Is Deflation Really a Bad Thing for the Economy?

Most economists agree that deflation hurts the economy. They believe that deflation increases the real value of debt and decreases the income of producers, which can lead to their insolvency. Also, deflation increases the real value of cash, and so people will hold cash and reduce consumption and investment, which is against the economic growth. Chen, from Humanism Economics Society China, are one of those few economists nevertheless question the mainstream thoughts and argue that it’s wrong to favour inflation in economy. Deflation is probably not as bad as we think.

On Decrease in Price Level

Is decrease in price level poisonous? In everyday life, people tend to favour price decrease as it allows them to consume more goods and services with their current income. Most economists, however, believe that company’s income decreases as price level decreases and may not survives the deflation. Companies, however, can in fact benefit from decrease in price level when the cost of input decreases. Historically, many enterprises can still stay profitable in times of deflation. During inflation, many firms rely on “low-cost funding” to run, which is rare to see during deflation time.

One example to show the benefit of decrease in price level is mobile phones: it is becoming more and more powerful and yet cheaper and cheaper. Of course technological improvement plays an important role, but it is also telling us that price decrease doesn’t destroy this industry. The decrease, on the contrary, makes phones more affordable and attracts more customers. It benefits the industry as a whole.

Price Level
Source: McCusker, John J. “How Much Is That in Real Money?: A Historical Price Index for Use as a Deflator of Money Values in the Economy of the United States.” Proceedings of the American Antiquarian Society, Volume 101, Part 2, October 1991, pp. 297-373.

If we look at the price level changes during 19th century, when the industrial revolution progressed, we may find that the prices of majority of goods are dramatically decreasing. This does not show the weakness of economy; it in fact reflects the boost of productivity of the society. If we look back centuries ago when the supply of currency in form of precious metal is stable, we can also find that the price level decreases as long as the productivity increases.

In their research article ‘Deflation and Depression: Is There an Empirical Link?’ of January 2004, Federal Reserve economists Andrew Atkeson and Patrick Kehoe found that “..the only episode in which we find evidence of a link between deflation and depression is the Great Depression (1929-1934). We find virtually no evidence of such a link in any other period.. What is striking is that nearly 90% of the episodes with deflation did not have depression. In a broad historical context, beyond the Great Depression, the notion that deflation and depression are linked virtually disappears.”

We can see that decrease in price level is not a bad signal. It is the consequence of increase in productivity.

Consumption and Investment

The other reason against deflation is that if price decreases, people will hold their money and defer their consumption and investment, which has negative impact on economic growth.

But is holding cash really a bad thing for economy? During inflation, saving money in a bank is value-destroying and people are encouraged to consume, not to save — this may also explains why people today are accumulating debts. During deflation, people can enjoy buying power growth simply by depositing money at banks. The deposit can be loaned out by banks to companies. Companies can increase productivity and continue to cut the price of goods. As we mentioned before, the decrease in price will not decrease the profitability of the companies. This cycle of price decrease actually benefits the economy as a whole.

And will all people really defer their consumption because of the price decrease? Not likely. People have desire for enjoyment and consumption, which is one important incentive for them to earn money. This desire will not disappear simply because the decrease in price level. Most people know the price of phones and computers will decrease next year, but not all people will defer the consumption on these goods.

It’s unlikely that deflation will have negative impact on consumption and investment.

Government

While inflation reduces the real value of money and increases the price of goods, it seems that government is the only beneficiary of inflation. During deflation, government has to control their spending and limit the amount of debt, otherwise their burden will increase year over year. During inflation, however, government can simply pay off debt by printing money. It is not difficult to understand why governments prefer the theory of inflation benefits.

Seth Klarman, a fund manager, has written on the artificiality of today’s markets: “The Fed and the Treasury openly discuss the aims of their policies: to manipulate financial markets higher and to generate reported economic “growth” and a “wealth effect”. Inside the giant Plexiglas dome of modern capital markets, just about everyone is happy, the few doubters are mocked and jeered, bad news is increasingly ignored… The artificiality of today’s markets is pure Truman Show. According to the Wall Street Journal, the Federal Reserve purchased about 90% of all the eligible mortgage bonds issued in November.”

Inflation may be not as good as we think and deflation can actually benefits the economy. Now we may look at all those fiscal and monetary policies from a new perspective.

If you have different opinions, you are welcomed to share with us via comments.

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