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Deflation and Broadband Video

Last week I had one of those days that made my head hurt. I suspect you’ve all had days like this, as well, as the economic crisis unfolds. One moment there’s news that temporarily makes you feel better. The next moment, there’s news that makes you feel worse than ever.

In this particular case, in the morning I appeared on a discussion panel with four leading market researchers at a New England-area conference focused on key technology trends in ’09. After listening to the others talk glumly about the trends in the sectors they cover, I was feeling a little more optimistic. As I explained when it was my turn to speak, “the fundamentals of the broadband video economy are relatively strong” and there’s reason to be cautiously optimistic going into ’09.

It’s true. Broadband video usage is growing each month. There’s a vibrant ecosystem of innovative, early-stage technology companies that continue to attract new investments. Many of these companies are hiring. The overall broadband user experience is getting stronger and stronger, making this new medium a more appealing environment for consumers, advertisers and content providers. And importantly, there are large pools of existing spending (e.g. advertising, DVD sell-through and rental, etc.) that broadband can share-shift.

When you add it all up and compare broadband to say, auto manufacturing, retailing, financial services, home-building and other industries that have been decimated by the economic slowdown, things look pretty decent.

But that feeling of tempered optimism dissipated that evening, not just because the market dropped another 400-plus points to a level not seen since 2003, but because of two articles I read about “deflation,” an insidious new consequence of the meltdown. The concept of deflation has economists deeply worried about what lies ahead for the global economy.

Deflation is defined as a “general decline in prices.” As one measure, the Consumer Price Index, which tracks how much we pay for groceries, entertainment and other goods and services, dropped by 1% in October, the largest decline in the 61 years the index has been calculated.

Deflation is so scary because collapsing prices force businesses to cut costs in an attempt to retain profitability, or at the least, contain their losses. As I understand it, the contraction process feeds on itself, causing a downward spiral of economic activity and possibly an overall paralysis as companies hoard precious cash. This is bad enough in established sectors, where a degree of inelasticity helps to buffer deflation’s effects. My concern is that in a nascent ecosystem like broadband video, deflation’s impact could be far worse.

Here’s what I mean: Say you’re an early-stage broadband technology provider selling to media companies. Your product has been developed by a savvy, highly-educated and well-paid technology team. In taking the product to market, it’s becomes clear that it meshes well with customers’ road maps, addressing key problems or opening up new opportunities. Further, you’ve priced it in a way to be sensitive to market competitiveness and also internal profitability goals.

But now the media company says that as ad spending has slowed (itself driven by reduced consumer spending in key product categories), it isn’t as confident in its own revenue forecasts. It is cutting costs and its willingness to pay is reduced or eliminated outright. If there’s a deal still to be had, you’ll have to accept it at a lower-than-expected price. In short, deflation’s impact is being felt.

Pretty soon, that “one-off” becomes standard pricing, and your whole business model becomes shaky. Your investors become nervous and tell you to preserve cash. You start to look at reducing head count, potentially disrupting that precious development team which worked so hard on the product in the first place. Meanwhile, at a broader level, early-stage investors become skittish and decide to hold off investing in new companies (or worse, re-investing in current portfolio companies) until the climate warms up.

No doubt you’re getting the picture: deflation can severely jam the gears of innovation. Since the broadband ecosystem is still in its early stages — and consequently quite fragile — the specter of deflation’s ripple effects is quite nerve-wracking. Let’s hope economists’ fears are not realized.