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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.
________________________________________

16 comments:

Anonymous said...

What was your stage name @ Chippendale's?

Randall Parker said...

Spanky Ridgewood.

Jeffrey said...

There is constant deflation in the tech market that has been very good for consumers, and the industry is always growing. I believe there could be innovation driven deflation in nearly every industry if the government would simply get out of the way.
The economy recovered very quickly in 1920-21 with the Fed conducting no OMOs while the federal government also cut spending rather than increasing it. Taxes were also cut and the roaring 20s followed. It is also interesting to note that within 9 months or so after the Oct 1929 crash unemployment had reached more than 9% and dropped back to just over 6% before taxes were raised and new tariffs put in place. This all happened under the Fed's tight money policy. I am beginning to strongly agree with Hayek and Ron Paul that we do not need the Fed, stimulus, or anything of the sort. The increased volatility in interest rates seems to me a more desirable thing than the results of the mistakes being made by our so called "leaders." The poor and middle class who save their money and engage in generally responsible financial behavior would be much better able to improve their lives if inflation wasn't eating away at the value of their hard work.

Deflation also helps us identify resource mis-allocation and at the very least we have been building houses for 3 or 4 years (really more like 12 or 14 years) that people could not actually afford to own. These houses were being built because of artificially low interest rates and bad government programs that created incentive for bad investments. We had deflation in the housing market because so many people were over extended and really should not have owned homes in the first place. As a result there are more sellers than buyers.

It seems to me that real savings drives real investment and that new and better products are all that is necessary to churn the economy. There should be periods of both inflation and deflation but the overall trend should be an ever strengthening dollar which would result in a poor and middle class who are increasingly better off. IMO the opportunity cost of inflation is drastically understated - much the same way other increases in taxation are.

Anonymous said...

What do you think about this? It says that deflation coming from negative demand shocks--like we have now--is harmful. But,deflation coming from positive supply shocks is different.

http://www.cato.org/pubs/journal/cj28n3/cj28n3-1.pdf

Randall Parker said...

Hi Anon: Thanks for the excellent reference. I have not read it all but will. I think you are on to something here and it relates to the literature on the cyclical behavior of prices...are they procyclical or countercyclical? If prices are countercyclical, then supply-related shocks dominate and it is hard to fault productivity-driven price change in the downward direction (see Den Haan in the 2000 Journal of Monetary Economics). Having said that any deflation, regardless of its origin, that threatens financial system insolvency and the structure of our financial system has to be opposed root and branch. I think history also shows price instability in the upward direction is a disaster too. So how about price stability as the overall goal?

Phil Rothman said...

Readers will be interested to know this this entry was referenced by Jim Hamilton on his blog:

http://www.econbrowser.com/archives/2010/07/fighting_deflat.html

Very nice recognition for Randy!

Jeffrey said...

thought you might be interested in this article:
http://blog.mises.org/9857/harvards-professor-scheme-to-revive-the-economy/

Randall Parker said...

Jeffrey: This is what was thought before the Great Depression...it is called Say's law, or supply creates its own demand. And demand can only be what supply determines it to be.
Say's law is now in the history books...and for good reason.

Jeffrey said...

So the idea that people work to produce something for others in order to buy products and services for themselves is history? I produce a product for people, and I enjoy doing that, but the reason I do what I do is most certainly because I want to purchase things that I cannot produce myself. My ability to produce most certainly controls my ability to consume.

Lets take money out of it, how do you consume in a barter system? If someone produces something you want, you have to produce something he wants in order to make an exchange.

Keynes and his theories are just plain silly. Take the broken window theory - to think that destruction of something is good for an economy is ridiculous. Investments in the production of things that improve society and move us all forward have to be forgone in order to fix the things that are broken. If Keynes is correct then it makes sense to have massive bureaucracies, high taxes, and regulation because creating friction in business and in people's ability to trade with one another would create more jobs and be good for an economy. I mean if Apple had more regulations placed on them and they had more red tape to deal with before producing a product then we could create jobs that were based on nothing more than the friction created by regulating Apple. But those jobs would be parasites draining the resources that Apple would like to put toward creating a new product. This would obviously slow advancements and be bad for consumers who want new products that improve their lives and increase efficiency.

Hayek and the Austrian economists have it right. Interest rates are an effect of market conditions not a cause. Controlling interest rates is just like controlling prices, it disrupts indicators that are a natural part of the price system. Keynesian economics has only been more popular because it is an economic theory that allows politicians to do what they want to do, spend money and control things.

