The Deflation Boogeyman

By: Frank_Hollenbeck

Here we go again.  A plunge in oil prices has spurred a bevy of articles from the bought-and-paid-for media, as well as quasi-governmental agencies, alerting us of pending disaster if deflation were allowed to make an entrance, however briefly. Never mind that there is no theoretical or empirical evidence to justify this fear of deflation. (explanation here) According to the St. Louis Fed:

“While the idea of lower prices may sound attractive, deflation is a real concern for several reasons. Deflation discourages spending and investment because consumers, expecting prices to fall further, delay purchases, preferring instead to save and wait for even lower prices. Decreased spending, in turn, lowers company sales and profits, which eventually increases unemployment.”

That such nonsense could be published by one of the regional central banks demonstrates how far macroeconomic policy has gone down the rabbit hole of utter gibberish.

Savings does not reduce spending since it is a transfer of claims from one group to another (Loanable funds theory of interest).  The saver is giving up an immediate claim to goods and services for hopefully greater future consumption. He makes this transfer to investors who, in turn, use these claims to purchase plants and equipment to produce goods and services in the future.   Hence, an increase in savings does not decrease spending.  It alters the composition of spending.  What the St. Louis Fed really fears is the holding of cash or hoarding, the equivalent of stuffing money in your mattress.  However, holding cash is irrelevant when output and input prices are allowed to adjust. Deflation is a critical part of the adjustment process and additional money printing just adds distortions. (Explanation here)

People are not lab rats, and are far more complex in their actions than the St. Louis Fed’s overly simplistic view. To propose such a silly argument is proof economists don’t live in, or accurately gauge, the real world. In the retail world, businesses run annual one-week sales with discounts of 50% or more. These sales bring additional, not less, volume during nominally slow periods. This volume accounts for only a fraction of annual sales. It, in turn, has almost no effect on consumer demand during holiday or seasonal shopping. In other words, many consumers will postpone their purchases so as to pay even higher prices in the future, so that the timing of those purchases coincides with actual need. In many cases, people actually do the opposite of what the St. Louis Fed postulates. They defer to subsequently pay more. Goods in different time periods are perceived as different goods.

Do we have complaints from technology companies that falling prices are forcing people to postpone the purchase of the latest gizmo? The proof of the pudding is in the eating. What we have learned from experience is that it takes significantly lower prices for consumers to delay purchases. There is a natural tendency to prefer current consumption over future consumption. It is the natural time preference of consumption.  Does anyone really think that a European deflation of less than 3% will cause massive delays in the purchase of goods and services?

Some claim that deflation would hurt debtors since they would be paying back with a dollar of higher real value.  In a functioning market, debtors would be hurt only if the deflation is unanticipated.   If the real rate is 3% and anticipated inflation is 2%, the nominal rate will be 5% (Fisher equation). If instead we have anticipated deflation of 2%, the nominal rate will be 1%.  If price changes are correctly anticipated, changes in nominal variable would not alter real variables.

Even if the changes were unanticipated, it would result in a zero sum game. If debtors lose, creditors win.  There is sufficient noise from the financial press about the cost of deflation on debtors, but very little said about the gain to savers. For years savers have seen the real value of their investments decline due to the Central bank’s policy of ZIRP. In a perfect world, the central bank should not exist. At the very least, it should not be concerned with deflation caused by a changes in relative prices, (explanation here) nor deflation that is not a direct result of a crash such as in 2000 or 2008 when the public and banking sectors massively increased their desire to hold cash (explanation here). Furthermore, it should not be playing games benefiting one group of society at the expense of another.

The central bank’s current policy is novocaine for government borrowing. The US government has not dealt with its debt problem and has constantly kicked the can down the road because the central bank has taken away the pain.  Without central bank intervention, higher interest rates could have led to an ultimate solution. Instead, what we are faced with today is an intractable and ever burgeoning problem.

Some reporters claim that governments, as the biggest debtors, would lose from deflation and gain from inflation. The reality is much more subtle. Much of the US debt is short term. The weighted average maturity of US debt is a little over 5 years, with large chunks being due over the next two years. This short term debt is simply being rolled over into more short term debt. The same is true of European debt, as low short-term rates have induced governments to reduce the average duration of their debt (unanticipated consequences of cheap money).

Inflation would quickly require the government to refinance at ever increasing rates. Higher rates would increase the pressure to inflate the problem away.  Lenders would quickly add a significant risk premium for the increasing likelihood of hyperinflation. Just like the money printing episodes of 1790-97 and 1921-23, the economy would then collapse with the resultant bread lines. The blame, of course, can be laid at the doorstep of the Eccles building.

Despite an incessant flow from pundits attempting to instill fear of deflation, a cursory reading of their comments section posits that the reading public is not being fooled. Common sense instead steers them to believing deflation should be cheered, not feared.

Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank. See Frank Hollenbeck's article archives.

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