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Deflationphobia!

It seems hardly a day goes by when the financial press fails to warn us about the looming dangers of deflation, despite the fact that the last period of price deflation in the United States was during the mid-1800’s. In fact, the threat of deflation is extremely slight given Bernanke’s well-documented deflationphobia.

This USA Today article, once again, needlessly sounds the alarm.  Let’s look at some of the claims, and conclude with a brief overview of the non-dangers of inflation.

“Sure, the government’s consumer price index has gained 3.5% the past 12 months. Even stripping out food and energy, the CPI is up 2.1%, the Bureau of Labor Statistics says. And anyone who lives in the real world knows you can’t live without food and energy.

But other prices have been moving relentlessly downward, from refrigerators to stocks to houses and salaries. Economist A. Gary Shilling argues that many of the factors for deflation are already in place, and that people overlook falling prices because they are so focused on the items they use the most.”

i.)   Note that economists worry about deflation even when the CPI increases by 3.5% in 12 months. This is simply the redefinition of deflation to mean “inflation which is not as high as we would (arbitrarily) like it to be.”

ii.)   The fact that “you can’t live without food and energy” would imply that as their prices increase, the prices of other goods would, indeed, decrease. This is given a relatively constant supply of and demand for money.  Nonetheless, if the money supply hasn’t increased, some prices will have to decrease to offset the increases in other prices. This shouldn’t be surprising at all.

“That’s a deflationary attitude — something policymakers fear. In deflationary periods, consumers put off purchases as long as possible, believing that prices will get lower. Fewer purchases mean lower economic activity — which, in turn, leads to lower salaries and higher unemployment. While deflation doesn’t necessarily mean another Great Depression, climbing out from a deflationary pit is tough — arguably, tougher than whipping inflation.”

i.)   This is the infamously dreaded deflationary spiral. It is true that an increasing demand for money will cause a general drop in prices. But there are problems with the analysis above.

ii.)   It is not necessarily true that higher unemployment is the inevitable result of price deflation. This position stems from a belief in sticky wages—while other prices are supposedly adjusting downward (including business revenues), wages refuse to budge! This is a fallacious viewpoint. If all prices are falling proportionately, then labor must accept the lower wage because there is nowhere for them to turn to receive a higher wage. In reality, minimum wage laws and unemployment relief do contribute a “sticky” element to wage rates.

iii.)   Ultimately, this is a problem of entrepreneurial forecast. Entrepreneurs make profits and losses based on forecasting future demands. If an entrepreneur fails to forecast an increase in the demand for money, he will reap a loss because he purchased factors of production at a higher price than his output ultimately fetched.  But why should a host of entrepreneurs make this exact same error, causing a depression?…

iv.)   Only if they were deceived by a preceding inflationary boom. There are a couple broad categories of deflation.  The first occurs when there is a general increase in the demand for money. This is a natural market phenomenon that entrepreneurs must forecast. They will simply reduce their bids for factors of production in order to preserve their cost-structures. The other kind occurs after easy-money has deceived entrepreneurs into unprofitable projects.  When entrepreneurs are unable to complete them, the resulting failure to repay loans results in credit contraction and a decrease in the money supply.

v.)   This second kind of deflation is, indeed, painful but it is necessary to wash out the previous malinvestments that occurred in the inflationary boom.

“whipping inflation”

i.)   Is as easy as turning off the government printing presses.

“Debt — specifically, the inability to repay it — is one contributor to deflation. As a simple example, consider what happens when your neighbor can’t pay his mortgage. Eventually, the bank forecloses on the house and sells it at a cut-rate price. When potential buyers look at other houses in the neighborhood, they base their bid on the last price — your neighbor’s discounted foreclosure price — and home prices on the entire block fall.

When enough people and businesses default on their debt, they set off a chain reaction. Banks, hurt by loan defaults, have to raise capital to cushion against further losses. That means selling profitable divisions, because those are the only divisions they can sell. As profitable divisions get chopped off, bank stock prices fall, banks lend less, and the economy grinds to a halt.”

i.)   This is precisely the kind of deflation mentioned above. This scenario occurs economy-wide only after a large number of entrepreneurs have made errors (see here for understanding the cluster of errors). Or perhaps the government has forced loans to be made which would never be extended under purely market conditions.

ii.)   What happens under this scenario in the short-run?  Due to the bankruptcies/change of ownership, there will likely be an interruption of production in the short-run.  However, the endowments of factors of production have not changed.  In other words, there will be shifts in ownership titles, but the underlying, physical factors of production themselves have not been damaged.  They are ready to produce as soon as all prices have adjusted.  In the long-run, there is no change in productive activity due to deflation.

iii.)   In large part, the fear of deflation comes from special-interest pleading because some individuals will, indeed, be harmed. In the aggregate, however, this is simply not the case. To the contrary, consumers always benefit from lower prices.

