Internet Startups Will Destroy The Government

Perhaps you’ve heard? Officials in Washington, D.C. are terrified over the specter of “deflation”. While inflation is usually considered to be an evil, the government is willing to print up untold sums to avoid what it sees as the calamity of falling prices.

Why are falling prices so bad? Actually they’re not bad at all, they’re a good thing. Falling prices means things are more affordable and plentiful, which is the natural state for a growing economy. The tech industry, one of the most economically lively and societally transformative, has been in a constant state! of deflation from the very beginning. Think about Moore’s Law, falling broadband prices, cheaper computers, ubiquitous cell phones, etc. Deflation. It’s all good.

But the government hates deflation because it’s bad for borrowers. The government, with its multi-trillion annual deficits, is the biggest borrower around. As a borrower, the government would prefer inflation — essentially paying off its debt through freshly printed currency. In a state of deflation, the government’s monster debt remains the same, but the tax base shrinks as prices and wages all go lower.

Yet that’s precisely what the Internet is doing. Sure, tech has always been a deflationary force, but it’s at the point where it’s really creating hyper-efficiencies and price pressure across all industries simultaneously. It’s contributing to the collapse in real estate prices, cars sales, travel industry profits, you name it. It’s b! asically done hollowing out media industry profits, for good. And as a ny self-respecting Web 2.0 windbag can tell you, it’s creating new markets where reputation and attention serve as substitutes for money. Historically, market forces and price signals have been the primary way in which a society regulates itself, but the Internet is providing ways to replace it. And these new non-money markets can’t be taxed.

In a vacuum, this is all great stuff. It’s creative destruction, and that’s a good thing, even if the collapse of old industries is painful. But we can survive old industries collapsing. That’s progress. Yet this progress for all people comes by creating a less-monetary, cheaper economy that will provide serious tax collection headaches for the government, which took out trillions in loans, thinking that the status quo would last forever. When the government goes bust, that won’t be quite as pretty or societally comfortable as when a legacy industry goes under.

Joe Wiesenthal is an editor at Business Insider. Reach him by email here.

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14 Comments

  • I usually find peHUB Wire interesting and informative, but today’s article is ridiculous. The only people that benefit from deflation are people with large fixed payment annuities. A deflationary environment would wreak havoc on the financial sector and put the economy into another tail spin. The last great deflationary environment was the Great Depression, and you are arguing for deflation? Prices would fall, and temporarily, things would be better, for maybe 1 or 2 quarters. Then defaults would skyrocket as would unemployment.

    Prices in the tech industry fall because it is highly innovative, the economy as a whole is much different from this 1 industry; it is an aggregate of all industries and different forces are tugging it in different directions than the forces on just the tech industry. If the economy as a whole were as innovative as the tech sector, prices would fall due to outdated products or technology, not due to deflation. This creative destruction in tech does not apply in the same way to the economy as a whole.

    First of all, lenders fear deflation because their collateral values erode. Second, the government is an atypical borrower. Deflation means a dollar today is worth more than a dollar yesterday, so in this respect borrower’s like deflation. However, collateral values fall in deflationary times and this causes higher default rates. The government is not in danger of defaulting and no collateral is tied to government borrowing. The government fears hyper-deflation and hyper-inflation alike. The budget deficit and national debt are getting so high that in a couple of years the only option will be to inflate the way out of the crises – the lenders/investors will take a major haircut on US government securities due to inflation. This is domestically better for the US than deep deflation. No one in the country wants a bankrupt government or Great Depression so the government is doing what has to be doing given the situation we got ourselves into.

    It is also not a good idea to let old industries collapse. It is ok to let them slowly go away or evolve into something more competitive, but we are seeing what happens when entire industries collapse in a short time frame (housing, auto, finance, etc…). I do not support such broad government intervention as we haven now, but it is also not a good idea to let an entire industry fail over night; a softer landing is much better.

