Why favoring a low and steady inflation rate? An Introduction to Deflation

The last few articles make inflation seem like an evil force corrupting the economy. However, the dark side is not always so dark after all. Despite all the talk about the bads of inflation, it might be surprising to you if I were to inform you that economists actually prefer a low and steady positive inflation rate. That is exactly what I am going to do. Ready?

Economists actually prefer a low and steady positive inflation rate. I said it again, and I still want to say it once more. You heard me right. However, note that, it must be at a POSITIVE but at the same time, LOW rate. In other word, we follow the rule of thumb: “too much of anything is never good, but a moderate amount is almost always perfect”. This rule actually applies to many facets of life. Think about it by yourself.

Have you ever heard of “inflation target”? That is what central banks in every country do first thing in the morning. Yes, even before breakfast. Although the inflation rates between 1%-2% are normally considered acceptable and most of the time, desirable, but in reality, most inflation targets, if I’m correct, would be in the range of 1%-5% to adapt to the current settings of different nations.

All the talk, where is the explanation? Why? Why do we want a slowly growing price (or slowly deteriorating currency value)? Like the great wise man once said, you can only realize the true significance, the real value of something when you lose it. By the same token, to really understand why inflation should remain in existence, we have to imagine a world without it, or to be more precise, not just a neutral world with 0% inflation (because trust me, this is really hard to achieve, not with capitalism, not with free market), but a world with deflation (i.e. negative inflation).

Before going any further, it is best that we get to know deflation first. What is deflation? Deflation is the exact opposite of inflation. Whereas inflation is an economic phenomenon made up of rising price/falling money value, deflation is an economic nonemonehp (spell it backwards) of falling price/rising money value. However, short-term fall in price due to competitive nature of the market and improved efficiency (ex: advanced technology lowering cost ==> lowering price) can be defined as a good deflation. The bad one mostly persists in the long run for a year or more. So to sum up, you can think of it this way. Short-term deflation is generally good. It signifies efficiency and high productivity which are vital for economic growth. Long-term deflation, in contrast, almost always results in false incentive and loss. Let me elaborate it in details below.

The idea, when first introduced to people, sounds like a good plan. Who does not want cheaper clothes? Or even better, cheaper luxurious cars, houses and vacations. That is why some might think: What a horrible world we are living in! Everything seems to always become less and less affordable! If only things could fall in price, that would make life a lot easier. You think so too? If you do, I am sorry to inform you that you are about 90% wrong. 10% really wrong. Like said, short-term deflation does not spell doom for the economy, but the longer term one usually does.

Individually, you will gain in short-term simply because of the sticky wage effect. That means your hourly wage/monthly salary resists downward pressure. So if you money becomes more valuable as a result of deflation, in the short run, you will be able to buy more goods and services. Due to income effect (more income –> buy more), you will just do so. You would feel richer, and you would make more purchases, living a life of a king/queen.

How long will this fleeting bliss last? Not that long I would say. Complacency is not an option during deflation. Most governments would take action immediately to tackle this problem. Wait, why is it a problem in the first place if everyone is so happy buying more of cheaper goods? Why can we not perpetuate this happiness of ours?

You see, the greatest fear for a government is probably not inflation but persistent deflation. Deflation is an insidious disease that is, to my understanding, even harder to cure than inflation. Deflation entails a huge loss for the aggregate economy. Try thinking from a businessman point of view. Your company manufactured a car. At the beginning of the year, you purchased raw materials and other inputs on top of incurring expense on input-to-output converting process/technology at a total sum of $100. Sadly, due to deflation, the market price was put under downward pressure as currency value suddenly increased. So if the car was priced at $110 ($100 total cost + $10 profit) before, due to deflation and competitive market pressure, you were forced to reduce price to $90, or else, you would not be able to sell the car at all. Long-term deflation creates this problem for almost every industry within an economy. It becomes a real headache when firms’ technologies, efficiency, and cost-cutting measures cannot keep up with this falling price. Their profit margins would shrink drastically, and most would be forced to cut production, layoff workers (since wage is sticky, it is difficult to lower wage), and eventually, exit the market (i.e. declare bankruptcy). Now you might question yourself, if falling price occurs, then should it not be applied to both production cost and revenue? And since money gains more value, how can $90 be a loss? Could this economind’s author be mistaken? Well, if you are thinking about it (at this very moment), then I must commend you for your swift economic mind. But the one thing about deflation is that prices of different goods and services do not fall uniformly. Which one falls quicker? The one on the cost side or revenue side? And that is what ultimately decides the fate of businesses.

Remember, companies have assets and liabilities. Most of the time, liabilities are where deflation hit the most. Say, before deflation, the liability-to-asset ratio of your company is 30%. That means out of all the assets you own, 30% belongs to other people. You owe them. Say, that 30% = $1 million. Your business operate normally, but suddenly, deflation hits and persists for a whole year. Keep in mind that you owe other people in nominal value. That means you have to pay back $1 million (+interest). Even though price falls and currency value rises, you still have to pay exactly $1 million back in principal. What if you can only sell your products at reduced price (due to deflation effects)? How are you going to pay $1 million if, say, the expected revenue of $1.5 million turns into $0.9 million actual revenue? You would be forced to sell some of your assets. Now you see how deflation impact on businesses can turn out pretty ugly.