“Another source of falling wages: competition from overseas. Factories in China and the Far East can produce goods at much lower labor costs than the U.S. The result is a relentless downward push on U.S. wages, particularly among unskilled or semiskilled labor.”

i.)   Given the inflationary climate in which we live, it’s unlikely that wages overall have fallen.  More than likely, certain sectors have decreased, while others have not or have actually risen.

ii.)   So competition is bad when it occurs within borders, but harmful when it occurs across borders? No, competition bestows a greater standard of living on all participants in the economy.

iii.)   There will not be a “relentless downward push on U.S. wages” as long as U.S. workers are productive at all.  In fact, they are far more productive than their international competitors, which is precisely why foreign labor is cheaper.

iv.)   Wouldn’t the fact that producers which outsource jobs are saving money simply mean that they have more money to spend on other things? High costs of production are not a source of wealth.

“The classic cure for deflation is inflation, and the Federal Reserve may be trying that by targeting a specific level of inflation, rather than interest rates.”

i.)   The intrinsic predilection for inflation over deflation by governments the world over can, perhaps, be explained by one fact: inflation benefits debtors and governments are the biggest debtors in the world.

ii.)   The Fed shouldn’t be targeting the overall price level any more than it should be targeting individual prices.

iii.)   The general trend in an unhampered market would be for steadily declining prices. One contemporary example is the computer industry which has seen declining prices almost since the beginning, yet the industry thrives. In other words, there is no need to search for a “cure for deflation.”

During the Great Depression, massive federal spending — both in the New Deal and during World War II— reflated the economy.”   

i.)   Government spending cannot produce anything. It can only distort the efficient allocation of resources on the market.

ii.)   In short, this myth needs to die.

“Few expect that in today’s political climate: Budget-cutting and austerity are the watchwords. Cutting government employment, however, simply means a higher unemployment rate and more debt defaults. Instead, much of the deflation-fighting duties fall to the Fed.”

i.)   Few expect austerity in an era of record-breaking public debt levels? Few expect austerity in an era of unprecedented money-printing? I can see why.

ii.)   Employment is only a virtue when the labor is producing output which consumers value. There is no way to determine this with government jobs because wages are paid from taxes which are extracted involuntarily.  The economy does not exist simply for production; it exists to satisfy the varied and numerous preferences of all individuals within the economy.

“In reality, rising prices could be the exception — and falling prices the rule.”

i.)   As they should be.

In summary, deflation can come from growth as output increases. This is helpful to all members of society.  Even if nominal incomes fall, real incomes have risen. The second type occurs when people hold more cash in the face of greater uncertainty. This is helpful for those engaging in the action. Furthermore, since entrepreneurs are people too, shouldn’t they predict this? Bank credit deflation, mentioned above, is the painful corrective to malinvestments. All in all, deflation is not something to be feared for the economy in the whole. But it might be painful medicine for the biggest debtors of all: government itself.

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3 Responses to Deflationphobia!

  1. Sam Stearns January 15, 2013 at 12:00 am #

    This covered a lot, and I’m not sure I was able to comprehend all of it, but I think I caught the most important points. Everyone was in a panic over deflation, mostly because they were repeating (without understanding) what they heard on the news. But I honestly wondered to myself what in the world the big deal was. I really liked the point about the factors of production being unaffected by a deflation period. Productivity is the key to a prosperous economy, right? Doesn’t matter what the nominal value is, really. Goods and services are intrinsically valuable, right? Who cares what the nominal dollar value is? As long as we remain productive, we have the key to a prosperous economy.

    • libertas January 16, 2013 at 7:07 pm #

      Right, there are several different types of deflation, but if prices are falling everywhere in the economy, the nominal prices don’t matter because you can still maintain profitability.

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