Why is deflation considered to be bad?

[warmonger]

The problem with deflation, the reason that deflation is so very frightening to bankers and central bankers and monetary economists, is that defaults tend to cascade.

So what does deflation do? It causes loan defaults. And when you have loan defaults, then you put the banks at risk. When the banks are at risk, they stop making loans.

And once we get that cascading of defaults and bank failures, central banks have very limited tools to prop the system up and fix it.

It's hard to convey tone of voice through an internet forum and I really do not want to sound condescending to the intelligent people who have tried to answer my question. I'm just wondering how many of you have actually run a reasonable sized business in the real world. I understand crashes - I've lived through more of them than most business people. I was the head of a $100M subsidiary in Asia of a global $40B company in '97 for the Asian financial crisis. Whilst I certainly didn't predict the crash, in the audit that I did when I took over the company, it was obvious that it had a huge exposure to currency fluctuations. It took me a year but I had the company hedged against a currency collapse 6 months before the crisis hit.

When Lehman collapsed, I was the head of the European trading and treasury office of another multi-billion $ global company. I remember that day like Americans of a certain age remember where they were when Kennedy was shot. Citibank was our global bank - we had to bring in $100M in new working capital credit each quarter just to fund the enormous growth of the company. When Lehman's collapsed, it looked like Citibank was left holding Lehman loans in the 10's of billions. No bank would talk to Citibank; Citibank wouldn't talk to us. It looked like they would go next. Instant cash conservation mode activated. I vacuumed every $, €, £ of cash out of every operating company in Europe and brought it to Switzerland. Monthly payroll was 2 weeks away - wasn't going to make it. Worked the phones for the next week and finally got a Swiss bank to come to the rescue with a $20M rolling line of credit. I understand crashes better than most.

Maybe I haven't explained myself well enough. I'm trying to figure out why central banks think that an inflation rate of +2% is "optimal" whilst -2% is held in great fear. It's clear that high inflation destroys savings and benefits debtors, high deflation destroys asset values and benefits savers. I'm not talking about crashes or extremes - just trying to understand why everyone seems to think that we should be ticking over with a goldilocks form of inflation.

 

[warmonger]

Basically, there is nothing wrong with deflation in itself. The problem is that we are a largely debt-based economy and deflation would now cause massive shocks to the economy because we are debt-based. In order to neuter the negative consequences, we would need to switch to a savings-based economy where debt is rare and indeed used as an investment tool.

This is the conclusion I'm heading towards as well. Thank you for contributing.

If you look at the increase in living standards in the developed world - particularly in the English speaking countries - since the 1950's it seems as though it has gone through 3 phases:

1950's - 70's; Huge increase in productivity, infrastructure building, one income households. relatively high level of savings

70's - 90's; huge increase in household disposal income by adding a 2nd income stream to the household. moderate level of savings

90's - 2008; huge increase in household consumption funded by debt; negative levels of saving.

post 2008; ??????????

I've always been allergic to personal debt. The only personal loans I have ever taken out were on my first 2 houses. Every car I've ever bought was with cash - from the $250 10 year old Toyota I bought at 18 to the $80,000 sports car I bought a couple of years ago. Never bought furniture, electronics, anything really, that I didn't have the cash for. In the times when I had very little cash, I bought nothing except food and fuel to get me to work.

Am I an endangered species - a saving man?

 

[Flying Pig]

I've always been allergic to personal debt. The only personal loans I have ever taken out were on my first 2 houses. Every car I've ever bought was with cash - from the $250 10 year old Toyota I bought at 18 to the $80,000 sports car I bought a couple of years ago. Never bought furniture, electronics, anything really, that I didn't have the cash for. In the times when I had very little cash, I bought nothing except food and fuel to get me to work.

Am I an endangered species - a saving man?

It helps to be sufficiently wealthy - and employed - to have the money for the essentials. I don't think that all debt is taken on out of imprudence. It's not all that unusual for unemployed single parents to have too little money for both food and bills, or even one of the two. Unfortunately, prices have risen over the past few decades, and people's incomes haven't necessarily kept pace.

 

[Farm Boy]

If the deflation was general and moderate and wages are as eleastic as Cutlass suggests, it's not just your sale price that has been deflated - your input costs - fuel, fertiliser, labour, whatever, - have also been deflated. Probably your interest rate is close to zero. I just don't get the knee-jerk fear over -2%. The farmers in my family worry about rain, frost, hail and government subsidies.

