Deflation, not inflation, is the real economic risk

Hi everyone, Peter Zeihan coming to you from Monterey Bay in California where I just spoke to the Naval Postgraduate School on threats and evolutions in the international system. Today, we’re going to take one of the questions I was asked there and turn it into a video for our ongoing open ended series on things that I do or do not worry about. This is one that I do worry about. Specifically, it’s about deflation. Now, before we get into deflation, for those of you who are not economists, we need to define what that is. And I think the best way to do that is to put into context that everyone would recognize readily. So we’ve all heard about inflation and inflation has been the foe for most countries in most of modern history. And it pretty much happens whenever there’s a disconnect between supply and demand, either supply of a product is insufficient, or demand for that product is too high. Now, I don’t mean to belittle the inflation pain that people have been feeling on and off for the last few years. It’s very real, it’s no fun at all. But one of the beautiful things about inflation and combating it is it’s relatively self regulating. So if inflation is too high, one of two things can very easily happen. Number one, that the producers of a product are now incentivized to produce more of it because they can charge more, in which case you generally bring the supply demand back into balance. Or Second, people can get tired of paying so much, and so they can buy less. And so either supply can go up or demand can come down. And those will happen naturally without any action from government doesn’t mean to suggest government doesn’t put their finger on the scale here. Of course they do. But the self regulating nature of inflation, means it’s a more manageable problem. In comparison, deflation is like the hideously ugly, bitchy little sister of inflation because it’s not self regulating. When you have a break between supply and demand, in an era where demand falls below supply, prices start to drop. But eventually, it builds expectations among consumers that they’re going to continue to drop. And so people put off their orders. Well, if that happens, then all of a sudden companies that are making these products tend to produce less of them, because they can’t make any money. And then people start to be unemployed. And when people are unemployed, their demand goes down because they don’t have the money. And so while as inflation tends to self limit, deflation tends to self reinforce. And building a policy set that can get you out of deflation is an order of magnitude more difficult. So we’ve all heard inflation, this inflation that on and off for the last few years, and honestly for the last 75. But deflation, when it gets its claws into the economy can be really, really terrifying and can take decades to fix. And oftentimes on its way out, it does a lot of damage. So for example, the last time we had meaningful deflation in the United States was during the Great Depression. And we got them in wage spiral that went up, but a product spiral that went up more in the roaring 20s. And what that eventually did was supply exceeded demand. And that led to a plunge in everything that ultimately culminated in the Great Depression. And if it hadn’t been for the stimulus that we saw, moving into World War Two from the government for the military buildup, we may have never recovered. A more recent examples in Japan were in the 1990s, they were boom, boom, boom, boom, boom. But eventually, their product production got so high that they overwhelmed the domestic market, starting off a three decade period of deflation that they’ve only very recently recovered from. And as a result of the American experience in the Great Depression, GDP dropped by a third. And in the Japanese situation, we had basically 0% economic growth for 30 years. And the Japanese economy of 2024 is in almost the same size as the Japanese economy of 1995. Now, where is this an issue? Well, any country that has a significant export portfolio for finished goods, but has run out of young people to consume them, is in some degree in danger. The two economic systems in the world where that is most true, are the German auto centric systems of Central Europe. And then of course, the Chinese system. Over the two I am much, much, much more worried about the Chinese system. In the case of Germany, there has been a recognition that a lot of the model needs to change. Most of the energy used to come from the Russian system and a lot of the end product used to go to China. And since there’s a recognition that neither of those are long term solutions for the Germans, there’s already a significant amount of industrial restructuring and as a rule when you have reached structure, you’re going to have an inflationary impulse because things are moving around. That doesn’t mean that the risk is zero. But it does mean at least some of the normal economic processes are taking effect and inflation tends to self correct. China has a much bigger problem. Every couple of months, we get even worse the demographic information about the Chinese system, we now know that they’re not just reading out of teenagers and 20 Somethings, but 30 Somethings and 40 Somethings. So the age group that would normally do the the consumption as getting smaller and smaller and smaller and smaller. At the same time, China’s dependence on exports gets higher and higher and higher and higher. All it would take is a significant policy change and not even a very large one. From a major economy. The United States and Western Europe are the two biggest chunks that would restrict Chinese exports. And all of a sudden, all of that product gets locked up in the Chinese system itself. We also know that 70% of private citizens in China is locked up in real estate, in an industry where there are more spare apartment units than anywhere else in the world. In fact, if there’s so many spare units now that are representative of people’s wealth, then you could house more people in China in those spare units, then the rest of the world has spare housing units by us of five. None of this works. And it’s a recipe for a deep deflationary system. And if you want to make this a little bit more complex and a little bit more problematic, it is perfectly capable a system is perfectly capable of having deep deflation and inflation at the same time. So again, the Chinese system this is a country that imports 80% of its energy. This is a country that imports more food than any other country in the world. And this is a country that imports most of the inputs that allows them to grow their own. You can have inflation in energy and food at the same time. You have deflation and overall consumer demand and manufactured goods. And that mix we have never seen before. And I can guarantee you, it would be ugly. So yes, deflation is an issue that I do have concerns about in specific parts of the world. Next up.