Anyway, thats just how I see it. I also consider it strong evidence for my case that so many people from the Austrian school of thought correctly predicted the housing crisis while Keynesian economists were saying that nothing bad could happen just before the current crisis and then blamed greedy bankers afterward. People will trade trash and use it as collateral if the government says they will buy it.

Norman said...

Jeffrey said "There is constant deflation in the tech market that has been very good for consumers, and the industry is always growing."

I have never understood this argument. Surely the difference between less demand in a competitive market and more demand in a market with increasing returns should be obvious? Surely the difference between falling prices on goods that never change, like wheat, and falling prices on goods due to the introduction of higher quality alternatives, like computers, is also obvious? And surely, surely the difference between falling prices in a single industry that does not involve any stores of value, such as technological goods, and falling prices in all markets, including assets and labor, is once again obvious? To note the fact that I can buy a computer of a certain power, or even one relatively high end for the time, for less than I could 20 years ago, and then call it "deflation" as if it were the same as a general drop in the price level, baffles me.

Jeffrey also said "Lets take money out of it, how do you consume in a barter system?"

Show me an advanced economy that has no money or financial assets of any kind, including foreign financial assets, and I will show you an advanced economy that obeys Say's law. Once the economy has a nominal side, though, Say's law is not a useful description of reality, as the Great Depression made clear. Certainly one of the main reasons that old-school Keynesianism has seen a resurgence recently is due to political opportunism. Old-school Keynesianism was adequately refuted back in the 1970s. But Say's law as a guide to understanding recessions was refuted before that.

Jeffrey said...

A 2 terabyte internal hard drive was about $150 this past Christmas. Now a 2 terabyte external hard drive (includes a case and connections and its own power supply) is only $99. That is massive deflation created by increasing efficiency in production. In terms of technology, your $$$ and your time and energy are constantly worth more. Technology has actually been deflating in price and increasing in power and efficiency at an EXPONENTIAL rate forever! I know that sounds crazy, but its true.

The real cost of goods IS always deflating – you had to work 2 hours to purchase 100kWh of electricity in 1950, in 2000 you only had to work 14 minutes. To purchase a dozen oranges in 1950 you had to work 21 minutes, in 2000 you only had to work 9 minutes. Earning enough to buy a 3 lb chicken required nearly 3 hours of work in 1900, 71 minutes in 1950, and only 24 minutes in 2000. These things all cost a considerable amount more in nominal terms only because our government has manipulated and devalued our currency.

Wheat and other commodities are no exception - we can produce more with less input and use what we produce more efficiently. Technology drives efficiency and increased production in every industry.

Jeffrey said...

I assure you that savings will always create investment AND one's ability to consume will always be determined by one's ability to produce. The introduction of money did not change the basic laws of trade, it increased our ability to trade efficiently and it is a technology just like any other.

The invention of the fuel injector did not change the amount of energy stored in a gallon of gasoline, it simply improved our ability to capture that energy.

It is very simple to see that forcing interest rates down hurts those who save and rewards those who hold, or desire to hold, debt. This is like subsidizing the growth of the financial sector and it has recently contributed to unsustainable increases in the demand for home ownership - which led to inflated home prices. It also led to more people investing in housing projects and entering the construction industry too. This whole thing has been a massive mis-allocation of resources and it is a result of Government policies, largely based on Keynesian economics.

If the government did not create inflation and bad incentives then I am sure the banking industry would look wildly different than it does today. There should be no Federal Reserve or FDIC and interest rates should be determined by free markets. This would mean that banks would be much more well capitalized, savings rates would be much higher, and the financial sector would be 1/100th of the size it is today. Do you realize how much money (the amount of resources) the financial sector consumes that could have otherwise been put to actually improving people's lives? Think about how many smart people have devoted their lives to working in the financial industry only because government actions have supported its growth. Those brains could have been put to much better use in industries that create much more value in people's lives. It is the same nearly everywhere you look - government regulation on a state level requires that anyone who would like to sit for the bar exam have attended law school. Law school costs many tens of thousands of dollars while access to the information required to study and understand law is now very cheap, as is all information in today's world. If the government would simply let anyone take the bar exam and practice law if they pass, then the increase in competition and the drop in required investment would drive the cost of legal representation and consultation WAY down. It is not hard to see that nearly all legal costs are parasitic and the government not only pushes costs higher by limiting who can practice law, but by creating complex rules and regulations that require legal consultation.

