Deflation is great if you have no debt. It’s even better if you are owed money! However, if you DO have debt – and most folks do, even if it is only their mortgage – then it makes loans increasingly expensive with each passing day because every month you end up paying it off with dollars that are increasingly more valuable.

It also tends to be a real drag on the economy because it discourages spending. Why spend money today when something is going to be cheaper next month? Over time, that in turn results in loss of jobs. Lots of them, as we found out during the last instance of sustained deflation in a little event called the Great Depression. ;-)

I’d like to see slow but steady rate of inflation – say 3 to 4 percent. Of course, as you and I both know, that gets tough to maintain in a healthy economy when the government is printing money like it is going out of style!

All the best,

Len
Len Penzo dot Com

All good points, but deflation doesn’t have to be a coffin nail scenario.

As the video stated, which is data taken from Federal Reserve Bank of St. Louis President James Bullard’s latest article, stating the US was in a period of deflation for 35 years in the late 19th century and the price level dropped 50%, but we still grew rapidly.

So while you’re correct about the Great Depression, deflation around obviously overpriced widgets could be a healthy thing if you take a pro-consumer point of view.

I think much of the negativity around the idea of deflation is almost like a knee jerk response: it’s bad, it’s spooky, and should be avoided at all costs.

But, humorously, it’s acceptable to debase our currency 2% to 3% every year, as long as we get fixed rates so we can “grow” into our debts and let inflation work it’s magic.

Matt, yes it is possible to have growth in a deflationary environment and the late 19th century is a good example of that.

But there was tremendous hardship for many people despite the rapid economic growth because money was in such short supply; as you know, we were on the gold standard then and supplies could not keep up with the expanding economy. The deflation didn’t end until new stocks of gold were found in Alaska and South Africa.

So what is the difference between then and now? An impressive array of revolutionary technologies during that time were driving economic growth – technologies such as railroads, the telegraph, and a bit later, the assembly line.

If the economy were growing I might agree with you, but it isn’t growing at all; the stagnant unemployment rate continues to prove that. We haven’t seen the emergence of a true worldwide revolutionary technology since the Internet to spur similar rapid growth. In the absence of that, the banks would be crazy to risk lending money to businesses in a deflationary environment – they’d be better off holding their money and getting a guaranteed return equal to the rate of deflation! :-)

Best,

Len
Len Penzo dot Com

Matt,
The US is drowning in debt making deflation a very bad thing. Japan’s been in a deflationary spiral for over 10 years (known as the lost decade.) Take a look at what’s happening over there to get an idea of what will happen over here.

If you’re interested, we wrote about this last week: http://bit.ly/Deflate

@Matt – I think sustained, substantial deflation like you’ve mentioned would be devastating. We are in the midst of a deleveraging cycle and as such, we have more loans out there than are justified by the current and foreseeable economic environment. As a result, if prices did drop with a stalled economy (and with aggregate demand having fallen off a cliff), we would certainly end up in a depression as whatever deleveraging doesn’t eat for lunch, deflation would most assuredly eat for dinner.

@Betty – That’s a solid introduction to the perils of deflation in light of existing economic conditions.

I’m not 100% convinced that 10% deflation in select sectors would be devastating. Deflation, or de-leveraging depending if you’re a bubble pragmatist like I am, is simply a part of doing business in a free market system.

Put another way: you can’t have inflation (price growth) without the fear of deflation (price shrink). Perhaps I’m dumbing it down too severely, to my own detriment, not yours, but you can’t expect continuous omnipresent inflation without a few hiccups along the way.

It will hurt some, and benefit others, as does everything in a capitalist society.

Excellent points Len. As impressed as I am with your knowledge on economics, the historical facts are even more impressive. (Makes me want to buy the new Civ V video game.)

I digress.

But I’m not so sure the Internet is a spur for economic growth as something like the steam engine or railroads. These inventions brought customers together that never had an ability to interact before. The Internet, however, has a bit of a deflationary effect since it’s causing disintermediation with so many established business models. VoIP, P2P banking, snail mail, publishing, music sharing, and on and on.

And to businesses holding onto their money, they’re already doing that. Businesses have more cash in their warchests than ever before. Instead of spending it or hiring new workers, they’re keeping in their vaults. That, in itself, is a deflationary signal, as you said, “they’d be better off getting a guaranteed return equal to the rate of deflation”. Scary thought, but one could make the argument that this is one of the reasons why corporate cash holdings are at all time highs.

But therein lies the crux of the problem: access to cheap credit falsely inflated much of our economy. And as the video describes in detail, and which is a very controversial subject, debtors defaulting on their debts is a healthy thing. In this manner, it acts like an evolutionary market should, by killing off the dead and dying banks, and replaces them with new ones. Painful? Absolutely. Helpful? Debatable since we saw what happened in March 2009 to equity markets.

In no way am I suggesting a late 19th century 50% deflationary environment, but what I am suggesting, is that we propped up the economy with cheap credit for so long, that eventually, that credit bubble has to pop. And when it did, free market theory suggests that prices will have to drop based on lower — organic — demand.

The reason why everyone is kicking and screaming to prevent it from happening is that they’re so used to an economy on steroids, that it’s only natural they fear to going back to the pay as you go withdrawal symptoms. It’s tough for the addict, but in the long run, it’s a healthier alternative.

As for Japan, the government bailed out all their failed banks and instead of pulling off the Band Aid quickly, they pulled it off slowly over the years. I would argue, this sort of prolonged quantitative easing is worse than short term pain of letting those who took the risk fail… which is very similar to what we’re doing now.

