Why Deflation is not a Catastrophe

One of the greatest economic issues that many governments, economists, and the average layman fear is deflation. What is deflation?  According to dictionary.com, deflation is “a fall in the general price level or a contraction of credit and available money.” According to mainstream economists and government officials, this is a bad thing. 

According to the St. Louis Federal Reserve Bank,

         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.

Wikipedia also explains objections to deflation in 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.

So according to mainstream economists, deflation reduces consumption, reduced consumption reduces production and lower production will shut down almost all economic activity. To many people, deflation, if not checked or eliminated, will lead to a great downward spiral in economic activity. That is why Federal Reserve Chairman Ben Bernanke believes in fighting deflation more than inflation through monetary policy. Paul Krugman, the most popular cheerleader for Keynesian economics, has compared deflation to a black hole. To some, the deflationary downward spiral doomsday has already happened since, according to the New York Times, deflation caused the Great Depression. 

Some Points About Deflation

One question that must be asked about criticism of deflation is this: should prices that have fallen be expected to continue falling. As Robert Blumen has pointed out, there are at least three response people can have to falling prices: One person may interpret the fallen price of a good as an indicator that the price of that good will fall in the future; another person may predict that the price of the same good will stay where it is at; and yet another person may predict that the lowered price of a good is an indicator that the price of that good will be higher in the future. 

As Austrian economist Jeffery Herbener has observed in his testimony about monetary policy before Congress, 

“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 are just as self-reinforcing as they are self-reversing. The economic models that are touted by most mainstream economists and economics professors are not a good way to examine the economic decisions people make, i.e. human action. I for one have always jumped on lower price like most people because there is an expectation that such a price will not last forever. 

The reality is that the idea that deflation produces a death spiral does not accurately describe the economic behaviors of people. Robert Bluemen provides the following 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 price.

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 investments.