Inflation forever?

March 25, 2009 12:17 PM

[EconomicsFilter] Deflation is evil... or so everyone in government and main stream media says. The government has an obvious conflict of interest in this instance (inflation is essentially a hidden tax) and I'm unimpressed with the main stream media's coverage of monetary policy. What's the real deal?

I have the idea that without deflation the monetary system is out of whack. It seems like inflation and deflation should balance out to a degree, but I don't know where to even start reading on this.

So, is deflation really always bad or are they not looking at the whole picture? In what kind of situations would deflation be a useful thing? Are there any good books out there on monetary theory that aren't totally anti-deflation?

posted by thekiltedwonder to education (11 comments total)

I know nothing about this but NPR has been really great at explaining the economy: Why to be worried about deflation? Hope this helps. Despite the initial simplicity, I really found this revelatory re the economy.
posted by scazza at 12:22 PM on March 25

Deflation is bad for two reasons.

First, it creates a disincentive to spend, because hey, things will be cheaper tomorrow, right? That has a tendency to lock things up, because, well, we've seen what happens when consumer spending dips.

Second, it has the potential to create shocks in capital markets due to insufficient liquidity. Deflation basically means that the units of currency in the money supply are decreasing. If there aren't enough units of currency available to cover all of the transactions that need to happen, they don't happen, i.e. businesses stop investing or default on their debt due to an inability to secure financing. Japan spent over ten years in a deflationary period which saw almost no economic growth. This is widely recognized as being less than optimal.

Deflation is always good for creditors, because it means that though they lent inflated dollars they recover deflated dollars, i.e. they're making more than their interest rate would suggest. But as creditors generally have more interests in the economy than simply collecting on their loans, they tend to dislike deflation on the whole as well, even if it isn't entirely bad for them.

But the idea that "inflation is a hidden tax" is wrong. It can feel that way for your bank account, in that the money you had isn't worth as much as it was last year, but this doesn't actually help the government much, as it does not represent any creation of wealth or transfer of wealth to the government. Get the idea that "currency" = "wealth" out of your head; it's just not true. Money does not represent wealth or value, it's merely a medium of exchange. Governments actually have a strong incentive to avoid excess inflation as there have been several spectacular economic collapses due to hyperinflation in the last century, e.g. Zimbabwe, Indonesia, and the best-known example, Wiemar Germany. If inflation was good for governments they'd be all over it. Instead, it's a bit of a bugaboo, though not as big of one as deflation is.
posted by valkyryn at 12:30 PM on March 25 [2 favorites]

Also, do not confuse "deflation" with "falling prices." They are not necessarily the same thing. Prices usually fall because increases in competition and productivity can lead to producers accepting lower prices. This is good. In a deflationary environment, however, prices can fall because the money being used to buy those goods is getting more and more valuable. If that goes on too long, then it discourages business activity. Why produce something if your revenues are guaranteed to fall? Especially since producers generally have debts to pay with regard to plants, equipment, etc. - those amounts are NOT falling.
posted by pandanom at 12:44 PM on March 25

Deflation isn't bad for everyone. People who have savings but little debt benefit from de flation, as their money is worth relatively more. Those with lots of debt are hurt because while the number of dollars [1] they owe stays the same, the value of those dollars increases, so their debt is growing.

The wikipedia article isn't too bad. The classic economic paper on why deflation is bad in general is Fisher's "Debt-Deflation Theory of Great Depressions".

[1] Or yen or euros or whatever currency you follow
posted by procrastination at 12:46 PM on March 25

It can feel that way for your bank account, in that the money you had isn't worth as much as it was last year, but this doesn't actually help the government much, as it does not represent any creation of wealth or transfer of wealth to the government.

I disagree to some extent; the U.S. government is a net borrower, and as such benefits from inflation.
posted by malocchio at 12:52 PM on March 25

Maybe I wasn't clear enough in my question. I know deflation can be bad. There is a plethora of information on why it is/can be bad. I'm interested in the counter-arguments and specifics on when, if ever, it can be a good thing.
posted by thekiltedwonder at 12:55 PM on March 25

malocchio, yes, the government is a net debtor, and thus does receive some benefit from inflating its way out of debt, but note that this is a two-edged sword. If it looks like this is what the government is trying to do, investors stop lending that government money very, very quickly. Thus though it may appear that there is a benefit to be had here, unless such benefit remains very minor, it turns into a much, much more significant drawback than the benefit could possibly have realized.

