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.

“As somebody mentioned earlier, people still buy electronics knowing that they can get something fancier shmancier for the same money next year.”

Not if they simply don’t have the money. Deflation also brings falling wages. Want to bet whether prices or wages fall faster or further?

During Carter’s stagflation, I was on unemployment for a time. I got $380 per **month**.

That represents more purchasing power than a person working 40 hours per week at $9.25 today.

That shows wages not keeping up with inflation. It works the other way too. The only people who do well during deflation—and the article does touch on this—are people who have substantial cash assets and few or no deflating assets.

Perhaps it benefits the economy in the long run—perhaps—but if you want to see what it does to ordinary people, have a look at Great Depression I.

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

It may be considered the poster child, but it wasn't. The prices of goods did fall because of the contraction in the money supply, but Hoover and FDR forced wages to remain high -- that was the cause for the disaster. Business saw profits squeezed to the point of bankruptcy.

If prices and wages are both allowed to fall together, the net result is that nothing has changed. Profits don't fall because the cost of production goods (and labor) have fallen, too. The author is correct -- deflation without government interference is not harmful.

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 suppose I can't think of an instance where a healthy economy was slowly overcome by creeping deflation, to the point where the economy was eventually wrecked. If that's what you're looking for, I doubt you'll find it.

I would say that the US in the 1930's, Japan in the 1990's, the US right now are all examples of some Bubble bursting in a fairly dramatic way (stock market, housing, etc) and then -- because so much value was suddenly gone -- finding that the following years experienced dramatically slower growth because of the onset of deflation. I think that's pretty much the standard model and examples of that can be pointed to (as I have done).

Deflation is bad for the economy. Basically you’ve got less $$$ chasing after a greater supply of goods/services. Producers are more likely to downsize there workforce if there’s a decreased demand for their products/services.

Or some such nonsense like that...

Perhaps it is true that the harm caused by deflation in the 1930's could have been avoided, if the government had not interfered.

But that's almost a semantic argument. There was government interference. There was deflation. There was harm.

When I say that the economy of the1930's was damaged by deflation, I believe I'm stating a simple fact. The additional fact that the harm could have been mitigated by a more laissez-faire govenment is also true. I would say that you and I are both correct.

I always thought inflation was bad and deflation was good. I was taught that these terms referred to the value of a dollar, not the prices in the market place. inflation=dollar worth less. deflation=dollar worth more. Am I more or less on target here?

>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.

If your money is imaginary [that is credit] then it stands to reason that that imaginary money/credit disappearing is irrelevant to the true worth/value that you had... like the recent stock-market bubble/collapse, it only happened because so many people had bought into the idea “housing prices *never* go down” and as such they imagined upward valuation on the properties they were buying; when reality hit and stripped that imaginary [future] value they were in reality not losing a single cent of their true value.

Deflation weakens the Dollar.

If the Dollar weakens crucial commodities such as oil and gasoline will soar.

Food prices also seem to be inflating in this environment.

A combination of deflation here and inflation there can wreak havoc as wealth decreases while expenses rise.

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

? One would think that the Great Depression of the 30's would garner at least an "honorable mention".

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

hehe, No kidding. I didn't realize that "decade" meant "20".

How serious are things throughout the industrialized world at this point in time? All deflationary "spirals" in the history of the world, at least for the the past 400 years or so (when the "world" moved to debt based monetary systems) have been caused by the collapse of the credit bubbles which preceded them. We've built over the last 20 or so years a credit bubble of historic proportions - the largest ever. Bubbles always, one way or the other, have to "pop". This isn't going to be fun for anyone. The credit destruction will represent a whole lot of "wealth" that people (businesses, gov's, etc.) think they have - until it suddenly vanishes.

Deflation strengthens the US dollar. Less dollars in the money supply mean that each dollar is worth more.

I was referring to the international exchange rate.

The Dollar falls in value relative to other currencies. If they are losing value, foreigners won't buy our debt. Which could be catastrophic.

Also as the value of that exchange Dollar loses value commodities become so much more expansive and you find that your Dollar buys much less gasoline, for one example.

Also there would not be less Dollars in the money supply.

If there is deflation, the Fed has to do everything in its power to inflate and it does that my increasing the money supply.

As I said, the total results are the worst of all possible worlds.

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