    My 2 cents on today’s email – this is the first email I have thought was a little ridiculous; It is opinion based and sounds like it belongs in a rant and rave blog somewhere.

  • There is a second major drawback to deflation that you didn’t mention and that is, in a economy heavily dependant on spending, whether it be consumer or business expeditures, the expectation that prices will fall makes the spending parties delay purchases in the hope that prices will fall. If this happens across the board in any sort of quantity, an economy can basically experience gridlock where a majority of spending comes to a halt.

  • Seriously? I Didn’t realize that the requirements to be an editor at Business Insider had become so lax.

    There is a fundamental difference between falling relative prices (e.g. prices in technology falling relative to the prices of the rest of the goods and services in the economy) and deflation (average prices falling across all goods and services in the economy). The former increases the purchasing power of the average person because the good requires fewer inputs to make than it did before; the later is accompanied by falling wages and zero increase in purchasing power. The only way that deflation could be beneficial to anyone in the short run is if it were unexpected.

    Had I known Business Insider had such a low standard, I’d have been vying for that job ages ago…

  • I have been a peHUB subscriber for 4 years and today’s guest columnist was one of the best I have read among an otherwise great newsletter.

    I say this because until now, I have yet to find honest commentary on Inflation / vs. Deflation. Most people don’t understand it an the Muppets reporting normally state that inflation is a long term problem and deflation is the immediate concern… This is of course crazy, as Joe states Deflation is exactly what we need! Massive deflation in fact, to bring our labor costs in line with the rest of the world… While we are at it, deflation is not falling prices. Falling prices are falling prices. Deflation is a reduction of the money supply (as inflation is an increase in the money supply), and the effect on prices is just that, an effect.

    The government can create any nominal GDP it wants by increasing the money supply. Where is measure of “real gdp”?

  • We are recovering from a near insolvent liquidity crises and you want to cut money supply?

  • You bet. The increased money supply is only going to continue pushing up valuations across the board; no real growth is going to come from it. A solid recession that realigns debts with real incomes is what is needed for sustainable growth in the long run and unfortunately what the fiscal / monetary policies of today are prohibiting.

  • The US consumers and US governemt have added so much debt over the last 30 years it will take a generation for real income to catch up with the debt service requirements of today.

    Also, valuations are not getting articifially inflated – they are still falling across the board.

    In equilibrium debt needs to be aligned with real income, but we are not in equilibirum. The government will have to inflate away the threat of deflation and stagflation which will lead to artificially high prices / inflation in a few years at which point interest rates will increase and money supply will tighten until inflation is under control and stabalized at 3-4% annually.

    You are right, a recession will realign debts with real income. We are seeing it in action. It is not smooth; it is painful, especially when a country is as leveraged as the US is. Think of an increased money supply not as a long term strategy but of an immediate necessity that is needed due to the extreme situation, but will cause problems in the future. However, those problems are the lessor of two evils when compared to an economy with falling prices and falling output.

  • Great debate, thanks – this is why I was impressed by today’s article, in that this particular debate is not occurring anywhere in the news media and people automatically associate deflation as bad, without understanding the reasons why it may or may not be bad.

    In a free market, the money supply would have already been tightened (by virtue of the savers being rewarded for saving), and interest rates would already be climbing higher.

    This being said, the governments current strategy of creating inflation to reduce debt burdens can only occur for as long as our creditors are buying our debt. China / India, etc… are already stocking up on gold (think the latest IMF sales bid) and the Fed is already buying treasuries. As international dollar debts are rolled into non-dollar debts the excess $ in the market will find its way into commodities valuations (2000/oz gold?), and in the short term, back into business valuations (as P&L’s will be the recipient of this until the next crash) until, as you point out, the US tightens rates (which I doubt will happen on the back of the expanded need to finance social programs)

    The problem with the GDP compares is sorting out what is real, as the government can great any nominal GDP it wants through inflation.

  • You commenters are missing the point…

    This is an “invisible hand” observation, not a clarion call to do something or other to the money supply.

