Is Deflation Really Bad For The Economy?

On Friday, July 30, the St. Louis Federal Reserve Bank president, James Bullard, speaking on CNBC television, said that the Fed must weigh medium-term inflation risks against near-term deflation risks. For most economists and commentators, a general fall in prices, which they label deflation, is a terrible thing. They hold that a fall in prices generates expectations for a further decline in prices. As a result of this, consumers postpone their buying of goods at present because they expect to buy these goods at lower prices in the future. Consequently, this weakens the overall flow of spending, and that in turn weakens the economy.

A fall in consumer expenditure subsequently not only weakens overall economic activity but also puts further pressure on prices, so it is argued. Note that from this it follows that deflation causes a spiraling decline in economic activity.

From this way of thinking, one could conclude that a general fall in prices should be associated with an economic slump. Indeed, during 1932, the fall in the CPI of 10.3% was associated with a fall in industrial production of 21.6%. But is it true that a fall in prices should always be bad news for the economy?

Take, for instance, a case where a general fall in prices results from an expansion in the production of goods and services. Why should this be classified as bad news? On the contrary, every holder of money can now command a larger quantity of goods and services; therefore, people's living standards are going up — so what is wrong with that?

If prices are trending down, does it mean that people will stop buying at present? As a rule, most individuals are trying to maintain their life and well-being. This of course means that they will not postpone their buying of goods at present.

For instance, since January 1998 the price of personal computers has fallen by 93%. Did this fall in prices cause people to postpone buying personal computers? Not at all. Consumer outlays on personal computers have increased by over 2,700% since January 1998.

Now, if deflation leads to an economic slump, then, following the logic of the popular thinking, policies that reverse deflation should be good for the economy. Since reversing deflation means introducing policies that boost a general increase in the prices of goods — inflation — this means that inflation could actually be an agent of economic growth.

For most experts, a little bit of inflation can actually be a good thing. Hence they would like the Fed to generate an inflation "buffer" to prevent the economy from falling into a deflationary black hole. They hold that a rate of inflation of around 3% could be the appropriate protective "buffer." It is held by mainstream thinkers that inflation of 3% is not harmful to economic growth, but inflation of 10% could be bad news.

In this way of thinking, at an inflation rate of 3%, consumers will not postpone their spending on goods and hence will not set in motion an economic slump. But then, at a 10% rate of inflation, it is likely that consumers are going to form rising inflation expectations. According to the popular thinking, in response to a high rate of inflation consumers will speed up their expenditure on goods at present, which should boost the economic growth. So why, then, is a rate of inflation of 10% or higher regarded by experts as a bad thing? Clearly this type of thinking is problematic.[1]

A general fall in prices can also emerge as a result of a fall in the money stock. An important cause for such a fall is a decline in fractional-reserve lending. The existence of a central bank and of fractional-reserve banking permits commercial banks to generate credit not backed up by real savings, i.e., credit created out of thin air. Once the unbacked credit is generated, it creates activities that the free market would never support — activities that consume, and do not produce, real wealth. As long as the pool of real savings is expanding and banks are eager to expand credit, various false activities continue to prosper.

Whenever the extensive creation of credit out of thin air lifts the pace of real-wealth consumption above the pace of real-wealth production, this undermines the pool of real saving. Consequently, the performance of various activities starts to deteriorate, and bank's bad loans start to rise. In response to this, banks curtail their loans by not renewing maturing loans and this in turn sets in motion a decline in the money stock.[2]

The point that must be emphasized here is that the fall in the money stock that precedes price deflation and an economic slump is actually triggered by the previous loose monetary policies of the central bank and not by the liquidation of debt.

It is loose monetary policy that provides support for the creation of unbacked credit. Without this support, banks would have difficulty practicing fractional-reserve lending.

The unbacked credit in turn leads to the reshuffling of real savings from wealth generators to non–wealth generators. This in turn weakens the ability to grow the pool of real savings, which in turn weakens economic growth.

It must also be emphasized here that government outlays are another important factor undermining the pool of real savings. The larger the outlays are, the more real savings are diverted from wealth generators.

