Why is deflation so difficult to deal with?

[Narmer]

It seems like Japan's been dealing with this problem for two decades now. I'm not an economist and am interested in an answer.

FWIW, I also emailed this question (more detailed) to three economists at my alma mater, two of them are Nobel Prize winners in economics (in the past 5 years) and one is the head of the business school. When I get a reply I will post it, with their approval.

 

[Jhhnn]

Deflation is problematical, in part, because it discourages active investment and growth. Why risk when your money increases in value stuffed into your mattress? Why borrow when every payment is more dear than the last?

 

[jman19]

Some believe that it can lead to a situation where prices continue to fall, companies produce less goods, workers are laid off, reducing spending, dropping prices further, etc., though this isn't really what happened in Japan I believe.

 

[jman19]

Deflation is problematical, in part, because it discourages active investment and growth. Why risk when your money increases in value stuffed into your mattress? Why borrow when every payment is more dear than the last?

Yes, this is a potential serious problem - when investing no longer brings returns, then the opportunity for growth is limited.

 

[Narmer]

Some believe that it can lead to a situation where prices continue to fall, companies produce less goods, workers are laid off, reducing spending, dropping prices further, etc., though this isn't really what happened in Japan I believe.

This is exactly what's happening in Japan. The reason I ask is because their debt ratio has gone from an excellent 20% to a scary 200%. In other words, they've thrown as much money as they could at it and it is still there. I would assume that the real problem is structural and the policymakers should just let prices fall until they stabilize (eventually). That would mean that there is little that can be done about inflation from the monetary policy toolbag.

 

[Jhhnn]

Yes, this is a potential serious problem - when investing no longer brings returns, then the opportunity for growth is limited.

Not quite. The problem with deflation is that *not* investing actually has a return in terms of increased purchasing power in the future from hoarding of cash assets... Investing still has returns, but with risk, too...

It's what happened in the early 1930's, after the crash. Cash was King, and those who had it squeezed their nickels so hard that the buffaloes pissed down their legs. They didn't buy any assets unless the price was so low as to be comparable to outright theft. They didn't need to- they already had money making assets and cash along with them.

Those who've financed the vociferous campaigns against the bank bailouts didn't do so because of any sort of principles, at all. They've done so in an attempt to drastically increase the purchasing power of their cash. They want it to all fall down, set it up that way, planned for it to do so...

In the kingdom of the blind, the one eyed man is King, after all...

 

[Hacp]

Not quite. The problem with deflation is that *not* investing actually has a return in terms of increased purchasing power in the future from hoarding of cash assets... Investing still has returns, but with risk, too...

It's what happened in the early 1930's, after the crash. Cash was King, and those who had it squeezed their nickels so hard that the buffaloes pissed down their legs. They didn't buy any assets unless the price was so low as to be comparable to outright theft. They didn't need to- they already had money making assets and cash along with them.

Those who've financed the vociferous campaigns against the bank bailouts didn't do so because of any sort of principles, at all. They've done so in an attempt to drastically increase the purchasing power of their cash. They want it to all fall down, set it up that way, planned for it to do so...

In the kingdom of the blind, the one eyed man is King, after all...

So you're saying that people who are frugal and save shouldn't have an advantage over people who pissed their cash away on vacations and the like?

 

[Special K]

On a related note, I don't see what the purpose is of inflating long-term wages and prices at the same rate. That is, one dollar might have had more purchasing power 50 years ago, but people also made correspondingly less. If prices and wages continue to rise at 3%/year on average, what is really changing? Why not keep both of them constant?

I suppose you could debate whether long-term wages have kept pace with inflation, but that might be going too far off topic.

 

[Jhhnn]

So you're saying that people who are frugal and save shouldn't have an advantage over people who pissed their cash away on vacations and the like?

I didn't say that at all, and anybody with a lick of sense or decency knows it.

 

[Jaskalas]

Those who save money.... wouldn't it be saved with the intent of using it later? It's not good for ecomonic growth NOW, but would it balance itself out later?

 

[bamacre]

If you look in the tech forums, and especially in the Hot Deals forum, people LOVE deflation. If you look in P&N, when they talked about housing prices, and health care prices, and college tuition prices, people hate inflation.

 

[bamacre]

Those who save money.... wouldn't it be saved with the intent of using it later? It's not good for ecomonic growth NOW, but would it balance itself out later?

Well, yeah, if we had market-driven interest rates. When savings are high, interest rates are low. It's a good time to invest because interest rates are low, and because people plan to spend later. However, when savings are low, interest rates are high. And it's a bad time to invest because interest rates are high, and because people don't have savings to be spent later. That's a little simplistic, but you get the point.

