Busting Deflation Myths

This article of mine originally appeared in the 1st Quarter 2015 edition of Personal Finance magazine.

The fear of deflation is sweeping across the globe. By ‘globe’ I really mean the clique of elite policy makers, bankers and the economists they employ. The rest of us mere mortals are positively chuffed about deflation – whoever said “no” to lower prices? So why are policy makers and economists so scared of deflation? How could 7 billion people be so wrong?

Well, it turns out, the fear of deflation, or Apoplithorismosphobia, as American economist Dr Mark Thornton wryly dubbed it, is largely an irrational fear. To show this let’s deal with three of the strongest and most common myths about deflation.

Myth 1: Falling goods prices cause people to stop spending which damages economic growth

The peddlers of this argument say that if people always expect prices to fall next month, they’ll delay their purchases indefinitely, causing a slump in retail sales. Retailers are forced to cut their prices even more, causing consumers to delay buying further, creating a vicious deflationary spiral and economic slump. The real world is not so glum. Each year computer technology prices remain stable or fall while computing power grows. People buy these products now because they value using the products now far more than waiting for a lower price for an already affordable product. The boom in the computer technology economy during a multi-decade period of deflation shows that deflation doesn’t cause an industry to collapse in recession.

Myth 2: Falling goods prices make people reluctant to borrow since they have to pay back more in real terms in the future

Less borrowing, so this argument goes, means less spending, forcing retailers to lower their prices and discouraging borrowing even more. Again, causing a vicious spiral. Leaving aside the fallacy that borrowing is needed for spending and growth (since purchasing power is merely transferred during borrowing and true purchasing power is funded by production), it’s clear that what matters for a borrower’s considerations about his repayment is inflation (or deflation) relative to the interest rate. A 5% rate of inflation and 15% interest rate means the borrower must pay back an amount roughly 10% more in real terms than he borrowed. This is common in today’s economy and millions of people and companies borrow on these terms. A 2% rate of deflation and 5% interest rate means the borrower must pay back around 7% more than he borrowed in real terms – a less onerous task than in the first example. It has nothing to do with deflation and everything to do with the real interest rate.

Myth 3: Companies will stop producing if the prices of their goods are falling, leading to a business slump and layoffs

This is a myth because producers care less about inflation or deflation in their products than they care about the difference between their cost of production and their selling price. Myth 3 assumes selling prices are falling faster than costs, but if costs fall first or faster then this won’t be the case. But what if selling prices do fall below production costs? Well then producers are clearly making too many of those products at too high a cost, which is economically wasteful. Companies need to restructure. But note, this is not peculiar to deflation – it happens with inflation too (often!).

Deflation = Economic Progress

Deflation is not only a fabricated menace, but it’s actually the very essence of economic progress. Whenever there is progress, there is deflation. Think back to the information technology example from earlier. Every time we see investment in productive machinery, innovation, and process efficiencies, we tend to see deflation. The major economies of the world grew rapidly in the second half of the 1800’s during deflation. Until Henry Ford built his production line, cars were unaffordable. The mark of underdevelopment is that the cost of living is high, not low. As undeveloped regions attract more investment, innovation and productive efficiency, so prices of previously out of reach goods become more affordable.

What the world desperately needs now is deflation. The early signs of falling prices around the world in 2014 was a major market signal. The market, made up of billions of ordinary people, is saying: prices are too high. It is peoples’ inability to afford the high costs of living that causes them to delay purchases, which begins to force prices down. Sadly, central banks and governments fight the will of the people by printing and borrowing money out of thin air in order to keep prices high and pay off national debts. Banks also lobby to avoid deflation. Their assets, acquired by lending money created out of thin air, can fall in value during deflation while their cash liabilities remain the same, leaving them insolvent. There are powerful vested interests to avoid deflation. Most of the time these vested interests trump the will of billions of people living under the yoke of high prices.

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