    Internet renders money’s monopoly on value a thing of the past. When someone figures out a way to convert attention to money and vice versa… oh wait, Google AdSense figured that out years ago.

    The only thing is that not everyone is playing that game, because once upon a time not everyone was a publisher. Now, with Facebook and Twitter etc, everyone is a publisher, and some are going to start thinking about making money off of it.

    Internet renders former areas of unbreachable competitive advantage for corporations obsolete. Kids in a bedroom can start mini-firms that threaten well-heeled industrial incumbents.

    SUBSTITUTION EFFECTS are the best business model on the Internet, the gold standard. The easiest way to trigger a substitution effect is to target an old-school quasi-monopoly and destroy it using the Internet etc. (example – NetFlix). As Internet becomes more ubiquitous and speed increases all around the system, startups will start targeting old industries in order to gain a right to existence. Old industries are not braced for these attacks (example – newspapers). It’s only a matter of time before a few internet billionaires pool resources to start a car company… whoops, that’s already happened.

    SUBSTITUTION EFFECTS DESTROY PROFIT MARGINS. Ergo, deflation. INTERNET DESTROYS MONOPOLIES. Monopolies and pseudo-monopolies generate the bulk of the profit in an economy. Things get cheaper as more competitors and more options. Many startups and independent projects decide to grab share instead of profit, offer their services for free, and demolish old product categories without generating revenue – look at OpenOffice and the various like-powerpoint-but-online-and-free sites. Why pay Microsoft anymore? DEFLATION.

    Only pseudo-monopolies (e.g. we retain customers through personal care and a powerful brand) can exist on the Internet, as shopping and competitive imitation are super-easy. ERGO, DEFLATION.

    Real estate bubble is an excellent example of the value of even physical commodities having to do with “information” and not with the true value of the commodity. People can research prices on anything before buying – I just bought a $75-list toner cartridge for $29.95 because of googling for a low price and then googling for a coupon code and then getting a free shipping deal for orders over $20. DEFLATION BABY.

    Price is now a “wild west” indicator of value, with the trend today being to undercut competition on price rather than basically cheating through information imbalance as was the case before. ERGO, DEFLATION.

    Stop thinking the writer’s main point is to recommend something when he is simply pointing out that the emperor of the mechanical monopoly economy on which we have based American capitalism has fewer clothes than might have earlier been thought. Internet shatters these monopolies into a million pieces, and that was the foundation of the inflation on which our government has been betting since Bush turned on the spending jets.

  • OK, economic reality check.

    1. Yes, productivity is good. It’s the source of all long-term sustainable income growth.

    2. Deflation is bad for a variety of reasons, well documented. It’s impact on the economy can be incredibly painful. This is primarily due to its tendency to produce self-reinforcing spending decreases. If I see that prices are dropping and hold my money instead of spending it, then I demand less now. Unlike normal individual decisions (which just means my money goes into a bank and gets invested by a company), the economy doing this as a whole doesn’t just cause cheaper prices – it actually causes mass unemployment and economic dislocation.

    3. The typical way around this is simply to relax or tighten credit to keep money stable (or actually since low inflation is far less damaging than deflation, target a low inflation).

    4. The Fed & Treasury don’t collude on setting interests rates to help government debt. That’s nonsensical.

    Sorry, this should never have seen the light of day on a professional journalistic site – it’s puerile; simply running it by a competent economist before publication would have helped quite a bit.

  • Mike, you are making some big assumptions.

    1. The government is not in danger of default
    2. The government will tighten interest rates when inflation increases
    3. The government has no collateral (the USA is its collateral!)

    Once our debt gets big enough to scare off our foreign investors- and this is already happening- then the USA will get hit with a massive wave of inflation as our printing-press dollars come back home. When no one buys our T-bills, the government will be forced to create even more inflation or default. There is no third option.

