Is Deflation really bad?

[Tahuti]

A lot of economists will be bound to be disgusted and inflamed by the view that deflation could actually be good. But what, if it actually is?

The common complaint against deflation is that it encourages unemployment and shrinking GDP, supposedly because deflation induces people to stop spending, in anticipation of lower prices. However, how about the possibility, that causal relation works differently, that deflation and unemployment have a common cause, but the former does not cause the latter? Deflation historically correlated with severe economic crises, but what if deflation only correlates with economic crisis, possibly as correction, instaed of causing it?

Another complaint is that deflation increases real-debt burdens. That's true, but what if that issue is overblown as well? In the light of the recent financial crisis, having a mechanism that punishes debtors may actually very well be a potent weapon in preventing yet another crisis. Banks are forced to lend out less, earn less profits, and become smaller in the process. Which is something everyone - save for the banks - would welcome.

Discuss.

 

[Cutlass]

You have it all wrong.

Deflation is massively destructive to an economy. While there are other causes to economic problems in other situations, deflation in and of itself is one of the worst things that can happen in an economy, and is one of the most common causes of other problems in the economy. Deflation will essentially always cause an economic crisis.

And for that reason, pretty much any price to be paid to prevent it would be cheap even if doubled.

 

[Tahuti]

You have it all wrong.

I have a hunch that common wisdom on deflation may be wrong, but I'm not saying it is. Hence, the questioning marks.

Deflation is massively destructive to an economy. While there are other causes to economic problems in other situations, deflation in and of itself is one of the worst things that can happen in an economy, and is one of the most common causes of other problems in the economy. Deflation will essentially always cause an economic crisis.

Circular logic: "Deflation is bad... because it is bad!"

This is a very big logical problem: We all know that deflation most notably happened alongside major economic crises. That's a fact. But I'm not impressed by the arguments I've seen so far that claim that deflation > economic crisis. It may very well be mystery X > deflation & economic crisis.

 

[Cutlass]

You have to look at cause and effect. What kicked off the Great Depression and made it last so long? Not enough money in circulation. What turned the 2008 financial crisis into a 5+ year dead economy? Not enough money in circulation. What caused pretty much every recession after WWII? Not enough money in circulation.

Now if you look at what is actually happening with deflation, there's no case to be made that it's anything other than a force for destruction.

What actually happens?

A company makes some good or service. This has costs associated with it. They are willing to do this because they believe that they can now sell for a figure higher than their costs. But with deflation, that stops being true. The profit is either squeezed, and the company has to decide if it will shut down, or it disappears, and the company does shut down. Why? Because the costs of production have no connection to the sale price, and so forcing down the sale price does nothing to reduce the costs of production. And many of those costs are fixed costs that won't be going down. And those costs that might go down, that won't happen quickly, easily, smoothly, or without a fight.

It is debt itself that makes deflation such a destructive force. Because companies have debts, they cannot take less revenue for their production, for debts are in nominal figures, and are not decreased by deflation. Instead they become a larger and larger part of the company's total costs, until the company defaults. So the company cannot reduce their nominal debt, but have less revenue to pay it. All they can do is try to force down their other costs. But labor has debts as well, and will fight as long and hard as they can to not lose wages. And when they do, then they have to default on their debts.

All this default means that banks fail, and companies and people cannot get the financing that they need. And then consumption dries up, because consumers have no money. This causes more companies to go out of business, and you get and endless downward spiral.

How you make this out to be something good is unimaginable.

 

[History_Buff]

Well deflation would immediately shut down the economy. Why would I buy anything today (aside from maybe food) if it was going to be cheaper tomorrow? That's the link.

 

[emzie]

Well deflation would immediately shut down the economy. Why would I buy anything today (aside from maybe food) if it was going to be cheaper tomorrow? That's the link.

Yeah, but what if that was a good thing?

 

[Dachs]

Circular logic: "Deflation is bad... because it is bad!"

It's not circular logic. It's not logic at all, actually. It's Cutlass presenting the position "deflation is bad" as being axiomatic.