You have to figure out how to get the profit margin back on those inputs, though, which were a year's worth of deflation earlier when you locked them in than when you got your harvest in. Plus, then you almost always have to dump your grain when, or nearly when, it comes in rather than having the capacity to store it for a better price later in the year to sell then, because not only are you eating storage costs and carrying on the loan, you're also eating further deflation on the grain itself. I'm not kidding when I say it comes close to making the whole thing not work on this alone, the profit margin isn't that huge.

Plus, a family that expects to earn $20,000 - $60,000 depending on the weather can easily be carrying $2.5 million on the real estate mortgage. Do you think a 2% asset bleed of ~$50,000 of worth per year there is negligible? I mean sure, the weather still matters, but you're really kinda worrying about the oil level after your car is already on fire here.

 

[Cutlass]

If the deflation was general and moderate and wages are as eleastic as Cutlass suggests, it's not just your sale price that has been deflated - your input costs - fuel, fertiliser, labour, whatever, - have also been deflated. Probably your interest rate is close to zero. I just don't get the knee-jerk fear over -2%. The farmers in my family worry about rain, frost, hail and government subsidies.

The problem with that argument is that not all actors in a deflationary environment are created equally. The weakest actors in any market take the earliest, and greatest, cuts in what they earn. So labor takes more of a cut than employers. But farmers, which is farmboy's concern, take more of a cut than farm suppliers.

I have actually opened a thread about it myself some time ago.

Basically, there is nothing wrong with deflation in itself. The problem is that we are a largely debt-based economy and deflation would now cause massive shocks to the economy because we are debt-based. In order to neuter the negative consequences, we would need to switch to a savings-based economy where debt is rare and indeed used as an investment tool.

Even without debt, deflation means that people who work will have an ever smaller share of an ever smaller economy. While people who own will have an ever larger share of it. And this will continue until the system itself collapses.

 

[Cutlass]

It's hard to convey tone of voice through an internet forum and I really do not want to sound condescending to the intelligent people who have tried to answer my question. I'm just wondering how many of you have actually run a reasonable sized business in the real world. I understand crashes - I've lived through more of them than most business people. I was the head of a $100M subsidiary in Asia of a global $40B company in '97 for the Asian financial crisis. Whilst I certainly didn't predict the crash, in the audit that I did when I took over the company, it was obvious that it had a huge exposure to currency fluctuations. It took me a year but I had the company hedged against a currency collapse 6 months before the crisis hit.

When Lehman collapsed, I was the head of the European trading and treasury office of another multi-billion $ global company. I remember that day like Americans of a certain age remember where they were when Kennedy was shot. Citibank was our global bank - we had to bring in $100M in new working capital credit each quarter just to fund the enormous growth of the company. When Lehman's collapsed, it looked like Citibank was left holding Lehman loans in the 10's of billions. No bank would talk to Citibank; Citibank wouldn't talk to us. It looked like they would go next. Instant cash conservation mode activated. I vacuumed every $, €, £ of cash out of every operating company in Europe and brought it to Switzerland. Monthly payroll was 2 weeks away - wasn't going to make it. Worked the phones for the next week and finally got a Swiss bank to come to the rescue with a $20M rolling line of credit. I understand crashes better than most.

Maybe I haven't explained myself well enough. I'm trying to figure out why central banks think that an inflation rate of +2% is "optimal" whilst -2% is held in great fear. It's clear that high inflation destroys savings and benefits debtors, high deflation destroys asset values and benefits savers. I'm not talking about crashes or extremes - just trying to understand why everyone seems to think that we should be ticking over with a goldilocks form of inflation.

Let me direct you to a couple of old posts. One by me, giving an overview of central banking, and one by Integral, who is much deeper into monetary theory than I am.

Now, the key points to answer your question are:

Money has such a huge effect on the economy that the incentive to manipulate it for political gains is overwhelming. Even with the independence designed into the Fed, efforts to influence the Fed's decisions are commonplace. A central bank that was too much subject to political interference, or directly politically controlled, would have much too strong of incentives to do what the current political leaders wanted, regardless of consequences down the road. That would mean both periods of much higher inflation than we have now, as well as periods of stagnation due to political majorities that wanted to crush inflation at all costs. And overall greater instability. Just keep in mind the current debate, where the majority in the House of Representatives wants government policy to help throw the current president out of office, regardless of the affect on the country. And this is why we have a central bank that in insulated, in the short run anyways, from the politics of the moment. And why Congressional proposals to hamper the Fed, audit it, restrict its freedom of action, prioritize inflation targeting above all other considerations, is such a disastrous idea.

