By Jeff Harding
I loved this article by Bloomberg’s Matthew Lynn about deflation. It doesn’t get into the causes of deflation or inflation, but it goes into the economic impacts of deflation. It’s a trade off in that savers and consumers are benefited and debtors are punished. With inflation, it is the opposite. The world, including the U.S., is experiencing deflation now, and it seems that neither the Fed nor the Obama Administration can stop it.
Deflation Theory Is Lemon We Have All Been Sold: Matthew Lynn
Aug. 18 (Bloomberg) — For much of the last year, central bankers, industrial leaders and politicians have been warning us about deflation. Falling prices, they tell us, will create another 1930s-style depression. The only answer is to print money furiously.
Now it turns out the theory is a lemon.
Deflation is no threat at all.
It doesn’t prevent an economy from functioning, and it doesn’t stop it from recovering either. The evidence suggests a period of sustained deflation might be what indebted economies need to get them back on the right track.
U.K. Chancellor of the Exchequer Alistair Darling said in a speech earlier this year that the Bank of England must be “prepared to act” to prevent price deflation.
“We are very keen on avoiding deflationary risk,” said European Central Bank President Jean-Claude Trichet in an interview this month. Much the same message has been pumped out around the world by economic leaders.
Nor have they been slow to put their freshly minted money where their mouth is. The Bank of England has embarked on a program of “quantitative easing,” or creating new money, to stave off the threat.
The trouble is, the theory doesn’t stack up.
Deflation, after all, has already arrived.
Falling Prices
In the euro region, prices fell a record 0.7 percent in July from a year earlier, after declining 0.1 percent in June, according to the European Union’s statistics office. In Germany, Europe’s largest economy, consumer prices posted their first annual drop in more than 22 years in July. Wholesale prices plunged almost 11 percent.
So the “deflating” euro area is disappearing over an economic precipice, right? Not quite. It is leading the world out of recession. Figures released last week showed Germany and France were hauling the region out of the global decline — both expanded 0.3 percent in the three months through June after four consecutive quarters of contraction.
Not much sign of the dangers of deflation there.
In reality, anyone with a sense of economic history would have been aware that the whole deflation story was oversold. In the U.K., the House of Commons Library publishes data on prices going back to 1750. From 1814 to 1914, prices rose a bit in some years, and dropped a bit in others, so there was no real change in the price level over the century.
Greatest Power
In other words, there were plenty of deflationary years. Yet over that period, the U.K. became the greatest economic power in the world: Its relative decline only started once inflation took hold. Deflation didn’t stop the Industrial Revolution, one of the most sustained times of economic creativity ever seen.
Likewise, a 2004 study by the Federal Reserve Bank of Minneapolis looked at the data on deflation across 17 countries over 100 years. It found that although the Great Depression of the 1930s was linked with falling prices, that wasn’t true of any other historical period. There was, it said, “virtually no evidence” that deflation caused a depression.
Why should it? We are constantly told that deflation is bad because it makes consumers hold off from buying things, thinking they will be cheaper tomorrow. But that is just silly.
Two Impulses
Everyone knows that a computer or an iPod will be both better and cheaper in six months. And people really want one right now. Torn between those two impulses, plenty of shoppers go out and buy computers and music players. It is true in the electronics industry, and, once they get used to falling prices, it will be true for other industries as well.
Deflation may be bad for particular interest groups, which happen to be very powerful. It is bad for chief executives. It is easier to keep your profits rising in a mildly inflationary environment. You can just jack up your prices a bit, and you can often cut workers’ wages by stealth by holding wages steady.
The banking industry, which has come to rely on inflation to make highly leveraged loans sustainable, also dislikes deflation. Likewise, it is bad for governments, which use inflation to reduce the value of their debts.
On the other hand, deflation is good news for savers, who get richer just by hanging on to their cash. And it is beneficial for consumers, who get cheaper prices. It is usually good for workers as well, as they can generally hold the value of their wages, even while prices fall.
There are winners and losers, just as there are from most economic developments. The important point is that the people who lose are more powerful than the people who gain. That might explain why we hear about the dangers of deflation, and not about its advantages. It still doesn’t make them right.