Falling price has a far-reaching effect. It has to do with human perception of the economy within which they reside. In the short-run, consumers in general might not notice the fall in price of goods and services. That is one of the reason, why short-run deflation is not considered harmful. However, humans are curious beings. Most put self-interest up front, and they are quick to discern any emerging opportunity favorable to their advantages. Thus, if the falling price trend lasts long enough, people would be able to notice it.

Based on historical observation, what would occur in this specific scenario is hoarding. Again, hoarding? Remember, we talked about this once before in an article: “Why is Economics important?”. Yes, hoarding is once again involved. You see, people hoard for a reason. People love having lots of anything they value or is valued highly by those surrounding them. So it is a very rational decision to start hoarding money speculating high return at the end of the day. With the falling price/rising value of money trend continues, most people expect price to keep on falling even further, and with that in mind, they begin hoarding money. To put simply, if you expect your $1000 saving (that means all the expense on necessities such as food, medical care, utilities… have already been incurred) to equate to $1500 (50% return) in the next 6 months, then would you spend it now? or wait a bit longer? Most rational people would hold on to their money a bit longer. I meant 50% semi-annual return is actually a better deal compared to almost any other investments you can possibly think of, which leads to an adverse economic situation.

First, consumption falls. People spend less, and by using our “paradox of thrift” learnt from the past article (spending = earning), we know that they will also earn less as well. When taking “Multiplier” into consideration, the loss is actually bigger than the face value.

Second, people become less willing to borrow, and thus, lowering investment. It creates a scenario where wealth is redistributed from borrowers to lenders. Think about it. If the value of currency rises by 20% a year, then the $100 you received from your boyfriend A (or girlfriend of course) on valentine’s, by the end of the year, would worth roughly $120. So it has come to a situation when banks find it hard to make loans. If A borrowed $100 from RipUoff Bank with 5% interest (just so he/she could give the money to you on valentine’s… I meant who want a bunch of inedible roses?), A would need to pay back $105. But wait, in real term, A would actually be paying $105 + 105*20% (rise in money value due to deflation). So unless your boyfriend/girlfriend is totally insane, in a way that he/she cannot even figure out basic calculation using common sense, then he/she would not take that loan from RipUoff bank. If you did receive $100 during deflation from your boyfriend/girlfriend, then consider breaking up with him/her. Another impact of deflation. Sad. Looking from the lender side of the story, from banks’ perspective, when deflation hits and people save their hard-earned cash, various assets value such as houses, lands, cars, etc., will drop, and as a result, banks would be less likely to make loans as they are aware of the expected lower value of the collateral (to back up the loan in case of default).

So when money itself becomes a safe haven for investment (with really high return), people would shift their interest towards hoarding. They would invest in cash itself, and since they also expect businesses and the whole packages of financial markets to function poorly during deflation, that creates another problem, the falling stocks/precious metals prices, and eventually, the collapse of the financial market.

All these will cause higher and higher unemployment. Now you should be able to grasp the big picture. People become jobless, less spending, less saving, less investment, less government revenue (less tax), less products and services offered, and the list goes on. These certainly exacerbates the impacts of deflation, taking the total worth of damages to a whole new level.

Wasting. Wasting is bad. There was an article solely dedicated to “food waste” in this blog, so do look it up. Anyway, wasting is a result of inefficient consumption/production. Deflation can cause wasting because initially, as goods and services become cheaper, everyone feels richer and they start spending more, sometimes on something they do not even need. If those things turn of to be perishable goods, then they will be wasted. Sadly, this spending surge at the start of deflation most likely does not create enough inflationary pressure to offset deflation simply because the price does not fall steeply in a single day. Imagine this scenario. If price of a microwave drops from $100 to $50 in a single day, then there would probably be lots of people who would buy microwaves pushing up the microwave price almost immediately. Sadly, that is unlikely the case. The whole falling price process might take months, but the change normally is noticeable. That is why people hoard, and that is why there usually is not enough inflationary pressure to save the day.

Deflation, like I said, is bad, but natural deflation is mostly harmless. Deflation resulted from the movement of free market under market force (natural deflation, I made this term up) can actually be desirable. An example can be seen in computer industry where prices fall significantly, but everyone is happy. You can buy cheaper computer, but the producers can still make a profit. It is a win-win situation. That is the magic of knowledge and technological advancement, and efficiency improvement. The harmful one is usually man-made, a consequence of bad economic policy, especially monetary policy, either expansionary (increasing money supply) or contractionary monetary policy (decreasing money supply). Deflation can result from both. What most people would think is that deflation results from contractionary monetary policy because with decreased money supply, there would be less money in circulation, and as a result, money value goes up. For instance, the deflation in Japan that lasts for 2 decades (and is probably about to end, or not) was believed to be probably caused and/or perpetuated by its policy failure. However, deflation can also be caused by excessive expansionary monetary policy. True story.

Do note that the effects of deflation witnessed in this article have been stretched to the extreme. The actual effects might fall somewhere in between with lower severity. That is why economics is sometimes called a dismal science because of its gloomy nature. Though that is actually not true and not supported by this author!

Entertain your economic brain with the below video about how the Japanese economy was afflicted with DEFLATION (which takes you on a more realistic journey on deflationary route):