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Source link: http://archive.mises.org/13532/is-deflation-really-bad-for-the-economy/

Is Deflation Really Bad for the Economy?

August 11, 2010 by

Deflation arrests the process of impoverishment that monetary inflation inflicts on the economy. It shatters the illusion of prosperity created by the central bank’s printing of money. FULL ARTICLE by Frank Shostak

{ 12 comments }

Prime August 11, 2010 at 9:24 am

I love the picture at the top of the article.

Wildberry August 11, 2010 at 10:37 am

I’m wondering if one of the biggest motives behind a policy to prevent deflation is not tied to two factors:
1. First, deflation would erode the equity basis for many loans and make default more attractive as a potion for the borrower. I the case of the housing market, this must scare the bejeezus out of anyone holding a mortgage or anything derivative.
2. The phenomena of “sticky wages” and it’s corollary in the supply chain (pricing in supply contracts are set before delivery and sale, and therefore can result in losses in the near-term).
Although I agree that the factors covered in this article are considerations, I would say that these two factors are by far the more important to those who fear deflation.

neoaustrian August 11, 2010 at 12:14 pm

You would have support for (1) if deflation is feared in non-recourse states (most of U.S.) but not feared in recourse states (Canada). Having gotten the bulk of my economics education in Canada, I can say that deflation is discussed in the same way up there as it is in the U.S. So, anecdotally at least, I think (1) is not really the driving factor here.

(2) is more interesting, although the “sticky price” phenomenon is the subject of great debate. For inventories, though, it depends on the how the firm valuates their inventory: FIFO or LIFO. A deflation would tend to lead to every-decreasing values of new inventory relative to old inventory. FIFO would tend to overstate costs relative to LIFO. Firms can switch back and forth, and right now most of them do LIFO since we’ve typically had inflationary periods. So, first thing would be to switch to FIFO and reduce tax burden. This would be satisfactory until contracts are renegotiated.

elgecko84 August 11, 2010 at 3:44 pm

I’m curious about how the housing market could withstand deflation. I’m relatively new to economics, so let me explain my rationale: deflation= lower prices & therefore wages (although those wages would buy just as much if not more as in the times of inflation). So if this is correct and deflation causes my wage to go down, how would I handle a mortgage payment? If I make $50,000 one year and take out a loan, but only end up making $35,000 the next because of deflation how would I continue making the payment? I realize that deflation on that scale may not be probable, but would it be desirable and if so how would the mortgage situation play out? What kind of deflation rate is healthy for an economy?

in_omnibus_libertas August 11, 2010 at 10:12 pm

You’ve hit upon one of the reasons why deflation of the money supply, while corrective, is painful: paying back a fixed loan using a currency that has appreciated in value (because wages and prices both fell to reflect the contraction of the money supply) effectively increases the burden of paying back the loan. In an economy where many people are highly leveraged (indebted), deflation of the money supply can create a chain reaction of defaults.

Of course, when the dust all settles, the economy will be poised for real recovery. But it’s the process that is painful.

This is the main reason why central banks are terrified of deflation: forcing the public to swallow bitter medicine often leads to revolt, either the figurative kind (where incumbent politicians get voted out of office) or the literal kind (where incumbent politicians wind up swinging from trees).

Smack MacDougal August 11, 2010 at 1:03 pm

Deflation is a fall of revolving credit and non-revolving credit.

It is NOT a fall in prices. Simpletons hold the false belief that deflation is a fall in prices.

Bankers do not want deflation, especially a fall in non-revolving credit, because 1) prices of assets already connected to outstanding credit contracts falls, which makes those paying interest to bankers less inclined to do so; and 2) the worth of future contracts fall because any future borrowed money would go to buy now lower-priced assets.

ANYONE who believes, falsely, that deflation IS a fall in prices rather than a process LEADING TO a fall in prices of some goods, e.g., houses, factories, is clueless about money, credit, banking, central banking and economics.

Winston Smith August 11, 2010 at 2:09 pm

This is an Orwelian takeover of the word “inflation” in order to confuse the public. After all, if inflation is rising prices, then obviously it’s the businesses that are to blame. Historically, these terms derive from the act of inflating balloons or bubble by creating more money.

