What is deflation? According to dictionary.com,
it is “a fall in the general price level or a contraction of credit and
Falling prices. That sounds good, especially if you have set some cash set aside and
are thinking about a major purchase.
But as some additional research
with Google would seem to demonstrate, that would be a naïve and
simple-minded conclusion. According to received wisdom, deflation is a
serious economic disease. As the St. Louis Fed
would have us believe,
While the idea of lower prices may
sound attractive, deflation is a real concern for several reasons. 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.
The problem with deflation, then,
is that it feeds on itself, destroying the economy along the way. It is the
macro equivalent of a roach motel:
perilously easy to enter but impossible to leave. The problem, you see, is
that deflation reduces consumption, which reduces production, eventually
shutting down all economic activity.
Wikipediaexplains it this way:
Because the price of goods is
falling, consumers have an incentive to delay purchases and consumption until
prices fall further, which in turn reduces overall economic activity. Since
this idles the productive capacity, investment also
falls, leading to further reductions in aggregate
demand. This is the deflationary spiral.
Deflation is far worse than its
counterpart, inflation, because the Fed can fight inflation by raising
interest rates. Deflation is nearly impossible to stop once it has started
because interest rates can only be cut to zero, no lower. For this reason, "The Ben Bernank" believes that monetary policy should be biased toward preventing deflation
more than preventing inflation.
Economist Mark Thornton cites
the prominent New York Times blogger Paul Krugman
who compares deflation to a black hole, a type of astrophysical
object whose gravitational field is so strong that no matter or energy that
comes near it can escape. Krugman
economy crosses the black hole’s event horizon: the point of no return,
beyond which deflation feeds on itself. Prices fall in the face of excess
capacity; businesses and individuals become reluctant to borrow, because
falling prices raise the real burden of repayment; with spending sluggish,
the economy becomes increasingly depressed, and prices fall all the faster.
In case you’re not already scared straight, the
deflationary doomsday has already happened in Americawhen (according to
the New York Times) it caused the Great Depression
Japan,according to Bloomberg“has
been battling deflation for more than a decade, with the average annual 0.3
percent decline in prices since 2000 damaging economic growth.” The New York Times reports that
Japan’s new prime minister Abe “has galvanized markets by encouraging
bold monetary measures to beat deflation.”
I hope that
everyone is clear on this.
Now that you
understand the basics, I have some questions for the people who came up with
Why do falling
prices make people expect falling prices?
observation that prices are falling, means that in the recent past,
prices have fallen.
noticing that the price of a good, that appears somewhere on their value
scale has fallen for some time, might interpret that information and conclude
that in the future, the price of that good will be lower. But a second
individual might see the same thing and expect the price to level off and
stay where it is, and a third might interpret falling prices as an indicator
that in the future prices will be higher.
Why should a
price having fallen indicate that it will continue to fall? That is only one
of three possible future trends. Why should past trends continue
Why will the
public mainly choose the first of these three outlooks, more than the other
economist Jeffrey Herbener, the assumption that
falling prices create expectations of more of the same is a feature of
certain popular macroeconomic theories in which price expectations are
modeled as part of the theory. In his testimony to Congress, Herbener observes that “the downward spiral
of prices is merely the logical implication of assumptions about expectations
within formal economic models. If you assume that the agents operating in an
economic model suffer from expectations that are self-reinforcing, then the
model will produce a downward spiral.”
expectations self-reinforcing? It would make just as much sense to say that
expectations are self-reversing—after people have seen prices go down
for a while, they will expect prices to go up.
formal models a good description of human action? Contrary to what these
models say, there is no fixed response to an event. In my own experience, I
can think of many times I, or someone that I know, jumped on a low price
because we did not expect the opportunity to last.
But what about
postponement theory depends on the assumption that a fall in prices will
benefit buyers who wait. This is true if we are talking about people who have
lots of cash and can sit on it indefinitely. But most of us have ongoing
monthly expenses and we depend on our wages to replenish our cash reserves.