"Under deflation, it is those non–wealth generating activities that end up having the most difficulties in serving their debt, because these activities were never generating any real wealth and were really supported or funded, so to speak, by genuine wealth generators." Many commentators, including Bernanke, are of the view that a fall in prices raises the debt burden and causes consumers to repay their debt much faster. Rather than using the money in their possession to buy goods and services, consumers use a larger portion of their money to repay their debt.[3]

In this way of thinking, a continuous debt liquidation could put severe pressure on the money stock and in turn on household demand for goods and services. All this, Bernanke believes, could lead to a prolonged decline in the price level. A fall in the price level in turn raises the debt burden and leads to a strengthening in the process of debt liquidation. Hence, to prevent this downward spiral, Bernanke recommends aggressive monetary pumping by the central bank.

Again, the debt liquidation and emerging price deflation are not the causes of the economic slump but the necessary outcomes of the previous loose monetary policies of the Fed, which have weakened the pool of real savings. Also note that it is not a fall in prices as such but instead the declining pool of real savings that raises the debt burden and intensifies price deflation. The declining pool weakens the process of real-wealth generation and in turn weakens borrowers' ability to serve the debt.

Similarly, it is not increases in real interest rates, as suggested by many commentators, but a shrinking pool of real savings that undermines real economic growth. On the contrary, increases in real interest rates put things in proper perspective and arrest the wastage of scarce real savings, thereby helping the real economy.

Now if the pool of real savings is falling, then even if the Fed were to be successful in dramatically increasing the money supply and increasing the price level, i.e., countering deflation, the economy would still follow the declining pool of real savings.

Contrary to the popular view, in this situation the more money the Fed pushes into the economy, the worse the economic conditions become. The reason for this is that more money only weakens the wealth-generating process by stimulating nonproductive consumption (consumption that is not preceded by the production of real wealth).

As we have seen, deflation comes in response to previous inflation. Note that as a rule a general increase in prices, which is labeled inflation, requires increases in the money supply. Hence a fall in the money supply leads to a fall in general prices — labeled as deflation. This amounts to the disappearance of money that was previously generated out of thin air. This type of money gives rise to various nonproductive activities by diverting real savings from productive real wealth generating activities.

Obviously, then, a fall in the money stock on account of the disappearance of money out "of thin air" is great news for all wealth-generating activities; the disappearance of this type of money arrests their bleeding. A fall in the money stock undermines various nonproductive activities. It slows down the decline of the pool of real savings and thereby lays the foundation for an economic revival.

But what about the fact that a general decline in prices is accompanied by a fall in general economic activity? Surely this means that deflation may be bad news for productive and nonproductive activities? The fall in economic activity, as we have already shown, comes not on account of falling prices, but on account of a fall in the pool of real savings.

The emergence of deflation is the beginning of the process of economic healing. Deflation arrests the process of impoverishment inflicted by prior monetary inflation. Deflation of the money stock, which as a rule is followed by a general fall in prices, strengthens the producers of wealth, thereby revitalizing the economy.

Obviously, the side effects that accompany deflation are never pleasant. However, these bad side effects are not caused by deflation but rather by the previous inflation. All that deflation does is shatter the illusion of prosperity created by monetary pumping.

Again, it is not the fall in the money supply and the consequent fall in prices that burdens borrowers but the fact that there is less real wealth. The fall in the money supply, a money supply created out of "thin air," puts things in proper perspective. As a result of the fall in money, various activities that sprang up on the back of the previously expanding money supply now find it hard going.

It is those non–wealth generating activities that end up having the most difficulties in serving their debt, because these activities were never generating any real wealth and were really supported or funded, so to speak, by genuine wealth generators.

Contrary to the popular view then, a fall in the money supply is precisely what is needed to set in motion the buildup of real wealth and a revitalizing of the economy. Printing money only inflicts more damage and therefore should never be considered as a means to help the economy.

Despite the almost-unanimous agreement that deflation is bad news for the economy's health, that idea is false. As we have seen, deflation comes in response to previous inflation. This amounts to the disappearance of money that was previously generated out of thin air. This type of money gives rise to various nonproductive activities by diverting real saving from productive activities.

Obviously then, a fall in the money stock on account of the disappearance of money created out of thin air is great news for all wealth-generating activities. The disappearance of this type of money arrests their bleeding. A fall in the money stock undermines various nonproductive activities; it therefore slows down the decline of the pool of real savings and lays the foundation for an economic revival.

>>Does a General Fall in Prices Cause People to Postpone Buying?<<

I’ve always thought this was a red herring. It may cause you to wait on something you don’t need, but it can be disproved just by looking at electronics sales. Everybody knows next year’s tv, computer, cell phone, you name it, is gonna cost less and offer more. But they still buy.