But rather than argue whether inflation/deflation is an increase/decrease in money or prices, we must, unfortunately, used hyphenated terms to be precise. Money-inflation, Price-inflation, Money-deflation, Price-deflation have now become part of the economic landscape. Many authors have accepted this need to change their language, but unfortunately the current article doesn’t do this.

If economists would all use the hyphenated terms, I think this would automatically teach the public the difference, without the need to argue on what inflation IS in historical terms.

Stephen Grossman August 11, 2010 at 1:10 pm

How does govt borrowing relate to the govt inflation of money and bank credit? That is, all three seem to be in some unidentified category which allows govt to spend without increasing production. I believe that statists (interventionists and socialists) claim that borrowing (eg, Obama’s current policy) avoids govt inflation of money and bank credit. The debt can be repaid in a shimmering, fabulous future in which govt revenues will have increased from increased production.

Eric August 11, 2010 at 2:19 pm

The connection between gov debt and inflation of the money supply is because, generally, when the FED creates the new money, it uses it first to buy government debt.

In recent years, however, the FED rules were changed to allow the FED to buy ANY asset it wants. Hence it recently bought up lots of toxic assets. But if it wanted to, I believe it could just as easily buy land or ocean liners, etc. They are supposed to hold onto these assets, and so some argue that this means the new money is backed by real stuff. But if the real stuff can lose all of its value, I don’t think the FED worries too much. They can always make more money.

Stephen Grossman August 12, 2010 at 3:57 pm

Thats a statistical, not an economic, connection. Ie, what is the necessary connection? Its something like extending the govts ability to shift resources to favored groups by increasing the context of inflation, as in Bretton Woods. Ie, US statists hope that China will economically aid them.

Seattle August 11, 2010 at 9:39 pm

I love Shostak’s articles. But it feels weird how the titles are always questions that just make me wanna scream “NO!”

David C. October 18, 2010 at 8:05 am

Perhaps I have not read into the subject far enough, but while the Austrian view of the quantity of money and its relationship to economic prosperity is quite logical (if not obvious, in retrospect), I have not encountered a discussion of the different effects of why prices would, overall, decline.

The experience of deflation in computer prices is instructive; the price level was irrelevant to advances in quality or quantity produced except in the important area of putting astounding quality in the hands of nearly every citizen of first- and second-world countries. This is obvious to all of us.

The trouble is (in my view) that a general across-the-board decline in prices can occur via at least two paths, one of which is undoubtedly associated with economic contraction (i.e. a collapse in over-extended credit/debt, a condition that appears imminent to me).

Changes in the broad money supply, if large, alter human action and patterns of ownership. Large inflation, such as that in the USA over the past 70 years, alters people’s behavior in profound ways, favoring some industry segments at the expense of others, not to mention feeding an unimaginable growth in the state. A credit collapse like that of the 1930′s (and what seems likely soon) impoverishes debtors, destroys inflation-amplified industries and the jobs involved, and undoubtedly causes capital ownership to concentrate from net-debtors to a relatively few hands who held onto “cash” and thus experience a huge rise in purchasing power. It provides rationale for activist political systems, creating Robert Higgs’ regime uncertainty and leads to a collapse in private capital formation.

It seems clear to me that monetary inflation is always an ill (coming as it must via money-creation-without-prior-production, violating Say’s Law) but that monetary deflation is benign when organic (arising from increases in production of goods and services) but potentially catastrophic when deflation is the result of the collapse of the overgrowth of bank credit inflation that is inevitable in a fractional reserve banking system.

Just because a deflationary credit collapse is catastrophic does not mean I favor Bernanke’s efforts to stave off such a condition. I believe he is powerless to stand before the tidal wave of distrust that is heading at breakneck speed toward our shores, distrust that will erode the value of outstanding debt faster than any central bank can monetize it.

We’ll know soon enough. The MBS debacle makes Enron or Lehman Brothers look like single matches compared to the firestorm of Tokyo 1945, and the stock charts of Bank of America and Citigroup are indicating that the greatest financial scandal in history is beginning to dawn. I doubt Bernanke’s Fed will be much more than a single firetruck standing before the conflagration that ensues.

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