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Is Deflation Really Bad For The Economy?
The Market Oracle ^ | 8-12-2010 | Frank Shostak

Posted on 08/12/2010 9:46:58 AM PDT by blam

Is Deflation Really Bad For The Economy?

Economics / Deflation
Aug 12, 2010 - 03:56 AM
By: Frank Shostak

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?

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

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 and the Money Supply

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).

Why Deflation Heals the Economy

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.

Conclusion

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.


TOPICS: News/Current Events
KEYWORDS: deflation; economy; inflation
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To: ClearCase_guy

Japan had deflation or stagflation.


21 posted on 08/12/2010 10:27:09 AM PDT by outpostinmass2
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To: detective

You are conflating two different things. When the price of a particular commodity drops because of increasing supplies that of course is a wonderful thing. That is not the same a deflation which is a GENERAL drop in the price of things across the economy. That is evidence that something very bad is going on in the economy.


22 posted on 08/12/2010 10:28:28 AM PDT by DManA
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To: RobRoy

>Everybody knows next year’s tv, computer, cell phone, you name it, is gonna cost less and offer more. But they still buy.

I usually buy “last years model”... and then “drive it into the ground” before buying a replacement.


23 posted on 08/12/2010 10:32:53 AM PDT by OneWingedShark (Q: Why am I here? A: To do Justly, to love mercy, and to walk humbly with my God.)
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To: DaxtonBrown

That is a very important concept - Price IS information. Government also garbles that information with massive and destructive regulations, and by subsidizing or punishing various industries. The result of this scrambling of supply and demand signals is people make poor decisions and resources are used inefficiently. Everyone gets poorer.


24 posted on 08/12/2010 10:33:13 AM PDT by DManA
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To: Pessimist

Yes that’s a long period of deflation, but Japan is definitely not a wrecked economy. I’m talking Zimbabwe and Weimar Germany kinds of wrecked economies, where you get paid by the hour and throw the money out the window of your factory to your wife who runs to the store to spend every last million-mark banknote to buy groceries. Japan has been making things the whole time, they still use their currency, etc., and prices are not exponentially going toward zero or infinity. And like in the Great Depression, their deflation was in response to the crash of their stock market and real estate bubbles.

I will allow, after just having read wikipedia (http://en.wikipedia.org/wiki/Deflation), that there have been episodes where deflation starts slowly on its own without a panic. I see that the deflation of The Panic of 1837, once again, was initiated by a bubble popping. And they mention the period after the Civil War, as the country returned to the gold standard. Not much chance of that IMO.


25 posted on 08/12/2010 10:33:38 AM PDT by jiggyboy (Ten per cent of poll respondents are either lying or insane)
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To: jiggyboy

” I’m talking Zimbabwe and Weimar Germany kinds of wrecked economies,”

Well, if you want to limit the type of damage to only that which is caused by inflation, then no. Defaltion doesn’t cause that. :)


26 posted on 08/12/2010 10:35:19 AM PDT by Pessimist
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To: blam

Deflation doesn’t cause people’s standard of living to increase on average. Because it’s usually associated with wage reductions, hour reductions and job loss.

If you expected long term deflation, you wouldn’t invest. Why invest when your purchasing power will go up if you just hold dollars. And if you invest, whatever company you are investing in, is getting a decreasing revenue stream.

Deflation is associated with economic depressions. It benefits only those sitting on large hoardes of cash, you can buy up bankrupt businesses and foreclosed homes for pennies.


27 posted on 08/12/2010 10:37:12 AM PDT by DannyTN
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To: blam

Deflation is bad if you’re in debt, especially in debt up to your eyeballs ... which is all of government and most Americans.

For those who saved and have a little nest egg (the minority) deflation is a good thing ... their money goes farther.

Guess which one they are going to prevent at all costs, deflation or inflation?


28 posted on 08/12/2010 10:37:49 AM PDT by Lorianne (During times of universal deceit, telling the truth becomes a revolutionary act. ___ George Orwell)
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To: blam

Who is buying and who is selling. Over simplify so we more ancient folk cam understand. Suppose a storekeeper buys horse shoes for say $300 per hundred pounds and of course has to mark up so as to make a little profit. A week after he receives his shipment the price drops 15%. Is that a good thing when the value of his stock in trade suddenly falls by 15%. The logger, farmer, butcher, baker, or do-whitchit maker all sees the value of his product decline, it begins with folks like FDR and whining TROLLS flooding the media with falsehoods.

