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Why Is Deflation Bad? Let’s Challenge The Commonly Held View Regarding Deflation/Inflation

24 April 2009 10 Comments

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.

Purchasing Power

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!

10 Comments »

  • Matt Peer said:

    I ahve refrained from commentying on here for a while, but I’ll bite on this one.

    First, the Great Contraction in the 1930’s would have been the garden vareity recession if the Fed were not so tight with M2. The policies the Fed undertook allowed deflation to sink its teeth deeper and deeper into the general economy. Right now, while I’m no fan of these absurd bailout programs and the constitutional boundaries they cross, the Fed by and large is able to fight this thing. When deflation is calming, the Fed can and will remove the excess liquidity out of the system.

    Predictably, your next argument will be a resumption of the gold standard. Another flaw. The Depression might not have even occured if the dollar was depegged from gold. When the physical posession of gold is outlawed, like FDR did, gold too is worthless in value. Gold is a crappy store of value and provided no sort of income. If you invested in it 20 or so years ago, you would be in the red.

    The savings argument is weak too. It is good to have a domestic, or consumption based economy. Is the very definition saving and investing delay of consumption today to undertake it in the future? You will say that China has a very high savings rate, but guess what? They do that because they CANNOT consume any goods in China! Command economy and everything… Their savings are parked in Treasuries, leaving our nation and theirs in an incestuous relationship. They are export-based and since their is no demand for their low value-added goods in the US, they must stimulate also. (They had the better infrastructure-based package, were I to choose from one). They have no domestic economy, no investment.

    I agree with you this nation is heading down the wrong road, but do realize, some Austrian School economic principles are a bit far fetched in my opinion.

  • Kevin said:

    Matt,

    Thanks for commenting. Why refrain from commenting? I encourage it!

    My post is not necessarily aimed to convince anyone that I’m right, but to present an argument we rarely hear. I am by no means saying that every idea I have presented is right and should be implemented. Mainly, I have a tough time accepting that we REQUIRE inflation to grow, which is what I hear from so many “experts”.

    I don’t say you should invest in gold in this article, but that wouldn’t it be interesting if your cash didn’t continuously lose its purchasing power?

    I completely disagree that a consumption based economy is a good thing. This doesn’t mean we should have NO consumption but that when it outweighs production, this is not positive. China would benefit by having more domestic consumption, but should they become like America? Absolutely not.

    Thanks for the comments.

  • Swansen said:

    Its a very debatable point that our consumption based economy created the collapse, so with that model in mind, how can it be good, and how could we possibly come out the other side if our current model has failed us? Extreme amounts of importing, zero exporting, and about the same domesticly produced/purchased goods. The chinese don’t spend as a whole, yes, there is an extremely impoverished section there, but the culture as a whole are savers. The government tries to make people be consumers, they want an economy like the US, but the people just aren’t like that.

  • Kevin said:

    It may be debatable about a consumption based economy, but it is not debatable that a debt-financed consumption based economy caused our collapse. Simply put we bought too much stuff with money we didn’t have.

    As for China, yes they still have poverty, because they are early in the ramp up of standard of living there (they’re just getting started!). I do not believe they want to be just like the US. Do they need a higher level of domestic consumption? Of course. But that does not mean they want to be like the US.

    Consumption doesn’t create wealth, it is the benefit of creating wealth. Production creates wealth.

  • Tim @ buy snowboard said:

    Hi really enjoyed reading your post.
    Just a few months ago, inflation seemed like the thing to fear. Now we've got deflation looming over…?!?

  • finance_future said:

    There is a fallacy that if people produce less, then they have less money to spend, thus deflation instead of inflation. There is a total of goods and services in any economy, and a reduction of this total means everyone has less if shared equally. This means those who are producing the same, will demand the same share as they had before others produced less.

    Thus the price for those who produce less, will rise. Price has to match where the supply&demand curve intersect. Whether this occurs via monetary inflation or not is irrelevant to whether prices will rise due to a drop in production. Monetary inflation is only relevant as to whether the price rise will be paid by those who are productive, instead of by those who are not. In other words, monetary inflation is a method of theft. And monetary inflation disincentivizes production, and thus can cause inflation to accelerate.

    Realize again, that inflation and monetary inflation are not the same. Inflation is the (increase in the) quotient of non-productive to productive. Monetary inflation is a way of stealing net worth from savers (producers) and re-distributing it to others (those who get their hands on the new money first, which is govt and bankers).

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  • recession said:

    I am a poor person on a fixed income, so deflation would help me.

    If I were rich and owned stocks, had lots of money earning interest or earned a large company then deflation would harm me. If I owned a business my wages would stay the same and what I could sell my widgets for would be less. Interest rates would go down, the stock market would go down…
    Deflation hurts only the rich.

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