concern, however, has been the impact of deflation on the world and not in the United States.

The differences between price declines due to supply and demand versus a deflationary spiral are substantial, and the strategies to deal with the two are different.  Policies which fail to deal with the principal reason for the decline in oil prices might in fact exacerbate the economic problems the world is currently facing.

Deflation is characterized by falling prices, falling incomes, declining value of real estate and an inability to fund government debt and unfunded obligations.

Since the 1980s, the world financial leaders have been continuously battling one crisis after another with each cycle becoming more severe and more pronounced. The Japanese have been dealing with the real estate deflation and concurrent economic deflation since the mid-1990s.

Since the “dotcom” bubble burst in 2001, the United States and the European Central Bank have been struggling to stabilize economies with aggressive fiscal and monetary policies. The net result of all of their stimulating policies since 2001 has been more erratic economic cycles.

The potential reasons for these erratic results are that the central banks are fighting the wrong problem.   They are attempting to stimulate demand where they need to make significant structural changes to the economy to combat deflation.

The unintended consequences of the current policy decisions have been severe and have resulted in low-to-no economic growth.

In Keynesian economic theory, government spending is used to smooth out economic cycles. The danger of such policies is that the negative growth effects of existing substantial government debt are not factored into the economic model because massive government debt was not a significant problem in 1936 when Keynes authored his theory.  

Keynes’s theory warned of deficit financing becoming a way of life in the political process, yet political realities encourage this irresponsible behavior to garner votes.

In 2009, German economist Ulrich van Suntum proposed Keynesian Economics 2.0, arguing for a monetary approach to solving the current economic quagmire.  The thought process was Keynesian theories were outmoded in the economic problems of the mortgage-created crisis of 2008. 

These academic exercises fail, however, to consider the tragic effects of misguided fiscal and monetary policy as the potential cause of the current economic disaster.  

The Federal Government’s perception is that government spending creates demand.  The pure monetarist believes that lower interest rates stimulate demand.  

Both fiscal and monetary policies have some merit under many circumstances. When those conditions no longer exist, however, the historical policies of more spending and lower interest rates set the stage to trigger a horrific deflationary cycle.

Additionally, the presence of extensive governmental debt beyond a certain point may have a negative economic impact when the rate of growth of debt slows.  

Debt is a source of funds when it is borrowed but it is a use of funds when it is repaid. The significance of that simple statement is that debt repayment and slowing of debt growth have a negative economic impact, as does slowing down the rate of debt growth!

Focusing only on governmental debt is problematic in that the changes in debt levels by consumers, municipalities, and states must be considered.    Debt repayment is similar to an increase in taxes on the economy and has a negative effect on economic growth.   “Too much debt” becomes an economic reality that is likely to increase the probability of a deflationary spiral.   Unfortunately, no one knows how much “too much debt is,” but there is a limit.  In reality, debt does matter.  

Further signs of the impact of deflation, despite trillions of stimulus funds, include:

1. Negative interest rates on short-term securities and debt instruments.
2. The reduction of risk premiums in short and long-term debt financing for governments.
3. Increasing costs of healthcare for virtually every American, which adversely affects disposable income.
4. Declining real wages in the United States due to tax increases at the state and local levels.
5. Declines in labor force participation rates.
6. Lack of wage growth despite allegedly higher employment since 2008.
7. Substantially declining commodity prices.

The implications of the causes of the declining oil prices in particular and commodity prices in general are profound.

Deflation has devastating effects in every aspect of life.    

First, anyone with debt will find it more difficult to repay the debt in a deflationary cycle. Incomes and prices will fall, making debt repayment difficult or impossible.

Second, organizations with high fixed cost such as airlines, hospitals, automobile manufacturers, drug and pharmaceutical companies, governments, and sports teams will find that they must reduce prices in order to cover their fixed costs or risk losing customers. While this strategy works in the short run, the economic consequences of the lower prices will ultimately translate into lower pay.

Third, once the deflation cycle starts, the ability of a society to pay for things such as Social Security, retirement benefits, unfunded obligations, and any type of retiree healthcare cost will be impaired. The deflationary spiral will prevent any of these organizations from increasing prices. 

Monetary and fiscal policies can only do so much for so long before they become ineffective. Sound fiscal and monetary policies mean that countries are bound by the same financial and economic realities as a household over the very long run.  Elected leaders fail to recognize this and this failure is core to the failed policies of the present.

To reverse the effects of deflation, government spending and taxes must be reduced.  Government must also improve the regulatory climate and avoid intervening in periods of economic stress because it only reinforces the concept that there are no negative consequences for bad economic decisions.   Finally, to stop a deflationary spiral, our government must reduce uncertainty and provide stable, consistent policies that permit planning by job creators.

Until our government realizes that the culmination of accommodating fiscal and monetary policies for decades is leading to a deflationary spiral, we are doomed to even greater economic volatility than we have ever experienced in the past.

Solve the deflation problem! It is not just about supply and demand. It’s about spending, taxes, and uncertainty.

Col. Frank Ryan, CPA, USMCR (Ret) and served in Iraq and briefly in Afghanistan and specializes in corporate restructuring and lectures on ethics for the state CPA societies.  He has served on numerous boards of publicly traded and non-profit organizations.  He can be reached at FRYAN1951@aol.com and twitter at @fryan1951.