Our purchasing power, at the time when we want to make a delayed purchase,
comes from our cash savings and our wages. A fall in wages, if substantial,
would wipe out any gains in purchasing power realized from lower prices.
do not buy today because they expect lower prices tomorrow, then what are their
expectations about their wages? Do they anticipate that their wages will be
the same, higher, or lower? If lower, then by how much? As much as prices
forecast lower prices and stable wages, then why are
consumer prices included in the models, but wages are not? Does
deflation only affect consumer goods prices, leaving all other prices
the deflationary death spiral theory, decisions not to buy drag the economy
into a death spiral. Does anyone expect that could happen without affecting
And what about
In addition to
cash savings and wages, individuals decide how much to spend and save taking
into account the amount that they have already saved. Someone who is trying
to save to meet their family’s future needs will feel less comfortable
hold some of their savings in cash. That portion of their savings increases
in purchasing power when prices fall. But people also save by purchasing
financial assets, such as stocks and bonds, or real assets such as property,
and rental housing. All of these assets have a price, which could rise or
fall. Depending on the mix of cash and other assets that an individual holds,
a fall in asset prices could wipe out any gains in purchasing power from the
cash portion of their savings.
Do people take
value of their past savings into account when deciding whether to buy or
wait? Or do people form expectations about consumer prices only and ignore
what might happen to their savings in a deflation?
consumer prices generate expectations of more of the same, what impact do
falling prices have on expectations about asset prices? Do buyers who delay
purchases expect the prices of their saved assets to be lower as well? If
not, then do they expect that consumer prices will be lower and asset prices
will be higher?
causes the economy to disintegrate, will asset prices be spared?
Is it only
buying behavior that is affected?
The deflation death star begins to destroy the earth
when buying is postponed.
But is it only buying that is
affected by expectations about the future? If buying is affected but not
selling, then why not?
If consumers expect lower prices of
most things, including things that they already own, it is equally logical
that they would sell their possessions and their assets in order to buy them
back later at a lower price. Selling your home and renting a similar one
would be the place to start. Selling your car and leasing would be the next
step. Finally, selling your assets for cash would be equally profitable.
Expectations of lower prices should lead to a spiral of selling, driving
prices down even faster, leading to more deflationary expectations and more selling
until everyone has no possessions and no assets other than cash.
If this happened, then who would
Do prices ever get low enough?
If buyers expect lower prices, then
how much lower? Any number in particular? If a buyer expects a specific lower
price, and the price reaches that level, will he buy? Or does he always
expect prices to go even lower than they are today, no matter how far they
have fallen already?
If expectations of lower prices
turn out to be correct, and prices drop to even lower levels, then is there
any point where a minority of contrarian buyers defect from the consensus and
begin to see a bottom, or even an uptrend? Or do these expectations go on
forever adapting to lower prices causing prices to drop indefinitely?
The point of delaying a purchase is
so that you can make the purchase in the future and have some additional cash
left over to make another purchase or to save. What is the point of delaying
a purchase that you never make?
We have all had the experience of
buying a new computer, or some other device, the day before the next version
was released and it costs less and does more. If you knew would you have
waited? Maybe, but maybe not. If you need a computer for work, then you will
buy it sooner rather than later.
Many people delayed their purchase
of the iPhone 4 in order to buy the iPhone 5, then
when available they bought the iPhone 5. My iPhone4 was worn out by that time
and I needed a new phone.
What about the Law of Demand?
According to the law of demand, a greater quantity of a
good is demanded at a lower price than at a higher price. If that were true,
then people would buy more, rather than postponing purchases.
to the law of demand in a deflation? It turns out that the law of demand has
a loophole: it requires that all other things remain equal. In a deflation
death spiral, all things are not equal. Consumer preferences change in
response to prices. Stationary supply and demand curves do not exist in such
a world. For prices to fall and yet still fail to induce buyers to buy, the
quantity demanded must always fall by more than enough to compensate
for the lower asking price. The demand curve is always shifting downward
faster than the price falls, to prevent an equilibrium price from ever forming.
Economist W. H. Hutt calls this “an infinitely elastic
demand for money.”
describe the world that we live in, or any world that we could imagine? Do
people really react in such a mechanical way to price changes? How do we
explain, for example, shoppers competing to buy at low prices?
Why do sellers
not lower prices?
Why is it only
buyers whose expectations of lower prices are based on falling prices? Are
the expectations of sellers included in the model?
If not, is
that because the models assume that sellers do not have expectations? Or do
the expectations of sellers not match the expectations of buyers?
have the expectations of lower prices, why do they not lower their prices
immediately in order to sell inventory ahead of their competitors?
the deflation spiral theory, expectations frustrate market clearing. Yet, as Rothbard argues, speculation about future prices
helps prices to converge to market clearing values. If buyers and sellers
both expect future prices to be lower, why do market prices not converge upon
this new, lower level immediately?
