Is deflation bad?

This post asks is deflation bad or good?

Deflation is good when:

  • It happens because technology and capital investment improve the production process and increase producer output, causing more supply of a good at a lower costs. For example, AI and Amazon delivering in 1 or 2 days. Computers in the 1970s were millions of dollars (today only a few hundred collars) not to mention the speed difference. Cell phones, exotic food now is common place like Sushi.
  • It is correcting a bubble. It is the way prices are brought back to the true market price and wild speculators are punished and hardworking savers are rewarded. When housing prices fell in 2008, I knew many hard working families that were saving, buying homes that they could not afford before.
  • It is a natural fluctuation in market prices, supply and demand rather than an artificial stimulus.
  • The 19th century in America was deflationary but we reach our gilded age with higher growth and more equality than today. 4.5% was a growth rate average compared to 2% today.
  • 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.
  • Prevents a business cycle – If you try to maintain a stable price level, there is a probability you are distorting the capital structure and will cause a business cycle.
  • 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.
  • Gold Standard Economists believe deflation is healthy as real investment and real savings are connected.
  • 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 into his house? People have a sense of entitlement. There are no guarantees in life. Economics is about change.
  • Wages are downward 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. The issue with Japan is really the Debt to GDP ration.
    Inflation – is the last resort of bankrupt banana republics and governments that can not manage their political-economic system and finances.

Deflation is bad when:

  • The government confiscates money or contracts the money supply irresponsibly. This rarely happens. Rather, the signature of central banks is to expand the money supply and cause a business cycle.

The ideal world is full employment and stable prices. By stable prices I have a different definition than the central bank. The central bank defines it as stable inflation of 2%. Knut Wicksell and early monetary thinkers defined it as literately stable prices.

  • Central banks have morphed stable priced into 2% inflation.

When deflation is a 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 does not happen. Expectational driven price changes usually are a hyperinflation experience. Deflation is more often -1%. Further, when you talk about deflation or inflation you are referring to the CPI or PPI and narrowly defined index. hen entrepreneurs make decisions they based it not on an aggregate number but the inputs ad choices relevant to their production or consumption function which is different than an abstract aggregate.

  • 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 is a myth. If you read Robert Murphy or Murry Rothbard on the Depression you will see the facts. If you compare this to the recession of 1920 where the money supply was not inflated you will understand that deflation helps cut short business cycles.

The story that 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 come more layoffs. Sound scary? It is a huge cognitive leap to say downward movement in prices causes 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 to 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 were 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.

My hope is we enter a time of Great Deflation and sound money where real savings is connected to real investment and the Central Banks of the world are replaced with a commodity standard or free banking.

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