Thursday, August 5, 2010

Scared of deflation?

I have always been puzzled at the assymmetry of 'flation fear'.  A little inflation is good, but a little deflation is a scary thing.

Paul Krugman outlines the general argument as follows:
So the argument that deflation is a bad thing is also an argument saying that some economic problems get worse as inflation falls, and that too low an inflation rate may actually be economically damaging.

For the life of me I can't see how an inflation rate of zero can be damaging in the long run.  Also, if we look at Krugman's argument in reverse, more inflation is better.  Why isn't the optimal inflation rate zero instead of some positive number? Why 3% instead of 10%? Do human have an inbuilt behavioural trait that only we are able to plan and invest knowing that currency in the future will worth less rather than more?

Steve Landsburg on the other hand makes the argument that deflation fears are not justified by economic theory or evidence - I don’t see the problem in theory and I don’t see the problem in practice.

And he concludes that even if deflation is bad, it is easily solved.
Even if deflation is a bad thing, we know how to solve it. Print enough new money and people will eventually start spending it. It’s alleged that no matter how much you print, it can all just fall into the liquidity trap, and it’s alleged that this is what happened in Japan over the past decade. But I am sure the Japanese just didn’t try hard enough. Liquidity trap or not, I guarantee you there’s a central banker in Zimbabwe who knows how to fight deflation. If we really get into trouble, all we have to do is hire him.

As I have noted before, the world survived just fine for a long period of time with inflation at zero on average. Positive inflation in the long run did not occur until post WWII. Some might even argue that this is simply the longest ever business cycle stimulated by enough debt to keep inflation positive, and that the next fifty years, subject to international politics, might see prolonged deflation.

Avoiding deflation in the short run may have made the global economy far less stable in the long, long run.

Maybe it is just that with high debt levels adjusting to deflation from a persistent inflationary environment will unsettle much investment, and mean a transition period were many jobs are lost.  Any thoughts?


  1. Deflation may seem ok, we may even feel comfortable with it.

    Right up until our incomes also deflate to where find unable to meet our debt payments; Do not see our debts decreasing in value, except at the rate our payments remain higher than interest charged.

    Inflation appears to help us pay the debts of quicker.

    More psychology than economics ?

  2. It's an interesting question that you have posed and I'm not sure that there is an easy answer.

    Like Paul said, the danger of deflation is that it makes repaying existing debts harder and could lead to a painful transition for many people. Imagine trying to pay-off a $500k mortgage with stagnant incomes and falling house prices? So inflation makes leveraging (speculation) less risky, since debts are inflated away.

    One benefit of the gold standard, which tied the value of a country's currency to it's gold reserves (i.e. the money supply could only increase if more gold was discovered) was that it ensured that a country's currency maintained its value and kept inflation to near zero. But ever since countries moved to a fiat (faith) based system, the money supply has expanded ever since, along with inflation.

  3. The assumption underpinning the deflation is bad argument is that we have high levels of debt. It is true now, but was it true when we began hating deflation? Or was it just an association between deflation and downturns in the business cycle prior to WWII that led to the new mantra? "Keep inflation positive and you will never have a downturn"

    Leith, you are definitely on to something about the gold standard ensuring that money creation, and therefore debt fuelled speculation, was kept low.

  4. Paul said: "Inflation appears to help us pay the debts of quicker."

    There are creditors and debtors, so inflation also appears to make it more difficult to save. One would think that this would have creditors demanding higher interest payments to compensate, so paying off the debt would probably not been quicker at all.

    But that's irrelevant. Apparently deflation makes debt harder to pay. Good! Debt should be hard to repay, and should not be taken on at a whim. Encouraging debt over savings sounds like a path to disaster to me. The world seems to be slowly realising this. It's a shame our central bankers are not.