We’ve all heard of economies completely wrecked by inflation, but there are no ready examples of economies completely wrecked by deflation.

Should I conclude that deflation is so hideous that it is always deliberately stopped, so self-correcting that it’s effectively impossible to get to the point where it can wreck an economy, a boogie-man that “they” keep loudly worrying in order to justify getting back to the business of inflating our lives away, or something else?

Hell, I’m rooting for inflation to retire my current debt with cheap dollars. Why, I could stop by the mortgage company with my wheelbarrow full of cash for groceries and pay off my house.

I never understood the fear of deflation. If inflation is bad, why isn’t deflation good? Aren’t lower prices better than higher prices? Seems to me that people who have savings benefit from deflation, while speculators lose if prices fall. Sounds good to me.

there are no ready examples of economies completely wrecked by deflation

I believe the Great Depression is considered to be the poster child of an economy wrecked by deflation.

It is either gonna be deflation or inflation. The “adult” solution is deflation. Let it reset. The political expedient way out is inflation, and it only makes it worse so that when it does collapse, it will be even worse.

It’s all academic (for the most part) until “worse” means world war.

” Aren’t lower prices better than higher prices? “

That depends on whether you’re buying, or selling/making/shipping/farming/mining....

And, please note, it’s the latter group that provides all of the non-government employment....

Deflation - Inflation — either way, we’re all gonna be getting a little hungry, bye ‘n’ bye....

My take on things. As long as prices are stable or falling I am buying. If prices are increasing I usually hold off until I see a stabilization. This might be wrong but as a consumer but I like stability or a downward trend. Upward momentum frightens me from the market in a way that I decide to hold off to see what is going to happen.

I have a large family and there are certain marks on meat prices where I just stop buying. If it is falling then I buy buy buy. When it is trending up then I hold off until it appears to hit the top and then backs off near my “mark”.

“We’ve all heard of economies completely wrecked by inflation, but there are no ready examples of economies completely wrecked by deflation.”

Try Japan’s “lost decade” (and counting).

I ahev already been postponing purchases. We are already in a deflationary economy. And we will be until January 20th, 2013. Unless obama resigns, gets impeached or dies before then.

Pray for obama. Psalm 109:8-9

“For most economists and commentators, a general fall in prices, which they label deflation, is a terrible thing”

This guy is an idiot. Nobody who knows anything about the economy thinks falling prices is a bad thing. Falling prices are usually the result of productivity increases or technical innovations. This is good for everyone.

What people call deflation is usually good in itself but is a symptom of severe economic collapse. Too few dollars are available to buy the goods that are available. Nobody has any money so the price of things goes down. This is usually the result of some disruption or impediment to to the economy or the confiscation of money from those who earn it. This deflation is a symptom of economic collapse. Everyone loses their job so no one can afford to buy things. Demand goes down and so does price. Lack of demand makes production unprofitable so the cycle continues.

I’m thinking mostly in terms of how the economy went bad. It wasn’t a continuing deflation that wrecked the economy in the 1930’s; the stock market crash in 1929 took people’s imaginary money away first and deflation was the result.

I’m thinking a healthy economy that had no deflation, then deflation that was kinda noticeable, then became something that everybody just accepted as a way of life, and then got worse and worse, and then the economy collapsed.

Here’s a simpler explanation: You can’t get something for nothing. Money is information. The Fed does not generate information by maniulating the money supply, it destroys information through uncertainty. That’s why a fixed rule monetary system is the only logical way to go. You can do that by going to gold, or you can do it with unmanipulated fiat money (if you can keep your politicians away from stealing you blind through pumping).

Right now, my bet is on gold and commodity based economies like Canada or Australia who have their fiscal houses in order. We on the other hand are toast.

The problem with government manipulation is that it hides and delays hitting the bottom. No confidence can be built in moving sideways.

In many ways humans have not changed in thousands of years.
The herd mentality is very difficult to tame. So long as blood is in the water the herd will be spooked.

Modern media has made steering the herd more convenient but it has also resulted in information overload. We are in a very dangerous position because USA has no leadership. 0, Ben, and Tim have very little street cred. It is only a question of when for the next flash crash, not if. With taxes set to go up on 1/1, I would expect that a great sell off will occur to avoid the higher tax rates.

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