Now meeting these competing demands is very difficult. In fact, it would probably be fair to say that the central bank essentially never "gets it right" in any one time period. Instead they manage a scattershot around right, and try to get the average right in the long run. Why aren't they getting it "right" all the time? Imperfect information. Remember MV=PQ? How many of those variables do they have next month's number for?

None of them.

Based on past experience and careful analysis of all available information they think they've got a pretty good guess at it. But it is a constantly moving target. And there are constantly external factors that throw the variables off projections, if even by only a tiny margin. And that is why the Austrian Economics criticism that "If only money was right, we wouldn't be having these problems" is essentially useless. Worse than useless really, extremely dangerous. Perfect is unattainable. So given that you know you are going to be wrong, you try to shoot for wrong in the direction that has the less harmful consequences.

Basically, the transactions cost of holding money is really, really small empirically. It's not really worth considering in the grand scheme of things. Now why might the optimal inflation rate be zero or positive? Four things to consider.
1. We are really bad at measuring inflation and probably overstate it somewhat. So aiming for positive CPI inflation means that "real" inflation is actually close to zero.

2. Downward wage rigidity. So suppose you're a firm and demand for your good declines. In general one response to this event is to downsize: lay off some workers and/or cut real wages a bit. But suppose you can't cut real wages because of labor contracts or other such rigidities. Then if inflation is slightly positive, you can cut real wages by holding nominal wages constant and "waiting it out" for inflation to do the cutting for you. Hence inflation "greases the wheels" of the labor market somewhat. I don't think this is a particularly strong argument but it is a major one in the literature.

3. Debt-deflation traps. Deflation tends to be "bad" because it increases the real value of debt. So low and positive inflation will reduce the proportion of times that we slip into such traps. This is potentially a very strong argument.

4. ZLB. Low inflation implies, usually, low interest rates. If you think that monetary policy usually works through interest rates, then a bit of inflation gives the central bank a cushion to lower interest rates in the face of recession. I think this is an awful argument on its own terms (though can be made very strong), but it's perhaps the primary justification of low-but-positive inflation rates out there.

For a summary, central banks do not target 0% inflation for a number of reasons. Primarily, CBs have, as we discussed, a fear of deflation, and so avoiding that is a very high priority. But, taken that avoiding deflation is the priority, why not 0%? Because of imperfect information about the future. 2% gives a cushion against being wrong. What is important to understand is that the central bank does not decide what next month's inflation is going to be, and then hit that target. That never happens. Rather, they decide what they believe it ought to be, and then adopt a policy of trying to move it in that direction. Think of it as trying to sail a boat through a storm. You know the direction you want to go, but something is always trying to push you off your base course. And so you must constantly adjust back to your base course. Now if you adjust away from the storm too far, you have a longer course, but if you adjust towards the storm too far, you might sink as the storm overwhelms you.

Consider this diagram, don't worry about the labels on it.



The trend line you are trying to get to is the line X. But your actual 'hits' are all the points around X, that average out to X over time. That's what a central bank's monetary policy is actually like over time, the scattershot around the mean, not the mean itself.

So the first reason why not 0% is that 0% is an impossible target, and missing that target in one direction is a hell of a lot more dangerous that missing it in the other direction. But the second reason for 2% instead of 0% is that at a 2% target, money is 'easier'. That is, credit costs less. And because credit costs less, businesses can more easily borrow to fund operations and expansions, and that is what allows greater wealth creation.

 

[Tahuti]

Even without debt, deflation means that people who work will have an ever smaller share of an ever smaller economy. While people who own will have an ever larger share of it. And this will continue until the system itself collapses.

An inflationary system can collapse as well: Inflation itself encourages debt since debt becomes cheaper to have when there is inflation. Which in turn fuels further interest in inflation. And so forth.

Now it is true that a deflationary system can collapse too: Deflation discourages debt and entices people away from personal debt until interest rates become too expensive to even use for investment forcing the economy to a standstill.

Whether deflation or inflation or good are bad is largely a personal question, informed by the position of an individual to the economy. If you are a saver and do not work for an organisation that is dependent on debt, you will fare great under deflation. Not so if there is suddenly inflation. Likewise, inflation is good for debtors particularly corporations and its employees.

