Friday, 07 February 2003 8:30 am
Deflation is hot, at least as the topic du jour.  No less than two articles in yesterday’s Wall Street Journal were on deflation, one appearing on the front page. Later in the day there were whispers that deflationary concerns may have been behind the Fed’s unexpectedly sharp cut in interest rates.

Economists will decide whether we are actually entering a deflationary period or not.  The most recent statistics show that prices for many goods (e.g. electronics, computers, clothing) and a few services (e.g. communications, air transport) are now clearly in decline. Price competition from Japan, China and other countries that are already in deflationary cycles are depressing prices here and in Europe, in effect exporting their deflation to the US and elsewhere.

From a business standpoint, the case is growing that we should start to consider contingency strategies for a deflationary environment.  

Deflation will feel a bit like living in Lewis Carroll’s world of “Through the Looking Glass” – some things will appear to work backwards from what we are used to.  Cash will appreciate over time instead of depreciating, so the “discount” applied in future cash flow models will need to be negative.  What will appear to be low interest rates may actually be high rates.  Paying as soon as possible will be wiser than paying later.  Et cetera.

We will have to be careful that business decisions at all levels within our companies are not still being made based on old inflationary instincts and assumptions.  Also, we will have to gauge how fast our customers’ make the transition. It could take much longer for consumer buying and investment habits to be affected than corporate buying and investment. There is already evidence of this dichotomy, as corporations have reigned in their capital expenditures and aggressively reduced debt (appropriate strategies for deflation), while consumer have increased their spending on durables while increasing their debt (appropriate strategies for inflation).

In the high tech sector, we have lived with our version of deflation for many years, courtesy of Moore’s Law.  The basic costs of MIPS, bandwidth, and storage have dropped at a rate around 50% per year for many years now, and we have structured the industry around this assumption.  Fortunately, the demand for cycles, bandwidth, and storage has up until recently grown faster than the cost declines, turning high tech into the growth industry of the latter 20’th century.

But if demand were to stabilize at its current depressed level, the 50% per year cost reductions would cause a 50% per year overall revenue reduction until Moore’s law abates. John Chambers yesterday evening argued that Cisco is well positioned for a recovery of demand.  But what if there is no recovery of demand? Or, more realistically, what if the increase in unit demand is not sufficient to overcome the price erosion? That is the danger we could now be facing.

The way back to health both for the industry and individual companies is the same road our industry has become famous for: creating new applications and new markets.  Applications such as word processing, spreadsheets, email, browsers, the World Wide Web, financial software, ERP, data warehousing, transaction processing, search engines, CRM, and ecommerce were what drove past growth in demand for cycles, memory, and bandwidth.  What do we need to do to assure that there are sufficient new applications now and in the near future to keep the demand increasing faster than the cost reductions? I will deal with that key question in the next few columns.