16 March 2012

In Praise of Deflation

It's counterintuitive that falling prices can be bad. After all, nobody ever complained about stuff being cheaper. The problems, though, are twofold. First, if prices fall across the board, so too will wages -- but debts won't. Borrowers will have a harder time making their payments. More of them will default. And defaults will push down prices and wages even more. This so-called debt deflation is basically a doomsday machine for mass bankruptcy -- and it's exactly what happened in the 1930s. The other way of thinking about why deflation is so toxic is that it effectively increases interest rates just when we want to reduce them. What matters for borrowers is the real interest rate: that is, the interest rate minus inflation. But falling prices mean inflation is negative, so real interest rates go up. Again, bad for borrowers.

Actually, falling prices aren’t bad at all, especially if they are coming down after having been artificially inflated.  This is how the market clears itself.  Will some get hurt by this?  Yes, especially those who foolishly bet on the bubble expanding indefinitely.  But this was always a bad bet from the beginning; declining nominal prices merely reveal this fact.

Now, it is generally true that lower prices will lead to lower wages, all things being equal.  But, as long as there are generally efficiency gains in labor, the rate of decline in regards to the price of goods should be greater than the decline in regards to the cost of labor.  As long as production efficiency is realized in some way, declining wages should not be a problem because they generally will not decline as much as product prices.  Caveat:  this analysis is predicated on the assumption that there is no expansion in the money supply.  Monetary inflation complicates analysis considerably, at least in terms of nominal price, but does not invalidate the fundamental point.

That debts won’t deflate is theoretical nonsense.  In the aggregate, debt will most certainly deflate because a certain number of people will inevitably default on their loans.  Others may settle their loans in lieu of default.  The practical outcome is that deflation will hit debt.  And those that get hit the worst by deflation will be those who most encouraged the bubble by loaning to those who caused it.

The conclusion that this will lead to some sort of doomsday scenario is absurd on its face, for it is obvious that aggregate demand will never be zero.  Humans always want something, and they will pay to get what they can.  And so, while it is most certainly true that practical aggregate demand will decline considerably in the wake of deflation, it is simply farcical to even suggest that aggregate demand will go to zero, or even be cut in half.

Ultimately, deflation is the markets way of cleansing itself, allowing misallocated resource to be used more effectively.  Once the market begins to clear, prices rise again until there is once again an optimal mix of resource usage.  Trying to prevent nominal deflation from occurring only encourages the continued misallocation of resources, and makes the inevitable pain worse, while also allowing for the possibility of rampant inflation.  Thus, preventing deflation is nothing more than a lose-lose proposition, and a fool’s errand to boot.

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