Wednesday, March 24, 2010

Deflation should be embraced, inflation should be rejected

The Angry Economist sums up much of the misguided fear that our economic and political "experts" have towards deflation.

Deflation is defined a decrease in the supply of money and results in falling prices. Each dollar has a stronger purchasing power. And just who wouldn't want this outcome ?

Well, our poorly schooled Keynesian economists warn that falling prices cause some kind of never ending deflationary spiral and a deficit in aggregate demand. Keynes asserted that people just won't spend anything under a scenario where all/most prices fell, and there would be pressure to cut wages as the outputs of industry fell in price. The so called spiral was as follows: Start->Inventories would grow, output would contract, employment would contract, incomes would fall -> Return to Start.

Keynes actually thought the laws of supply and demand didn't apply to labour like all it did with all other goods, and that wages could never adjust downwards to clear. So he blindly assumed unemployment would result and an economy would contract. When he suggested that this was the underlying cause of the business cycle and the great depression, the politicians swallowed every word of his.

This theory should have been flushed down the toilet in the face of reality. People always need to eat, they need clothing, work tools, housing, schooling and education. Not all purchases are speculative decisions. Sure, you'd think people might postpone many investment purchases if shares or property kept falling, but deflation isn't some never ending process. And real economic activity will continue despite the fall in speculative activity.

The kind of speculative activity that thrives under inflation - like the huge credit bubble that fueled the US property market till 2006, or the share market, or other asset bubbles across the world that occurred under inflation.

But returning to the fearmongering about deflation, The Angry Economist gives a great example of how misguided the arguments are:

The common wisdom is that deflation of the currency is bad. When money deflates, it becomes more valuable, even when you do nothing. So the theory is that people won't spend their money, because it will become ever-more valuable.

That theory cannot be true.

Look at the PC market over the last 30 years. In each one of those years, the PC became more reliable, faster, came with more memory and storage. The original MDA display was one color and text only. The CGA had 16 colors and 640x200 bits. The price -- of the computer you really want to have -- has stayed constant, at about $5000.

If the story told about deflation was true, then you would always be better off delaying your purchase of a PC by 6 months. You could be confident that the PC you would buy would be a more valuable PC.

Except ... that people did that very rarely, if ever. The standard advice was always "don't wait to buy a computer, because there will always be a better computer on the horizon."

So, in a situation where people can predict a constant stream of increase in value, people STILL made the trade. Thus, I think it's safe to predict that in a similar situation, where people could predict a constant increase in the value of their money, they would spend their money as needed.