Thursday, July 15, 2010
What's wrong with deflation? Let me count the ways.
Someone recently emailed and asked "Why couldn't deflation be a good thing? Lower prices for consumers, greater investment, economic stimulation....."
Well, not quite. Here's my answer....
Dear (fill in name here): That's not how I think of these things. In my mind....
1. Deflation means much higher real interest rates that will kill investment when it is dead already. Remember the Fisher equation: real interest = nominal interest minus inflation. If we have deflation, then that minus sign becomes a plus sign. With nominal rates already at zero, the real rate becomes unbounded on the up side. See Great Depression 1929-33.
2. We had deflation in the housing industry and the financial industry, just two sectors of the economy. How's that working out for us?
3. Deflation puts consumption in a downward spin cycle of households playing chicken to see how low prices will go and thus never spending as deflation begets further expected deflation. See Japan 1989-2005.
4. Deflation would trash housing prices further and would convert toxic assets that are still on financial institutions' balance sheets into radioactive garbage.
5. Deflation would drop wages and incomes and raise unemployment. Quite the opposite of what you envision.
6. Deflation would trash firm cash flows, wreck already weak balance sheets of both households and firms as assets plummeted in value and would give us another round of financial institutions needing to re-capitalize since their capital would be vaporized with deflation. Credit to any but the most ultra safe investments would be unobtainable at any price. The European P.I.I.G.S. would go over the edge.
7. Deflation could potentially increase the real burden of debt so that people with falling incomes and falling wages could face higher real, price-adjusted debt servicing. That is called "debt deflation".
8. Once this started, public expectations would become even more depressed than they already are and would begin looking to worse times in the future, not better. That would definitely kick start the party of further and deeper economic misery.
Of course none of this would be a concern if changes to prices and wages were instantaneous and perfectly flexible in the downward direction. That of course is nonsense.
Deflation only has to happen if the central bank wants it to happen. And you can believe that more than anything. If Chairman Bernanke were to let that happen I will quit my job as an economist and go back to my old position as a Chippendale dancer.