 

[Cutlass]

The difference being that a deflationary system will collapse.

 

[Zelig]

You could probably eat a small measure of deflation on your annual operating loan if the prices at harvest are adequate to make back the increased cost of carrying each loan for the year, every year compounded by the fact that all your investments are purchased a year of deflation in advance of your gross return. It'd suck a lot. But that's all pissing into the wind. If experiencing consistent deflation - the mortgage on the tillable acreage will end you.

Sure, but if there's expected deflation you could get a loan at a negative interest rate.

 

[Borachio]

That means someone will pay you to borrow their money?

What's in it for them?

 

[Farm Boy]

Wait, you want to try and make that 30 year mortgage work, assuming you can get it signed at the right time, and assuming the deflation works for decades on end without smashing the system or returning to stable/inflation, by essentially short selling on cash? And you think you can make this a profitable transaction? I'm really fantastically dubious.

 

[warmonger]

Thank you Cutlass, Farmboy and Flying Pig for making serious attempts to bang some economic sense through my thick skull. We seem to be making some progress.

There is no doubt that Central Banks need to be independent from political issues and that is now generally the case in most of the large economies with the obvious exception of China (and perhaps Japan as well, I've forgotten)

So Central Banks aim for +2% inflation because they don’t believe the published data; they think the numbers are an overestimate. I don’t know perception in the US, but I’m pretty certain over here in wealthy Europe, that most people outside of Central Banks believe that the published inflation figures underestimate the rate of inflation. I understand why CB's and lay people come to different conclusions - they don't have the same mix of items in their price index basket.

Integral's 4 points make some sense to me. Perhaps I don't appreciate just how much debt households in the US have. My impression is that household debt in Europe is much less - much lower proportion of home owners; little to no education debt; little to no healthcare debt. Does the debt argument against moderate deflation hold a little less true over here?

What is an optimal level of household debt? I guess for me it peaked at around 2x gross annual income. This was way too high and while I was keeping my head above water with interest rates at 6%, I was in serious trouble when they went to 18% for a short period of time. I can honestly say I wasn't concerned about deflation. I avoided default by the sale of minor assets and a significant promotion and subsequent salary increase. I was debt free 6 years later and have remained so ever since.

 

[Zelig]

That means someone will pay you to borrow their money?

What's in it for them?

Normally inflation is say 5%, bank lends out at 10%, makes a 4.8% real gain. (Bank lends $100 for a year, they get back $110, equivalent to $104.76, inflation-adjusted to start of year.)

If deflation is -10%, bank lends out at -5%, makes a 5.6% real gain. (Bank lends out $100 for a year, they get back $90, equivalent to $105.56, deflation-adjusted to start of year.)

Wait, you want to try and make that 30 year mortgage work, assuming you can get it signed at the right time, and assuming the deflation works for decades on end without smashing the system or returning to stable/inflation, by essentially short selling on cash? And you think you can make this a profitable transaction? I'm really fantastically dubious.

No, I'm saying it's all about expectations. (Like El Mac also said.) If you sign a 30 year mortgage expecting 3% average inflation and 5% average deflation happens, you're pretty much equally screwed as if you sign it expecting 12% inflation and only 4% inflation happens.

 

[Borachio]

18%! That was a while ago. Golly! Mid 80's?

(Bank lends out $100 for a year, they get back $90, equivalent to $105.56, deflation-adjusted to start of year.)

This is fine. But why does the bank lend out $100 and get back $90? Why doesn't the bank just keep the $100? Deflation-adjusted to the start of the year, this gives them a greater profit than lending it out.)

 

[warmonger]

An inflationary system can collapse as well: Inflation itself encourages debt since debt becomes cheaper to have when there is inflation. Which in turn fuels further interest in inflation. And so forth.

Now it is true that a deflationary system can collapse too: Deflation discourages debt and entices people away from personal debt until interest rates become too expensive to even use for investment forcing the economy to a standstill.

Whether deflation or inflation or good are bad is largely a personal question, informed by the position of an individual to the economy. If you are a saver and do not work for an organisation that is dependent on debt, you will fare great under deflation. Not so if there is suddenly inflation. Likewise, inflation is good for debtors particularly corporations and its employees.