How you make this out to be something good is unimaginable.

Kaiserguard did acknowledge the real-debt thing in the OP. He claimed that it was a good thing because it would punish debtors. And apparently this is a good thing because "too much debt is bad". That's not unimaginable; it's a very common position held by a lot of people who are incapable of thinking that something is real if they aren't holding it in their hands RIGHT THE [FREAK] NOW.

 

[metatron]

But what, if it actually is?

Deflation is not desirable. One can argue over its necessity, over when and for how long it should be tolerated and what costs should be justified in fighting it.
But it's not desirable pretty much by definition.
History Buff has the core of the matter: Why would anybody buy anything if it was cheaper tomorrow?

Deflation discourages investment and consumption. Sometimes delaying consumption may be virtuous for individual participants in an economy, but if everybody does it that may be troublesome. Essentially one of two things have to happen with money that is not used on consumption. The money has to be either invested or people have to hold on to it (i.e. either the actual currency or illiquit assets).
The problem is that the latter contributes absolutely nothing to the economy. It only further decreases demand and thus prices. In effect the deflation is perpetuating itself.
When left unchecked this only stops when enough activity has ceased and supply has collapsed to the low level of demand (the latter being comparatively inelastic at that point).
Depending on the original causes of the deflation this can be quite the catastrophe.

So in and of itself deflation is very much not desirable. It may be necessary or unavoidable in some situations though. The most common would be massive malinvestment in the form of overinvestment, which at some point results in rapid and unpleasant correction.
The good part is that once things have stabilized somewhat actual investments (instead of the previous faulty ones) can be made and the economy procedes to operate normally.
It may be helpful if the government midwifes said stabilisation. But when to do that is less a matter of economic theory than one of sociology, psychology and pedagogy (economists are of course in denial about that).
In a way deflation is money's way to send people to the corner and think about what they've done.
If and when people will make better choices when given the oppurtunity by government stimulus is not so much affected by economic mechanisms as it is by how stubborn and idiotic people are about their behavior in that particular instance.
If they are stubborn and idiotic enough the stimulus will do nothing but enable them to continue the malinvestment and make the (inevitable) mess worse.

A somewhat different matter are deflationary forces that are caused by a sudden increase in supply caused by unforseen outside forces (such as increases in supply or productivity resulting from chance discoveries that required little to no investment).
That's typically fine, since in most of these cases people will welcome the opportunity and increase consumption, thus largely avoiding actual deflation.
An example would a discovery of easily exploitable natural reasources that can be used to meet elastic demand.

These two causes of deflation can be easily confused, especially if one is used to one of them but then confronted with the other. Hence the frequent and heated debate.

In summation: Maybe the hunch (or whatever) you are having is rooted in the fact that deflation can be caused by things that are good, even though it is itself not desirable.

Disclaimer: I'm not an economist. I hope this made (some) sense none the less.

 

[Tenochtitlan]

It depends on your long term vision.

First of all, you can't say deflation\inflation is good\bad because it depends on the degree. There's a big difference between 1% deflation\inflation, 5%, and 40%. We can all agree that 40% of either deflation or inflation is massively destructive to most sectors and people (can benefit some specific sectors, like inflation benefits land owners\yacht owners)



Now, a reasonable percent of deflation encourages saving, affords people financial security long term when they know their dollar will still be worth something 5, 10 and 20 years late.


Inflation on the other hand, encourages consumer spending, debt and discourages savings and kills the purchasing power of middle class people, causes downward pressure on real wages.


Just 3% inflation destroy 34% of the currency's value over a period of only 10 years.

The government gets away with massive theft because people think 2-3% compounded annually isn't a big deal.

“Inflation has now been institutionalized at a fairly constant 5% per year. This has been determined to be the optimum level for generating the most revenue without causing public alarm. A 5% devaluation applies, not only to the money earned this year, but to all that is left over from previous years. At the end of the first year, a dollar is worth 95 cents. At the end of the second year, the 95 cents is reduced again by 5%, leaving its worth at 90 cents, and so on. By the time a person has worked 20 years, the government will have confiscated 64% of every dollar he saved over those years. By the time he has worked 45 years, the hidden tax will be 90%. The government will take virtually everything a person saves over a lifetime.” - G. Edward Griffin.