That's what happened to Zimbabwe, and is in no small part responsible for that country's abyssal economy. No one will invest any money in the economy or lend the government money, because there is no realistic expectation that any such investment will be worth the paper it's printed on this time next year, even if the government doesn't just seize it.
posted by valkyryn at 1:00 PM on March 25

I've recently read a few good articles on point. I think that James Hamilton laid out the case against deflation pretty simply. (1) It increases the real cost to debtors of their debt load (pretty much exactly the wrong thing for us now) and more importantly, (2) it means that our economy is underperforming on the demand side. A new entry from a new blogger draws some interesting distinctions between "good deflation" and "bad deflation." It seems to me that a hallmark of good deflation would be lowered prices with increased production. That is certainly not what we are looking at at the moment.
posted by Lame_username at 1:01 PM on March 25

The fact that the value-store (money) gains in value while doing nothing economically productive basically locks up the economy, no one invests in anything or spends. It queers the basic assumptions of the economy (e.g. risking capital on new wealth-creating projects generates returns on that capital). To repost something I quoted from Interfluidity in another post:

Ultimately, a financial system has to find productive projects for the private parties to invest in. The government can invest directly, can delegate investment to the best and the brightest, can saturate the public's demand for money until private parties try to find other means of storing wealth. But it's what real human beings do with real resources that ultimately matters. Our financial system didn't fail because it was overlevered. It failed because it was uncreative: It could not conjure up worthwhile things to do with the capital it was asked to invest, and instead of owning up to that, it pretended that poor projects were good.

In a deflationary situation, the financial system works backwards: no one invests in anything, because the financial system is providing a positive return on just holding dollars. This is even worse than pretending poor projects are good. Its pretending leaving your capital under the bed is good.

Or in other words, what valkyryn said in the beginning of valkyryn's post. Hey me and valkyryn are agreeing! On an economic issue at that!

On the other hand, I'm really posting to point out that inflation is in a way a tax via seignorage but I'd agree with valkyryn generally (although on more nit: governments are all over a small amount of inflation. That's what they want because (a) it is a small tax, especially for governments with large debts denominated in their own currency (e.g., the US). This is why the default risk of the USA is essentially 0 (or, put another way, why the treasury rate is the 'risk free' rate): they can always print more money to pay their debts. Sure, the currency will eventually become worthless, but the holders of dollar-denominated federal debt still get paid the right amount of dollars. (b) it gives them a comfortable margin away from deflation and (c) other really complicated reasons. Deflation is so unpalatable that rich-country central banks essentially target a small rate of inflation to avoid it. However, normally inflation is the more threatening problem (in the rich countries in the last thirty or so years excluding Japan) than deflation so you hear more about fighting inflation on the news (generally by raising interest rates).) Whoah parentheses much?

I think its interesting to think about how certain subsectors of the economy function when you think about deflation, like...tech gadgets. Tech gadgets are something of a microcosm of the way the whole economy would function, because the buying power of your dollar increases so rapidly with time when buying tech gadgets. You know how some people put off buying a new Macbook Pro cause they are waiting for the bump, month after month, year after year? This is one of the reasons Apple is so tight-lipped about the new product pipeline, and why the tech industry in general is so afraid of the Osbourne Effect. In the tech gadgets market, the amount of value you get for your dollar is almost always increasing at a very rapid rate. In markets like hard drives, digital cameras, RAM, sometimes it doubles in six months or less. This provides a huge challenge to producers of these products in terms of inventory control, time to market, etc. It also leads to that familiar story we all know of a friend who never took any videos of his kids because he's always waiting till the next generation of video camera comes out, and eventually the kids are all grown. Imagine if the whole economy was subject to that effect. Now, before the economics people jump on me, this is an extremely different situation from deflation, and its caused by completely different forces. However, I think it can be useful to extrapolate from the problems that face consumers, producers, investors, etc. in this market when thinking about inflation because its a very familiar situation in which currency gains value with respect to time.
posted by jeb at 1:08 PM on March 25

Deflation is an intrinsic and retroactive increase in the effective interest rate on all loans made in that particular currency. The borrower has to pay the loan back with currency that is worth more than it was when the loan was originally taken out.

In business a lot of loans are used immediately for investment e.g. borrow money from the bank or by selling bonds in order to purchase equipment for a factory to produce products at a gross profit, some of which is used to pay back the loan. The calculation of whether doing that is a good thing is based on whether the borrower thinks the gross profit from that investment will be enough to pay back the loan.

If you switch from 3% inflation to 3% deflation, then the interest on that loan just increased 6%, and that can be enough to turn a profitable investment into a loser. Too much of that can put the company out of business.

Most businesses do this kind of borrowing-to-invest, so significant deflation can lead to economic collapse because of widespread business bankruptcy, which leads to widespread unemployment. These are Bad Things.

In what kind of situations would deflation be a useful thing?

I can't think of any situation in which deflation would overall be good. Certain people can benefit, but overall it's pretty much always bad. Deflation makes the economic engine seize up.
posted by Chocolate Pickle at 2:08 PM on March 25

Deflation can also squeeze banks. During deflationary periods they have to reduce interest rates on new loans, because otherwise borrowers won't borrow. Sometimes that can lead to them charging less interest on the loans than they pay on deposits, for a net loss.

And if they don't reduce interest rates, it can lead to them having a lot of money in deposits that is not invested at all (or invested in T-bills at a negligible yield). Either way it means they're paying more for deposits than they're taking in on loans.
posted by Chocolate Pickle at 2:12 PM on March 25