Is Deflation Desirable?

My friend Nick linked to a story in my last post by a guy named Matthew Lynn.  I don’t know what his credentials are, but I imagine mine are less in the department of economics.  Still, I can’t find anything in his article I agree with.  I’ll begin with his conclusion.

[With deflation] there are winners and losers, just as there are from most economic developments. The important point is that the people who lose are more powerful than the people who gain. That might explain why we hear about the dangers of deflation, and not about its advantages. It still doesn’t make them right.

This strikes me as incredibly naive. Short bouts of deflation are manageable, especially when they are caused by a short-term panic, like the one that just ended. But in the long run, deflation is a prosperity killer, equivalent to hyperinflation it isn’t magnitude.  Deflation doesn’t just hurt the powerful if it is around long enough.  Lynn lists governments and banks as losers because they borrow, and people who save as winners.  But for people that are so afraid of government borrowing, I don’t understand why they would wish for it’s liability to increase over time, the government is funded by the public after all.  Also, savers should not be views as inherently virtuous to borrowers.  After all, most of us have to borrow to buy a home. I wouldn’t want the principle on my mortgage to increase over time, penalizing me. Lynn neglects to mention this.  This would in turn help the “powerful” banks since they would be payed back with more valuable dollars.  Lynn’s final sentence is as follows:

[Deflation] may even be desirable if it encourages a balance between saving and consumption, and discourages governments and banks from taking on debt.

Those are huge ifs!  I’m not willing to find out if that would happen, and even if it did, I don’t see it as necessarily more desirable than the status quo.

Lynn’s evidence for backing up his claims are misleading. He claims that the Euro-zone is experiencing deflation yet is leading the world out of the recession.  He’s evidence of this is the total price drop in European prices over the last year, but this is not an indicator of current deflation.  I suspect the current situation is flat to slightly inflating, as it is in America.  I expect to see an upward swing as the economy improves.  Also, the US is about to take off with or without Europe. We are in fact currently growing rapidly, but we won’t see the GDP data until the end of October.  Expect to see 3-4% in the 3rd quarter and an average of 4-4.5% through 2010.  This will be followed by a resurgence in inflation, but some inflation is necessary for sustained growth.

Lynn’s make some other claims I take note with.  One is that because computers go down in price it obviously follows that the consumer will gladly keep up consumer demand for everything in a deflationary economy.  I seriously doubt this.  Technology is an exception because it is continuously improving at a rapid pace so many are willing to pay full price for a large jump in quality even though they know it would be cheaper in the future. But if something like furniture, lets say a table, continuously went down in price, you would probably hold out on your purchases as long as possible since you are confident you aren’t losing any value to the advances in table technology.  One would know they can get practically the same item for a lower price in the future, and there likely won’t be a spectacularly better table at the time.

Finally, and I think this is most important, long run deflation would cause a drop in wages, or equivalently, the loss of jobs. Lynn’s rightly claims that wages would be stable in the short run.  But if deflation expectation took hold, wages would have to decrease with it, and I don’t know how many people would take a smaller pay check even if they are told prices are coming down too.

He doesn’t mention it, but the whole article seems like an argument for the gold standard.  When the US was on the gold standard we had lots of deflation.  Back then, the money supply wasn’t controlled by an American entity (The Federal Reserve) which is generally concerned with the welfare of America.  Instead, it was controlled by the amount of gold.  The gold could be found in the US or it could be controlled by those that don’t hold the best interests of America.  Either way, it would be uncontrollable, and we would be susceptible to sharp swings, from both deflation to high inflation whenever a new gold reserve was tapped.

I tried to keep this short and failed.  This is a complex issue and I could expand a lot on what I said here, hopefully more than a handful of people take the time to read it.

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2 Responses to “Is Deflation Desirable?”

  1. Nicholas Harmon Says:

    So if you had to choose, would you choose inflation or deflation? Maybe defltation has its downsides but I think inflation’s downsides are worse.

    • mikehinton Says:

      I think deflation is just as damaging as hyperinflation because they both destroy economies. When there’s deflation, the problem is that the actions which are in the best interest of the individual, like saving your money because prices are dropping, hurts everyone else by stifling economic growth and tends to cause more deflation and so on. When there’s a small amount of inflation, I believe it gives people who want to buy something anyway a slight extra push to make the purchase now rather than later since it will cost more in the future. But that’s more of a beneficial side-effect than the main reason.

      Ideally, we would have perfectly predictable zero inflation. This would require us to know the exact size of the economy so we could print the exactly correct number of dollars. But I believe even this knowledge wouldn’t be enough because there are other psychologically based variables, like the recent panic. This effectively decreases the money supply and had the potential to send us into a deflationary positive feedback loop. This is why I believe a small amount of inflation is desirable, it gives us a buffer against deflation and hyperinflation which can destroy nations.

      I am a strong defender of the Federal Reserve, but there may be a better way to control the money supply. I’m not a fan of the Fed’s “duel mandate” which couples stable money with maximum employment. These mandates are often contradictory and I would rather stable money be its only goal. The job could be done, perhaps as well or better, by a computer. Milton Friedman was known to advocate this. I’m not sure of the consequences of having a predictable interest rate, but it’s worth study.

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