Why deflation is good

This post asks is deflation bad or good? The ideal world is full employment and stable prices. That is, red-headed freckled American boys mowing the grass in the summer and mom baking apple pies and little sis with a lemonade stand while the father pulls in the driveway at 4 p.m. in the afternoon after work, changes into a cardigan sweater and reads the evening paper.

This economic condition is a rarity, some economic fairy-tale along with working for one company and getting a gold watch for retirement. The reality is economics and prices is about change and there are always people who gain and lose. If you take a step back from the gobble goop economists spout, in their specialized vocabulary and authoritative postures, and look at economics on a day to day level. This will give you a better answer about inflation and deflation.

Is deflation bad? For me no, in fact it can be good. Here are some economic arguments why deflation is good, and these are not naive arguments, but based on real economic theory, even if they go against conventional wisdom. Deflation is one of the big boggy mans of modern economics. Countries destroy their finances battling this non-issue.

  • Why let markets determine prices? Prices, are information points. If they need to adjust downward, they adjust for a reason. Either demand is less or supply is more. The market is trying to adjust and correct so the economy can be more healthy. Any prevention of this adjustment will result in a less than optimal disequilibrium.
  • Austrian economists certainly would disagree that deflation is bad. Austrian economists Mises, Hayek, Menger believed deflation was the cure for credit expansion inflation. If housing prices went wild because of excess easy credit, the market needs to adjust.
  • Please do not reinforce the status quo – I like it when the price of junk I want to buy goes down. For me it is good. Every price change has winners and losers, let the market decide, rather than intervene with printing money. For example, I would not mind if housing prices fell, along with the price of other assets like cars. Therefore, I could buy things at a lower price. I have cash and I am not a spender and I do not have credit. If financial assets, like the stock market tanks I know to quickly move my money into cash. I want to buy a cheap house for my family. What do I care if some guy with a half million dollar house must live in my apartment and I can move myself into his house. People have a sense of entitlement. There are no guarantees in life. Economics is about change.
  • Wages are downwardly rigid – No one wants to take a pay cut. Therefore, instead of cutting salaries employers lay people off and try to improve efficiency. So the deflation story is not that simple as I have painted above, but it still comes down to letting markets work, or there will be a prolonged process of adjustment and unemployment.
  • Market intervention is bad – If there was a bubble, it is better to let prices adjust then try to prop them up, which can cause another cycle or worse stagflation.
  • Is Japan poor? – Everyone points to Japanese deflation and how bad it is, but Japan is a rich country and the citizens have a lot of purchasing power.
  • Inflation – is the last resort of bankrupt banana republics and governments that can not manage their political economic system and finances.

Therefore, for me and others it is not bad when the stuff we want costs less. It just means the market is working.

When deflation is bad argument

Deflation is bad when it becomes expectational or runaway and has no relation to reality. Expectations can drive prices into a downward spiral. This rarely happens. Expectational driven price changes usually are a hyperinflation experience. Deflation is more often -1%. Big deal.

  • The cliché argument that deflation suppresses demand because people put off purchases in hopes prices will fall is not true. If you look at history, periods of deflation do not always correspond with periods of poor economic growth. This is a historical fact. This is a huge point. In fact, there have been many times of prosperity and downward movement of aggregate prices. Read economic history, not just take the word of anyone, including the chairman of the Federal reserve. Again, let the markets work and prices changes do their job.

Further, on a day to day level, people have different indifference curves and not everyone will delay a purchase based on future price expectations. Some people want or need to have something now. For example, think of all the people who stood in line for the new generation of iPods, or bought them soon after they came out, even though next year it will be cheaper.

The old IS/LM model with liquidity traps is simply out of date.

Causes of Deflation

There are many causes of deflation but basically there is less money in the hands of each person. Therefore, the purchasing power of each unit of currency increases.

  • Supply side deflation is the best. It is when technology and productivity gains lead to lower prices.
  • Demand side inflation is what most people are afraid of and is associated with a financial crisis.

For example, during the great depression deflation the cause was a contraction of credit, combined with Federal reserve tightening (why do we have a Fed, they were wrong with every major decision?). This decreased the money supply and went hand in hand with a general decrease in demand. When lending is depressed, so is demand, then corporate profits, then comes more lay offs. Sound scary? It is a huge cognitive leap to say downward movement in prices cause this, rather it is still more a symptom. It is saying wet leaves on the trees cause rain. It simply is not true, but a cause effect thing. Yes, in extreme cases deflation can exacerbate problems but generally the markets should be allowed to adjust.The real question is, in times when there was a contractionary deflation, was deflation a symptom or a root cause. I think it is more a symptom and the way you fix it is let the markets adjust.

Consider Japan’s experience with prices after a huge unrealistic bubble, prices have been dropping for years. The cause was a bubble, prices needed to adjust. It is interesting to note, Japan in 2006 gave up many years of quantitative easing by its central bank because it did not work. It was pushing against the wind.

Other causes of price movements downward are demographics, population changes, increases in productivity, decrease in the velocity of money and global trade can also cause deflation. Many deflationary episodes in history where caused by political economic events, like the post American civil war great deflation and the return of the gold standard.

Knut Wickell had a lot to say on the problem of price movement and the causes. He believed it was a mismatch between the marginal productivity of capital and the bank rate of interest. His cumulative process explained price movements better than most theories, including the IS-LM curve.

Whatever the cause it does not matter. The take away from this post on is deflation bad is let the markets work. If you do not, you will be in for prolonged pain. The next time someone tries to scare you with deflation, say ‘I think it is a good thing’, and watch a few eyebrows raise.