Everything we’re doing here is an oversimplification, but in the most fundamental terms, deflation hurts borrowers (we’ve got lots of this) and helps cash holders (and not so much of this). This isn’t just consumers, but businesses as well. The key to the dramatic growth and the reason we’re one of the wealthiest nations on earth is because we have a good combination of innovation and the capital markets to develop these innovations (this is the working mechanism of increases in productivity).

Should a large number of households and businesses file bankruptcy under the weight of loans that become unpayable, the financial system and capital markets are destroyed. This means fewer jobs and the losses to retirement and pension plans become alarming. Since these businesses and families have less income to tax, the government debt as a ratio to GDP become vastly larger. In short, the economic system as we know it dies. This wouldn’t hurt a few people, it would hurt everyone. Not just in the U.S., but around the world.

In a persistent deflationary environment (meaning deflation is happening now and is expected to continue into the future), innovative new projects will be less valuable in real terms. The reason for this is aggregate demand continues to decline as consumers decide to postpone purchases – waiting for prices to decline. As a result, firms take on ever fewer productive projects which means more people are unemployed. This feeds a downward spiral and can only be stopped by dramatically expanding the money supply and pumping money into the economy through fiscal stimulus.

The exception to this is when there is a major innovation that drives production costs down or if the supply of factors of production (usually raw materials) falls as a result of new supplies. A major innovation (such as finding an energy source that is 50% less expensive to produce than coal) or a major natural resources discovery (like suddenly discovering the earth’s oil supply is 20x greater than currently thought with a resulting 80% drop in oil prices) can create a very nice form of deflation.

Going back to the 19th century referenced above and in the video, we had the invention of the steam engine, the opening of railroads, and the costs of production were dramatically lowered. That’s the good form of deflation. When demand falls because people stop buying, that’s the bad form of deflation. Remember people were better off with cheaper goods thanks to transportation advances in the 19th century. Today, people aren’t better off when they have cheaper goods because more and more people cannot afford them because they’re unemployed or under-employed.

When deflation happens as a result of aggregate demand vanishing, that spells economic doom and gloom.

@Matt – Our lines of thought aren’t far apart. The basic question was whether we wanted a fast and extremely painful deleveraging cycle or a slower, more controlled version. The Fed and our government have elected for the latter for a variety of very good reasons.

We’ve had about 8% or so of the labor force leave permanently. During a fast and painful deleveraging, unemployment necessarily skyrockets. If we’re hovering around 10% now, it would have been 20% or more. This creates armies of permanently unemployed (see the research re: long-term unemployed and lack of re-entry into the labor force) which is very expensive and hinders recovery and future growth.

To say, “letting those who took the risk fail” ignores the interdependencies within the economy. If someone fails, there is a ripple effect. To let a large number of someones fail creates a tidal wave. If people are upset now with where the economy is, I would hate to see the chaos from a free fall deleveraging cycle (letting the markets cure themselves).

Perhaps this timely argument on inflation vs. deflation from a higher authority, The Big Picture blog, more eloquently summarizes my thoughts…

http://www.ritholtz.com/blog/2010/08/food-for-thoughts-on-prices/

http://krugman.blogs.nytimes.com/2010/08/02/why-is-deflation-bad/

All of these are simplifications, but the long-term scars that happen to economies that experience rapid deflation as a result of demand cliffs is perhaps the single most important element missing from this discussion.

At any rate, it’s fun to opine on subjects for which we are sorely lacking in credentials:)

Ha! I’m glad we can laugh and have a spirited debate about it even though we obviously disagree.

But, ugh… Krugman. I fully admit to knowing slightly more than what the modern American knows about economics, but Krugman seems to he would ask a government to keep even the tulip bulb bubble inflated. I’m glad the government funds some things, and to a degree, a little bit of government sponsored stimulus is necessary here and there, but I’m in the Niall Ferguson camp when it comes to the Krugman based economics.

The only problem with Krugman is that he’s right far more often than any man should be.

Great discussion nonetheless.

Matt,

“…debtors defaulting on their debts is a healthy thing. In this manner, it acts like an evolutionary market should, by killing off the dead and dying banks, and replaces them with new ones. Painful? Absolutely. Helpful? Debatable since we saw what happened in March 2009 to equity markets.”

In theory this makes perfect sense. In practice we have a government who’s determined to tinker around under the hood of the so-called free market economy resulting in competitive advantages given to favored companies (hello GM & Goldman) at the expense of unfavored ones (any community bank.)

If the current administration is in favor of an economic position, my default position is to oppose it. That goes double for Mr. (let’s just spend more money) Krugman :-)

Check out this article: http://dailyreckoning.com/heavenly-recovery-or-hellish-correction/
He’s on your side.

Thanks for the stimulating (and not at all deflationary) discussion.

Ha! Unlike most of my friends, I wasn’t throwing spit wads and/or sleeping during high school history class. ;-)

“I’m not so sure the Internet is a spur for economic growth as something like the steam engine or railroads.”

I have to disagree. Although I have no facts at my disposal (and why let facts get in the way of an argument!) I would venture that the Internet may be the biggest disruptive technology of them all (other than, perhaps the internal combustion engine). I would also venture that the Internet created more whole new mega-industries out of thin air than any invention this side of the internal combustion engine. Cisco’s IP router business, for example, which was the engine for their ascendancy. And Amazon. Even Perez Hilton and Matt Drudge.

Thanks for a fun discussion!

Best,

Len
Len Penzo dot Com

It’s funny, everybody talks about deflation eroding our spending power and such. But we should be cheering for a couple years of deflation to allow us mega savers to catch up!