There is no threat from deflation. It may even be desirable if it encourages a balance between saving and consumption, and discourages governments and banks from taking on debt.
(Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: Matthew Lynn in London atmatthewlynn@bloomberg.net.
Jeff-
Yes, deflation’s great for individuals who have money and are looking to buy stuff, but it’s a problem on the macro scale.
This piece strikes me as another example of MSM turd-polishing. I suspect if we had 20% inflation Mr. Lynn would be telling us double-digit inflation’s nothing to be feared either. Whatever the latest number, the MSM finds a silver lining.
The problem is, we have a banking, consumer & commercial credit system and gov’t that are predicated on inflation-driven growth. Mr. Lynn says deflation “is bad for governments, which use inflation to reduce the value of their debts.” Well, “their” debt, like it or not, is our debt. With the debt and obligations of the various levels of gov’t being several multiples of our nation’s yearly GDP, this is no small problem.
Mr. Lynn’s suggestion that deflation might encourage gov’ts to not take on more debt is dreaming. If anything, the advent of deflation will spur Mr. Bernanke to double down, like FDR did when he revalued gold.
Seriously? Deflation is good for savers? If what we have today is deflation — and zero interest rates — how is that good for savers? I don’t understand this.
Joanbob,
Good question. Inflation robs savers of the value of their money. Prices go up and their dollars buy less. In a deflation, dollars become more valuable in that things are cheaper to buy. While the nominal (not adjusted for inlfation) return on their bank deposits are lower, in inflation the real (adjusted for inflation) return is greater because dollars buy more. Does this make sense?
Lloyd,
I like your metaphors. You make some valid points.
But step back for a moment and think about the implications of deflation. It would be nice if our currency was stable, but it isn’t. Thus the case for gold. Someone’s ox gets gored in inflation or deflation
I don’t think deflation is necessarily bad in our present case. Yes, it would seem that governments aren’t limited by deflation, as our present situation has shown. But …
The way many free market (Austrian school) economists look at business and credit cycles is that the real damage is done on the way up, during the inflationary phase of the bubble where cheap money pumped into the economy by the Fed drives asset prices up. These investments are not economically viable but for the massive money pumping by the Fed and the resulting inflation. In our situation trillions of dollars were directed to economically bad, mostly real estate, investments.
How do you correct this? The economy always responds by getting rid of the bad assets and debts that burden them, resulting in deflation. So I would say that the deflationary period is the healing process. Capital is saved rather than consumed, asset prices go down to a point where they may be economically viable, and some people are always hurt. But it’s the only way to wipe out the malinvestment and pave the way (through savings) for a recovery.
Since wages are declining, that seems to be a problem, but if prices are also declining the impact isn’t as bad.
It all depends on the context.
If you look around the world, we have deflation everywhere. The Fed would like to do something about that, but for all the trillions poured into the economy, deflation still goes on. They can’t stop it. But inflation? That distorts everything and robs people of their savings and favors debtors and speculators. My guess is that if we had a true gold standard, without fractional reserve banking, these cycles would disappear.
Jeff-
All of what you say is good. In theory. If we had the gold standard and Austrian economists at the levers at Treasury and the Fed, I would be comfortable. We’d ride out this deflation phase and be the better for it on the other side.
The problem is, deflation is anathema to the control freaks in DC. They don’t view it as a natural corrective. They view it as a consequence of inadequate tweaking on their part. They will overreact and make things worse.
Lloyd, while I agree with your sentiment, it’s not about theory. Right now we are in deflation and neither the Fed nor the Treasury can do anything about it. God knows they’ve tried. The fact that they continue to make policy mistakes is another matter. Deflation is always the consequence of malinvestment.
I’m in awe. A sane article on the economy from a mainstream source? Shocking.
[...] the existing money supply at any given moment. Both factors are operating right now. This is reflected in the economy by falling prices, such as with real estate. Also the money supply is contracting despite the [...]
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[...] the existing money supply at any given moment. Both factors are operating right now. This is reflected in the economy by falling prices, such as with real estate. Also the money supply is contracting despite the [...]