Productivity graph


Number of hours per week needed to produce as much as a 40-hour worker in 1950 This means that the average worker now produces almost 4 times as much as he did in 1950 (with the help of technology)

Inflation Graph I wonder what happened in 1970-1971? (Hint: The US Dollar went off the gold standard)

REAL WAGES)

Real wages have went down for the most part, however it's interesting to see them still rising from 1964 to 1973. There are two forces going on at the same time, the increase in productivity and wages, and inflation on the other hand. And inflation seems to be taking wages down despite the increase in productivity! So where does the value of the money go? It's lost to the new money, by however much new fiat money is created for government deficit financing.

The cost of living is going down because of technology, but going up because of inflation!

Sources:

http://groups.csail.mit.edu/mac/users/rauch/worktime/

http://inflationdata.com/inflation/Inflation/Cumulative_Inflation_by_Decade.asp

http://en.m.wikipedia.org/wiki/File:US_Real_Wages_1964-2004.gif

They lowered our wages by inflating the currency, even though the productivity per labor hour increased 4x since the 1950s. That means government inflation of a currency (to finance themselves with the new currency) took away 75% of your wage, and now you produce more for less. They robbed us blind and we just accept inflation, which is probably the most insidious and pernicious of all theft of wealth from the middle class to the wealthy.


The rich and ruling class love inflation because they own a lot of assets. Assets are immune to inflation.

 

[Hygro]

Argh why couldn't you have waiting until I got back home to have this debate. Deflation is one of my favorite topics.

You ask valid questions but I would like to tease you by saying only that your argument is the argument of the Federal Reserve from 1929-1933, which was a time marked by constant economic destruction, whereas the anti-deflation crowd took over in 1933 at the Fed and the White House and the economy immediately turned around.

Also, http://krugman.blogs.nytimes.com/20...y-in-a-liquidity-trap-again-again-again/?_r=0

 

[Tahuti]

Well deflation would immediately shut down the economy. Why would I buy anything today (aside from maybe food) if it was going to be cheaper tomorrow? That's the link.

I don't buy that argument, however commonly advanced: Would you say there was a major depression in the IT markets between 1995 and 2005 while computers were becoming cheaper and faster (and so relatively cheaper on top of that)?

Yeah, but what if that was a good thing?

I'm not a de-growth activist, but I suppose that if deflation cause economic shrinkage, I guess you could defend deflation on anti-consumerist grounds.

You have to look at cause and effect. What kicked off the Great Depression and made it last so long? Not enough money in circulation. What turned the 2008 financial crisis into a 5+ year dead economy? Not enough money in circulation. What caused pretty much every recession after WWII? Not enough money in circulation.

You certainly like Friedman don't you?

Anyway, if a central bank said: "Look, higher interest rates, we want deflation NOW!" then I'm pretty sure it will lead to an immediate depression, not because of deflation, but because of lack of credit. The current financial crisis was definitely caused by a sudden shortage of credit. The two are related, but not the same. Lack of credit in an otherwise credit addicted society is the cause, deflation and depression are the results.

You probably see a pattern here: The two correlate. However, correlation does not imply causation, and indeed, they have both a common cause. So we now know who that mystery X guy is in this case, namely, tight credit policies. And if deflation is ever to be pursued as a positive economic policy (which is now the case with inflation), then it is something that is to be implemented over time.

Anyway, if nominal economic growth stayed nill, but there was deflation of three percent, real economic growth would still be three percent(!).

 

[JohnRM]

I wonder what would be the case if we could have only slight deflation over a period of time, almost zero inflation/deflation, just slight enough to be measurable, but unnoticeable by the public. If a given item cost you 10.00 today, it will cost you 10.00 tomorrow. It may take a month just to go down to 9.99 or lower. I really don't think that this kind of deflation would hurt too much, if at all, but I'm not an economist, either.

