Why Is Deflation Bad? Let’s Challenge The Commonly Held View Regarding Deflation/Inflation
There is a big debate going on whether inflation or deflation is occuring, which is worse, and what should we do to create a nice balance between the two. The most commonly held view is that deflation is a disaster for an economy, and inflation is tolerable as long as it doesn’t get out of control.
Deflation is characterized by a reduction in the money supply (the amount of money circulating) and by falling prices of consumer goods. Inflation is characterized by an increase in money supply and higher prices. If you knew nothing else, wouldn’t you guess that falling prices would be better than higher prices? I would. But there are a few things why this is terrible for our economy.
Why Deflation Hurts Us
There are two big reasons why deflation hurts our economy. First, our economy is based on consumption (this isn’t a good thing, but it’s reality). It’s generally accepted that in a deflationary environment, people will hold off on a purchase because they think it will get cheaper. People saving their money, and not spending it, hurts our economy (remember, our economy is dependent on consumption), which hurts businesses, who then lay off workers and the cycle gets worse.
The other reason why deflation hurts is us falling asset values. In a deflationary environment, our home values and most likely stock values will go lower. Many people are dependent on both for financial security and retirement.
My Problem With This Argument
If we first address the idea of not spending money because of falling prices, I have a few problems with this. First, don’t prices on specific items like LCD TVs, other technology products, etc. always go lower? Last I checked, people still bought plenty of iPods and huge TVs in recent years. Any product that is innovative is always going to get cheaper, because newer and better products are just around the corner. Does this stop people from buying them? No.
Second, this argument clearly states that saving money is bad for our economy. With the way our current economy is setup, yes it is bad for our economy; but, this shows that our economy is itself not in good shape. If we were an economy based on production (which we should be), people saving money would be a great thing, because it would lead to investment and higher productive capacity. Instead, we emphasize debt and spending vs saving and production. Saving money is not a bad thing and should never be discouraged. Unfortuantely, because of a major flaw in the fundamentals of our economy, saving hurts us. Re-structure the economy; don’t discourage saving.
My last issue is the fact that deflation hurts asset values. Let’s look at home values first. Yes, falling home prices is bad for anyone owning a home, but what about those were have been saving to purchase their first home? Falling home prices make homes more affordable for people. Falling stock prices is definitely bad for any long term investor, but have we ever considered that we are perhaps too exposed to the stock market as a society? One of the reasons why everyone needs some stock market exposure is because stocks will keep up with inflation for the most part. What if we didn’t have inflation? It’s interesting to at least ponder this idea.
The topic that rarely gets brought up in this argument is purchasing power. Deflation increases our purchasing power because prices are lower (basically, there are fewer dollars chasing the same number of assets or goods). Your savings actually increase in value during a deflationary environment. The opposite is true in an inflationary environment.
It is actually the official un-official policy of our government to have moderate inflation each year. Many people accept that inflation equals growth. Because of this inflation, the dollar has lost over 97% of its value (or purchasing power) since the Federal Reserve was created almost 100 years ago. This long-term inflation is almost entirely caused by government and monetary policy. It’s important to understand that government’s benefit from inflation. It allows irresponsible fiscal and monetary policy. You can borrow millions, inflate the money, and all of a sudden a few million doesn’t seem like too much to pay back. We’re currently in the trillions, where to next?
A World WIthout Inflation
What would your financial life be like without inflation, or better yet, what could it be like? Well, if inflation were not a factor, your money would keep its purchasing power or even gain purchasing power. This means you could save money and keep it in cash. You wouldn’t feel the need to chase huge gains in speculate markets. Your home would become a place of residence versus an investment that your retirement depends on. Why is this an unattractive picture for society? Do we really prefer the asset bubble after asset bubble type roller coaster of an economy that we have had over the last decade(s)? Do we prefer that most Americans just had their retirement funds cut in half due to a stock market implosion? Do we prefer a low (or negative) savings rate because we’re addicted to debt and consumption? Why is holding onto cash such a terrible idea? Why can’t the money I earn retain its purchasing power over time? Does this make sense?
I encourage you to stop listening to the re-election focused politicians who think they can run an economy. Ask yourself these questions I’ve listed in this article. I’ll leave you with one last thought… if inflation worked, there would be no poverty in the world. Every society would print away to achieve prosperity!