If customers are postponing
purchases expecting lower prices in the future, but sellers do not cooperate,
then inventories will accumulate. If this began to happen, then why would
sellers not lower their prices immediately in order to clear out inventories?
All of us are both buyers and
sellers, of different things at different times. To say that only the
expectations of buyers are affected by falling prices, is to say that the
same person, early in the day, has expectations about his own future
purchases, but later the same day, does not have expectations about his own
current and future sales. Does the model assume that we have all been
lobotomized so the two sides of our brain do not communicate with each other?
Do producers have any control over
Previously, I asked if sellers
could anticipate lower prices as well as buyers. If the producers anticipated
lower prices, why did they go ahead and produce the item, or order raw
materials with such high costs that they could not make a profit?
If a single business firm is
experiencing fewer sales, they may not be able to reduce their costs because
a single firm is close to being a price taker in the markets for labor and
capital. There are usually alternative uses for their factors that value them
more highly, at or close to current prices. But if prices,
and sales are falling everywhere, or if everyone expects this to be the case,
then why will suppliers not lower their prices if they expect their costs to
What are people doing with the
money that they did not spend?
Suppose that people postpone
spending. What do they do with the money they did not spend? Are they
increasing their cash holdings? Or are they spending on investment goods? Saving and investing is a form of spending, only the expenditure is for capital goods rather than
consumer goods. In this case, there would be no general decline in total
spending or employment. Workers would have to change jobs from the
consumption industries to capital goods industries, as Hayek explains in his
essay "The Paradox of Savings"; but
production would continue during the transition.
How much lower
prices are necessary to induce people to postpone purchases?
There is a
return on the purchase of a consumption good that results in the services
provided by the good. This must be balanced against the return on the cash by
holding until prices are lower. As noted by theCenter for Economic
Policy Research (CEPR),a small price change is not much
of a motivation to wait, if you need a new product:
[postponement of purchases] would be true for rapid rates
of deflation, but Japan's deflation has almost always been less than 1.0
percent a year. In 2011 its inflation rate was -0.2 percent. This means that
if someone was considering buying a $20,000 car, they could save $40 by
waiting a year. It is unlikely that this rate of deflation affected the
timing of many purchases to any significant extent.
quantities adjust but not costs?
If there is a
generalized increase in money demand, then prices need to adjust downward.
Why is it that all the quantity of goods bought and the quantity of labor
employed can adjust, but prices cannot?
According to The Asia Times, when deflation strikes,
factories lay workers off in order to cut costs. Why cannot producers lower
their bid prices to their labor force and their suppliers in order to
preserve production? If they could lower their costs, then they could produce
profitably at a lower price level.
price level does not matter to business firms, so long as their costs are
below their sale prices. Why does a deflationary meltdown assume that
business can not operate profitably at any nominal
price level? Why can business not lower costs?
Is this really
what caused the Great Depression?
What about the
credit bubble of the 1920s?
What about bank failures? The great
contraction of the money supply?
The Smoot-Hawley tarrif?
What about regime uncertainty?
How about new deal wage and price policies that prevented prices
from falling, which would have allowed employment to recover?
The deflation death spiral is a
theoretical description of a situation but it does not describe the reality
of human action, for any number of reasons:
1. There is in reality always a
diversity of expectations among the public. While some people will expect
prices to continue in the same direction, others will form the opposite view.
Everyone’s expectations will change not only in response to changes in
the data, but taking into account their entire life experience, their own
ideas, and their situation.
2. Expectations are not entirely
driven by prices. A broad range of things influences our expectations about
3. Lower prices are not always
sufficient motivation to delay purchases because everyone prefers to have
what they want now, rather than later.
4. Expectations of buyers tend to
be met by sellers, if not at first, then fairly soon. In some cases, buyers
can hold onto their cash for a bit longer, but most businesses have no choice
but to sell their inventories at what the buyer will pay. In other cases,
buyers may not be able to delay purchases, or may not wish to, and will pay
what they must in order to buy.
5. Everyone—buyers and
sellers (and every one of us acts in both of these roles at different
times)—has expectations not only about consumer prices, but about
wages, employment prospects, even asset prices, the economy in general, the
progress of our own life, and the future of our family. A coherent plan of
saving and spending takes all of these things into account.
6. Expectations can be met. Buyers
have a buying price. Even if not known in advance, they know it when they see
it posted. Even if they do not know what they plan to buy in the future, a
bargain price will be met by buyers.
7. People only need so much cash.
Beyond that, they start to look around for either consumption goods, or