 

[SS-18 ICBM]

I don't buy that argument, however commonly advanced: Would you say there was a major depression in the IT markets between 1995 and 2005 while computers were becoming cheaper and faster (and so relatively cheaper on top of that)?

I though deflation had more to do with the supply of money as opposed to production of goods and services.

 

[Tahuti]

I though deflation had more to do with the supply of money as opposed to production of goods and services.

Deflation is the relative increase of the value of money. Decreasing the money supply is just one thing to induce that.

 

[Cutlass]

You certainly like Friedman don't you?

Actually, I don't. Friedman made a number of notable contributions to economics, and had a number of interesting ideas. But it was also Friedman who proposed Monetarism, which should have been entirely on the ash heap of history while Friedman was still in diapers. He also proposed the constant monetary growth rate rule, which is virtually inexplicable from someone who spent his professional career studying money, because it required the assumption that something was unalterably true even though he knew it to be false. And he was wrong on a number of other major points in economics, such as assuming that an activist government economic policy could not produce a better outcome than a passive one.

Anyway, if a central bank said: "Look, higher interest rates, we want deflation NOW!" then I'm pretty sure it will lead to an immediate depression, not because of deflation, but because of lack of credit. The current financial crisis was definitely caused by a sudden shortage of credit. The two are related, but not the same. Lack of credit in an otherwise credit addicted society is the cause, deflation and depression are the results.

These things do tend to go together. But why is there a lack of credit? Not enough money to lend at acceptable rates. Supply and demand drive up the price of credit when money is short.

You probably see a pattern here: The two correlate. However, correlation does not imply causation, and indeed, they have both a common cause. So we now know who that mystery X guy is in this case, namely, tight credit policies. And if deflation is ever to be pursued as a positive economic policy (which is now the case with inflation), then it is something that is to be implemented over time.

Anyway, if nominal economic growth stayed nill, but there was deflation of three percent, real economic growth would still be three percent(!).

The problem being if there was a deflation of 3%, would nominal growth be 0? And the answer is that it almost certainly would not be. Because the ultimate driver of growth is consumption. And if incomes are going down, consumption will be too. As debt eats up an ever higher portion of an ever shrinking income, the only available response is to cut consumption for the consumer and cut production for the producer. And these thing reinforce each other and cause the situation to get ever worse.

 

[SS-18 ICBM]

Deflation is the relative increase of the value of money. Decreasing the money supply is just one thing to induce that.

Okay, so why are you using technological advance in one specific industry to try to refute a point about the general value of all goods and services?

 

[Cutlass]

I wonder what would be the case if we could have only slight deflation over a period of time, almost zero inflation/deflation, just slight enough to be measurable, but unnoticeable by the public. If a given item cost you 10.00 today, it will cost you 10.00 tomorrow. It may take a month just to go down to 9.99 or lower. I really don't think that this kind of deflation would hurt too much, if at all, but I'm not an economist, either.

Japan has had more or less that over the past 20 odd years. The results being that Japan's economic situation in the long run has gotten steadily worse, and long run more precarious.

 

[JohnRM]

Well, like I said, I'm not an economist.

So, what I gather is that...inflation deflation is bad, m'kay?

 

[Cutlass]

A little inflation isn't necessarily bad. It lubricates the system, as the old saying goes. Which is a net benefit to everyone. A little inflation also decreases the risk of economic crises.

 

[Tahuti]

These things do tend to go together. But why is there a lack of credit? Not enough money to lend at acceptable rates. Supply and demand drive up the price of credit when money is short.

On the other hand, there is already a lot of debt in the private sector right now. As you certainly would agree, you can't just say: Let's decrease debt; lower government spending, tighten interest rates and everything like that. It will certainly cause many existing debts to fail.

When financial institutions provide loan, they rely on the (false) assumption that debts issued in the future will be roughly set in the same circumstances and terms. If that prediction doesn't hold (and that happened during the Great Depression and the current financial crisis), everything collapses. I'm certainly not trying to say that monetary policy decisions that cause deflation are good.