We seem to be on the same page Kaiserguard. During the times I had significant debts, my main concern was the interest rate on that debt i.e. the cost of servicing that debt. The US mortgage system seems to be built around a 30 year term at fixed rates, that you can renegiotate when rates move in your favour. That is not common in other parts of the world. Mortgage debt here is more frequently 25 year terms at either fixed rate for 3 - 5 year periods or flexible rates that can and do change monthly.

 

[warmonger]

18%! That was a while ago. Golly! Mid 80's?

1989 to be precise. I'm an old fart trying to understand a modern world. I was raised by two parents who lived through the depression and WWII. They taught me the fundamentals of financial management. Their teachings have made me rich even though they remained rather poor all their lives.

 

[Borachio]

You could be me! Except that I'm not rich. But I've certainly avoided debt like the plague (i.e. as much as possible). I really don't know why people go in for it so eagerly.

 

[Zelig]

This is fine. But why does the bank lend out $100 and get back $90? Why doesn't the bank just keep the $100?

Presumably because the bank is the government.

http://www.nytimes.com/2009/04/19/business/economy/19view.html?_r=0
http://blogs.ft.com/maverecon/2009/...n-are-they-coming-to-a-central-bank-near-you/

 

[Tergiversater]

Similarly, farmers are always in debt. Farmers borrow against their harvest to purchase seed money in the planting season. Then they pay it back from the harvest money. Debt is the only way farming, as an industry, can work.

Simply not true. Poor farmers, on the edge of folding might run that way, but trust me, any decent farm does not run on debt.

 

[Cutlass]

Thank you Cutlass, Farmboy and Flying Pig for making serious attempts to bang some economic sense through my thick skull. We seem to be making some progress.

There is no doubt that Central Banks need to be independent from political issues and that is now generally the case in most of the large economies with the obvious exception of China (and perhaps Japan as well, I've forgotten)

So Central Banks aim for +2% inflation because they don’t believe the published data; they think the numbers are an overestimate. I don’t know perception in the US, but I’m pretty certain over here in wealthy Europe, that most people outside of Central Banks believe that the published inflation figures underestimate the rate of inflation. I understand why CB's and lay people come to different conclusions - they don't have the same mix of items in their price index basket.

"Don't believe the published data" is, I think the wrong way of stating it. After all, they themselves are publishing the data! They know exactly how the data is collected, and how it is used, and as such they know exactly how accurate it is. Which is to say, not perfectly. Now, also keep in mind that they are not making policy decisions based on data. They are making policy projections based on projections! You know what last year's and last month's sales data was. Do you know next month's and next year's? Based on your experience, and your data from previous periods, you believe that you have a pretty good estimate. But it is only an estimate. And sometimes factors that you did not consider will result in your estimates being substantially off.

Now let me introduce 2 other factors to consider: Imperfect information, and information lag.

The data that the Fed acts on is developed from numerous sources, both within and without the government. Several departments of the government contribute to them. Other data is gained through the voluntary, or not so voluntary, forwarding of data from private sources. All this data then has to be aggregated, and analyzed. This takes time, and it is a process with a margin of error built in. You hear from time to time that the government has revised this or that number, like the unemployment rate. What that means is that in any given month the government collects the best real time data it can, and then continues to collect data to improve the estimate. But the final figure always lags the time period that is being talked about.

So the Fed is setting policy for, say, the second quarter of 2014, but at the time they are doing so, they have not yet received the final numbers for the first quarter of 2014. In fact, they are still finalizing the numbers for the third quarter of 2013. See? Imperfect information, and information lag.

Integral's 4 points make some sense to me. Perhaps I don't appreciate just how much debt households in the US have. My impression is that household debt in Europe is much less - much lower proportion of home owners; little to no education debt; little to no healthcare debt. Does the debt argument against moderate deflation hold a little less true over here?

It doesn't change that much. Remember, the most important factor is not household debt, it is business debt. At what point can businesses either not get the credit they need, or only get it at costs that are too high for them to find acceptable?

What is an optimal level of household debt? I guess for me it peaked at around 2x gross annual income. This was way too high and while I was keeping my head above water with interest rates at 6%, I was in serious trouble when they went to 18% for a short period of time. I can honestly say I wasn't concerned about deflation. I avoided default by the sale of minor assets and a significant promotion and subsequent salary increase. I was debt free 6 years later and have remained so ever since.

I don't know if there are studies on that. As with any debt, the question is whether you would be better off with it or without it. And can they afford to service the debt?