If the government subsidizes something it generally promotes inefficiency and hurts competition and when they regulate something they drive costs way up which also often has negative effects on competition and less competition means less efficiency - the government is the source of nearly all of our problems, that is why our constitution placed so many limits on government - it really is too bad so many people think it is an outdated old document. I sincerely hope that people are waking up so we can turn this mess around.

If you want some more good info - watch Tom Woods on Youtube, watch Ron Paul, and Milton Friedman's whole Free to Choose series is online. Read Hayek, Sowell, and Skousen.
The Mises institute, Cato, and Heritage are all great too.

Jeffrey said...

I assure you that savings will always create investment AND one's ability to consume will always be determined by one's ability to produce. The introduction of money did not change the basic laws of trade, it increased our ability to trade efficiently and it is a technology just like any other.

The invention of the fuel injector did not change the amount of energy stored in a gallon of gasoline, it simply improved our ability to capture that energy.

It is very simple to see that forcing interest rates down hurts those who save and rewards those who hold, or desire to hold, debt. This is like subsidizing the growth of the financial sector and it has recently contributed to unsustainable increases in the demand for home ownership - which led to inflated home prices. It also led to more people investing in housing projects and entering the construction industry too. This whole thing has been a massive mis-allocation of resources and it is a result of Government policies, largely based on Keynesian economics.

Jeffrey said...

If the government did not create inflation and bad incentives then I am sure the banking industry would look wildly different than it does today. There should be no Federal Reserve or FDIC and interest rates should be determined by free markets. This would mean that banks would be much more well capitalized, savings rates would be much higher, and the financial sector would be 1/100th of the size it is today. Do you realize how much money (the amount of resources) the financial sector consumes that could have otherwise been put to actually improving people's lives? Think about how many smart people have devoted their lives to working in the financial industry only because government actions have supported its growth. Those brains could have been put to much better use in industries that create much more value in people's lives. It is the same nearly everywhere you look - government regulation on a state level requires that anyone who would like to sit for the bar exam have attended law school. Law school costs many tens of thousands of dollars while access to the information required to study and understand law is now very cheap, as is all information in today's world. If the government would simply let anyone take the bar exam and practice law if they pass, then the increase in competition and the drop in required investment would drive the cost of legal representation and consultation WAY down. It is not hard to see that nearly all legal costs are parasitic and the government not only pushes costs higher by limiting who can practice law, but by creating complex rules and regulations that require legal consultation.

If the government subsidizes something it generally promotes inefficiency and hurts competition and when they regulate something they drive costs way up which also often has negative effects on competition and less competition means less efficiency - the government is the source of nearly all of our problems, that is why our constitution placed so many limits on government - it really is too bad so many people think it is an outdated old document. I sincerely hope that people are waking up so we can turn this mess around.

If you want some more good info - watch Tom Woods on Youtube, watch Ron Paul, and Milton Friedman's whole Free to Choose series is online. Read Hayek, Sowell, and Skousen.
The Mises institute, Cato, and Heritage are all great too.

Jeffrey said...

If the government did not create inflation and bad incentives then I am sure the banking industry would look wildly different than it does today. There should be no Federal Reserve or FDIC and interest rates should be determined by free markets. This would mean that banks would be much more well capitalized, savings rates would be much higher, and the financial sector would be 1/100th of the size it is today. Do you realize how much money (the amount of resources) the financial sector consumes that could have otherwise been put to actually improving people's lives? Think about how many smart people have devoted their lives to working in the financial industry only because government actions have supported its growth. Those brains could have been put to much better use in industries that create much more value in people's lives. It is the same nearly everywhere you look - government regulation on a state level requires that anyone who would like to sit for the bar exam have attended law school. Law school costs many tens of thousands of dollars while access to the information required to study and understand law is now very cheap, as is all information in today's world. If the government would simply let anyone take the bar exam and practice law if they pass, then the increase in competition and the drop in required investment would drive the cost of legal representation and consultation WAY down. It is not hard to see that nearly all legal costs are parasitic and the government not only pushes costs higher by limiting who can practice law, but by creating complex rules and regulations that require legal consultation.

Anonymous said...

this blog has given some knowledge and insight that I never really thought about. an average person, much like myself, would think deflation is the way to go. but thing is, it looks like deflation only affects the consumer who just buys products and services positively because the goods are now cheaper to purchase, therefore, we save more money. what us consumers don't realize is the effect it has on businesses and firms and moreover, consumers who like investing in various institutions, and most importantly, the economy is negative in the long run. what we may think is a good idea now will become a great catastrophe later on because everything, especially assets, will become almost worthless in the future because they become that cheap. capital and income become less, economy starts to suffer... that is an interesting topic to actually think about.