Friday, August 20, 2010

Who's Afraid of the Big Bad Deflation?

Not good economists. Deflation is the current fright-word used by economists and politicians alike to justify more inflation in the form of monetary reserve expansion by the Federal Reserve. A good example of this recently came from John H. Makin at the American Enterprise Institute. A less academic manifestation of the phobia-du jour can be found in U.S. News and World Report. In his succinct case for fear of deflation, Paul Krugman claims that inflation is bad because
  1. "[W]hen people expect falling prices, they become less willing to spend, and in particular less willing to borrow."
  2. "[F]alling prices worsen the position of debtors, by increasing the real burden of their debts."
  3. "[W]ages as well as prices often have to fall – and it’s a fact of life that it’s very hard to cut nominal wages — there’s downward nominal wage rigidity. What this means is that in general economies don’t manage to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept those wage declines."
Is all of this, however, truly reason to be fearful? Sound economic theory tells us the answer is no, not very much. The fear of deflation is primarily the result of trying to do economics from the perspective of the businessman. If the price at which a firm can sell its goods decreases due to decreased demand, this will reduce its revenues and, if it such a drop is unanticipated, the firm will reap losses or at least smaller profits. However, if there is general price deflation, then wages, land rents, and the prices of capital goods will fall along with those of products. Production costs will fall along with revenues, so firms will not necessarily be in long-term financial distress.

These points and others are brought out by the following recommended reading. Financial analyst Frank Shostak answers the question, "Is Deflation Really Bad for the Economy?" concluding that a fall in the money stock following previous artificial money creation actual assists the wealth-creating process by hastening the demise of unproductive malinvestment.

William L. Anderson explains Murray Rothbard's analysis of "the Deflation Bogey,"  pointing out how deflation affects both prices of factors of production as well as prices of final products. He also identifies reasons why deflation is positively beneficial after an inflationary boom.

Douglas French, President of the Ludwig von Mises Institute, presents a defense of deflation, explaining why so many economists get the deflation issue wrong while those following in the Misesian tradition get it write. Quoting economist Guido Hulsmann, French explains
Lower prices increase demand; they do not reduce or delay it. That's why more and more people own flat-screen TVs, cellular telephones, and laptop computers: the prices of these goods have fallen, and people with lower incomes can afford them. And there are more low-income people than high-income people.

Lower prices don't mean lower profits; nor do they mean that employees will be laid off. More demand for a good or service means more employees needed to produce those goods and services. "There is no reason why inflation should ever reduce rather than increase unemployment," Hülsmann writes.

Do not fall into the trap of thinking there is only one opinion on deflation--that it is the unpardonable economic sin. As the literature referenced above reveals, there exists a better framework within which to analyze deflation and that analysis indicates we need not succumb to deflation phobia.

1 comment:

  1. Heaven forbid that Americans would become less willing to borrow money!