Whether thou art a troll or just a funning with us, you do those of us still around from the great FDR depression no favor by falsifying facts and events.

Right Turns
Caddis the Elder


29 posted on 08/12/2010 10:39:35 AM PDT by palmerizedCaddis
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To: OneWingedShark

On black thursday last year I bought a 32” 1080p set from costco for 350, knowing full well the LED sets were going to flood the market. If I threw away the tv today, I would have gotten my money out of it. But I will hand it down to one of my daughters when we make the permanent move to Kentucky.


30 posted on 08/12/2010 10:43:49 AM PDT by RobRoy (The US Today: Revelation 18:4)
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To: DManA

“deflation which is a GENERAL drop in the price of things across the economy. That is evidence that something very bad is going on in the economy.”

I spoke about them both separately to show the author was confused. The author made it sound like deflation was in itself a cause of economic conditions. In his title “Is Deflation Really Bad for the Economy” and the article the author says that deflation is good for economy.

Falling prices are good for everyone. General deflation is not a cause but rather an effect of a severe economic downturn. It is a symptom of lack of demand which will lead to production being unprofitable which will lead to a downward economic cycle.


31 posted on 08/12/2010 10:44:52 AM PDT by detective
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To: palmerizedCaddis; blam

” Whether thou art a troll or just a funning with us, “

In all fairness, Blam (who is in no sense of the word, a ‘troll’) did not write this article - he merely posted it from an outside source for our perusal and discussion..

And since this has been a fairly lively - and reasonably coherent - discussion, I’d say that Blam did pretty well with this article.....


32 posted on 08/12/2010 10:45:09 AM PDT by Uncle Ike (Rope is cheap, and there are lots of trees...)
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To: detective

Can’t argue with that. Terrible article.


33 posted on 08/12/2010 10:47:04 AM PDT by DManA
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To: Pessimist

Indeed. Ok the opposite then, where nobody buys anything or hires people. I just don’t see how a working economy could fail because economic activity — sales and employment — drops so low by people choosing not to spend money (as opposed to people not spending money because they’re broke) that it just collapses.

But I admit that I might have been simply making the argument that deflation by itself can’t wreck an economy. I suppose the current situation, where the economy is already on the ropes, is where the question of deflation matters. And on that question, I’m of the opinion that it’s a boogie-man. As somebody mentioned earlier, people still buy electronics knowing that they can get something fancier shmancier for the same money next year. The brief illusion that individuals had to keep themselves at maximum debt in order to live a good life is over, and that’s what I think is scaring the economists.


34 posted on 08/12/2010 10:47:51 AM PDT by jiggyboy (Ten per cent of poll respondents are either lying or insane)
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To: blam

DEFLATION’S COMING, Says Gary Shilling, And It’s Going To Clobber The Stock Market

Who is Gary Shilling? Wasn’t he that whiny comedian who had that awful sitcom on HBO twenty years ago?


35 posted on 08/12/2010 10:55:11 AM PDT by Buckeye McFrog
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To: jiggyboy

Obviously necessities (food, etc) will still be purchased. But those are just a small part of the economy.

So in theory at least, it can get quite bad indeed.

In practice, of course, cash is king and debt sucks.


36 posted on 08/12/2010 10:59:46 AM PDT by Pessimist
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To: jdege
Stable prices are good, instability is bad.

Nailed it. When people start making economic decisions based on whether their money is going to fluctuate in value from one day to the next - that is a not a good thing.

37 posted on 08/12/2010 11:35:18 AM PDT by vbmoneyspender
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To: blam

Regardless of inflation or deflation, an acre of ground is still an acre of ground and an ounce of gold is still an ounce of gold.


38 posted on 08/12/2010 11:41:17 AM PDT by The Duke
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To: blam

Short Term Moderate Deflation can be a good force to help clear out inventories to make way for newer stuff and prompt new manufacturing. Too Much deflation and it starts to hurt businesses as they have to lower the cost of their wares.


39 posted on 08/12/2010 11:41:54 AM PDT by GraceG
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To: vbmoneyspender

” When people start making economic decisions based on whether their money is going to fluctuate in value from one day to the next - that is a not a good thing. “

And, when enough people take the next logical step, and lose faith that ‘money’ reliably reflects value - it’s an even worse thing....

It appears to my untrained eye that the growing “Wall St - Main St” schism is symptomatic of just such a loss of faith....


40 posted on 08/12/2010 11:42:47 AM PDT by Uncle Ike (Rope is cheap, and there are lots of trees...)
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