Should we fear deflation?

Should we fear deflation?

As consumers the prospect of lower prices are always enticing as it means we suddenly have greater purchasing power over goods and services. However, as economists we often espouse the view that deflation, which is the decrease in the general price level of goods and services, is bad and that the economy should operate with mild inflation. A contradiction is immediately seen as personally we would prefer if prices were low whereas we have always learned that deflation is bad for the economy and must be avoided.

So let us try and reconcile this difference by actually considering what the consequences of deflation are for the economy. This is perhaps most effectively summarised by the Federal Reserve which suggests “deflation discourages spending and investment because consumers, expecting prices to fall further, delay purchases, preferring instead to save and wait for even lower prices. Decreased spending, in turn, lowers company sales and profits, which eventually increases unemployment.”

However, there are several issues with this argument. Firstly, it is often the tendency of consumers to maintain their current lifestyle and well-being and thus they will not necessarily defer their consumption. A prime example of this is consumer behaviour towards tech products. Since 1998 the price of computers has fallen approximately 93%, however there has been almost no evidence of deferring purchases, with consumer demand increasing by 2700% in that period. Furthermore, it is a large oversimplification to assert that our expectations are only based on the past. Past prices are only one of a multitude of factors which consumers base their spending decisions on, making human actions very difficult to model.

Secondly, even if we are consuming less basic economics tells us that we must be saving more and thus investment must be higher. This will in fact not decrease demand but simply change its composition as demand shifts towards capital goods as opposed to consumer goods. Such a shift could in fact be a positive for the economy as it means more consumer goods can be produced in the future.

Finally, let us consider the effect on the company profits. Profits are not based solely on the selling price of products but rather on the difference between selling prices and cost prices. In a deflationary setting both sets of prices will drop and thus profitability can continue for the business.

Yet despite all these reasons economic textbooks and economists continue to suggest that prolonged deflation is the cause of recessions and economic depressions.  The most common basis for this claim is econometric data regarding the US Great Depression. In many countries deflation and depression did indeed go hand in hand during this time period, however we must be careful to distinguish between causation and correlation. Atkeson and Kehoe recently completed a study of economies over the last 180 years and have found in the great majority of cases there is no relationship between deflation and depression. In fact in the last 29 economic depressions 21 have had no deflation, while in 65 of the last 73 deflationary periods there was no consequent depression. Furthermore, in two of the greatest deflationary periods, from 1820 to 1850 and from 1865 to 1900 where prices fell by 53% and 48%, the US economy sustained significant economic growth.

So given the lack of correlation between depressions and deflation, is it truly warranted for governments around the world to be so fearful of the prospect of deflation? Perhaps it is time to rethink the concept of deflation and acknowledge that it may be benign. Such deflation arises from increases in productivity, which is the same as declining production costs and correspond to lower prices to consumers. This means that deflation will in fact be beneficial for the economy. However, due to the constant prevention of deflation due to inflationary policy such as pumping money into the economy, these positive externalities are never reflected. For example, in America since 1945 the general real unit cost of production has halved, but due to artificial inflation promoted by the Federal Reserve general price levels have in fact risen nine-fold.

Furthermore, deflation can actually assist the recovery process for an economy. As any simple business cycle suggests, deflation follows inflation and is characterised by a decrease in the money supply. This decrease is the disappearance of money that was previously being pumped out by the central bank, created out of thin air. This type of money drives unproductive investments or ‘mal-investments’, which occur systematically through distorted price signals during this inflationary period. Deflation however can alleviate this matter by driving money away from these investments, which relied on the previously expanding money supply, and thus alleviate the misallocation of resources in the economy. Although, these effects are indeed unpleasant, they cannot be attributed to deflation, but rather an inevitable consequence of inflation. Furthermore, deflation will stop the pool of real savings from diminishing as it had during the inflationary phase as a result of the unproductive investment. This will provide the economy with solid foundation for future growth.

This has led me to question whether our paranoia of deflation is truly grounded in economic thought. The concept of deflation is currently shrouded by myths and misconceptions, whereas in reality it is a tool of economic revival. So next time you hear the exaggerated consequences of deflation remind yourself of the inconvenient fact that what was once the country with the greatest deflation, China, was also experiencing the greatest economic growth.

Image: ‘sign of deflation’ by garycicles8, Licence at by