    Prices may be temporarily low because consumers have retrenched, but we’re sitting on the edge of the next big bubble caused by printing dollars. The government will NOT raise interest rates as it should because they have too much debt to pay back. They need inflation. Of course, inflation is already high (albeit hidden right now) and the government continues to moan about deflation. That should tell us what their priorities are.

    A healthy economy sees deflation occur because production increases outstrip the money supply growth. The same amount of dollars chasing more goods causes the price shrinkage. That’s what happened in the Industrial Revolution and what propelled our economic golden age. Quite simply, that’s what we need to do now.

    Rather than creating inflation to prop up a national debt that is in turn caused by our unwillingness to accept a lower standard of living, we need to invest money in our industrial infrastructure.

    This is econ 101. Works every time. But only for nations that are willing to sacrifice! Instead, we have the Obama Administration working on expanding our social programs such as universal health care. We can not afford this! It is an empty promise that will eventually wreak even more harm for poor people when our economy fully tanks.

    I agree with some measure of bailouts / adding liquidity to the finance sector because yes, a lack of liquidity can be very harmful. But the government overall spending increases are just foolishness that all Americans will pay dearly for.

    (And as a final side note, I do not believe we had a liquidity problem last fall. We had a bad debt issue that caused fear among lenders. Fear kills economic health).

  • RyanH hit the nail on the head. It is our lack of industry and dependence on a high standard of living that is killing us. A healthy economy produces more than it consumes; we have been buying more than we are selling for a very long time (hence our debt). We are going to have to pay the piper eventually.

  • Ryan –

    I agree with most things you say except for a few points.

    If the US defaults, we will see a global economic melt down of epic proportions. This is not impossible, but it should not be allowed to happen, even if severe inflation is option B. Collateral can be assigned and perfected by lenders and bondholders. Treasuries and US bonds are sold on the goodwill and good faith of the US. This is not collateral and not tied to specific assets.

    Production is not increasing, it is decreasing; so we cannot have the same amount of money chasing more goods. Increase money supply will likely create a bubble,and the US government and economy has put itself in a tough position with so much debt, but increasing interest rates too early is not a good idea, just as keeping rates too low for too long is not a good idea. I agree inflation and increasing money supply is not an optimal course of action, but a necessary course of action at this point in time. Keep in mind, just as a retracted rubber band slingshots, so will prices. However, it is the lessor of two evils. We are not expierencing a giant increase in production like the industrial revolution, output if falling and unemployement is going up. The US should and will have to adjust the standard of living in this country. This is necesary and inevitable as we are seeing.

    The stimulus plan is supposed to be investing in transportation and industrial infrastructure, albeit there is too much going to welfare programs that would have a greater multiple affect going to true infrastructure projects. In addition, the US needs to figure out how to be competative in a global supply chain of industry and manufacturing or else we may not have much industry left in 20 or 30 years. Universal Healthcare may not be the correct answer, but the problem is that healthcare is such a large part of the economy and so inneficient, something has to be done – it should probably be done in a few years though. First we need to get out of this mess.

    Whether it was a liquidity or fear crises taking grip last fall, something had to be done.

    I agree with Srini above. The internet has introduced a pricing dilemma to entrenched industries. This is because it re-structures the supply chain. Entrenched companies can, if they are willing to, adapt to this. I do not think this is the same as deflation. It is cost reduction and new efficiencies brought on by new technology in an evolutinary economy.

  • Fascinating debate. Mike appears to understand these issues fundamentally, and writes in a way that is accessible. Srini makes good points, but fails to distinguish between deflation and the effects of innovation. Ryan also has some insights, but doesn’t understand that increased productivity increases wealth, and is generally accompanied by economic growth – neither of which is deflationary. Interesting to see obviously bright minds that grasp a subset of the information needed to think clearly about our current economy. We need more voices like Mike in our financial press; he’s probably found more productive ways to allocate his time, but is clearly good at this. As he put it, our options are not attractive, but our government is attempting to choose a course that makes sense for this particular moment in time. I don’t fully agree with it, but a productive debate requires parties like Mike who actually understand the basics of how economies function.

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