 

[Medu]

It's not so much that deflation is a bad thing but it's a sign that there is something wrong, or at least a rebalancing is taking place, within the economy.

To understand it you need to know how banking works. When one borrows from a bank money is created so the money supply increases which causes inflation. When that money is paid back it is destroyed which causes deflation. As this process is constantly happening it balances itself out. However interest must also be paid on the principal but that money doesn't exist as only the principal was created by the bank. This is solved by someone else borrowing more money which the first borrower goes out and earns to pay the interest and so the cycle, which is basically a legal pyramid scheme, continues.

Now if you accept what I told you above, which is hard to believe but is largely correct, then it's easy to see why deflation can ruin an economy. If inflation is caused by borrowing money faster than it's paid back then deflation is caused by repaying loans faster than new loans are issued. If new loans aren't been issued then the money supply is reduced and it becomes impossible to repay the interest on the principal and you get mass default on loans. This is why central banks all around the world have been printing money over the last two years.

 

[Narmer]

It's not so much that deflation is a bad thing but it's a sign that there is something wrong, or at least a rebalancing is taking place, within the economy.

To understand it you need to know how banking works. When one borrows from a bank money is created so the money supply increases which causes inflation. When that money is paid back it is destroyed which causes deflation. As this process is constantly happening it balances itself out. However interest must also be paid on the principal but that money doesn't exist as only the principal was created by the bank. This is solved by someone else borrowing more money which the first borrower goes out and earns to pay the interest and so the cycle, which is basically a legal pyramid scheme, continues.

Now if you accept what I told you above, which is hard to believe but is largely correct, then it's easy to see why deflation can ruin an economy. If inflation is caused by borrowing money faster than it's paid back then deflation is caused by repaying loans faster than new loans are issued. If new loans aren't been issued then the money supply is reduced and it becomes impossible to repay the interest on the principal and you get mass default on loans. This is why central banks all around the world have been printing money over the last two years.

But printing money doesn't always work, as we can see with Japan.

 

[Medu]

But printing money doesn't always work, as we can see with Japan.

A lot of the experts will say that Japan didn't print enough money soon enough which let things get out of control. Others will say that all they did was prolong the pain.
There is also a lot of other issues at play in japan- it's population has 'peaked' and has the highest average age of any country. The Japanese also save a lot more than westerners which has enabled the government to borrow from it's own people- infact >90% of the debt is held by themselves.

 

[Jhhnn]

It's not so much that deflation is a bad thing but it's a sign that there is something wrong, or at least a rebalancing is taking place, within the economy.

To understand it you need to know how banking works. When one borrows from a bank money is created so the money supply increases which causes inflation. When that money is paid back it is destroyed which causes deflation. As this process is constantly happening it balances itself out. However interest must also be paid on the principal but that money doesn't exist as only the principal was created by the bank. This is solved by someone else borrowing more money which the first borrower goes out and earns to pay the interest and so the cycle, which is basically a legal pyramid scheme, continues.

Now if you accept what I told you above, which is hard to believe but is largely correct, then it's easy to see why deflation can ruin an economy. If inflation is caused by borrowing money faster than it's paid back then deflation is caused by repaying loans faster than new loans are issued. If new loans aren't been issued then the money supply is reduced and it becomes impossible to repay the interest on the principal and you get mass default on loans. This is why central banks all around the world have been printing money over the last two years.

Definitely a part of the picture. What's happened wrt housing in this country is kinda like musical chairs. Few of the people who bought near the peak had any intention of sticking around to actually pay off the debt- they planned on the price of real estate skyrocketing forever, on transferring debt to some greater fool out there, showing a profit on the transaction. The music stopped when investors discovered that the AAA securities they'd been buying were anything but, slammed the door on the securitization pipeline. Prices dipped, dropped, and new mortgage holders were stuck with making the payments or defaulting. Either way, the actual money supply drops sharply, because money can't be lent at the same terms as before... More is being taken out of circulation or destroyed with paybacks and defaults than is being created with new loans. Debt/deflation only occurs after a period of over lending, of over heating the economy, such as occurred under the leadership of the Bush Whitehouse and the Greenspan FRB... It's essentially a form of upper class looting, as can be seen by the changes in income distribution accompanying it...

 

[Anarchist420]

There's nothing wrong with deflation. You just lower prices and wages.

 

[Jhhnn]

There's nothing wrong with deflation. You just lower prices and wages.

Uhh-huh, you bet. What about the 25 years left to pay on the mortgage? Other debt outstanding? What about liquidity in the general economy, the use of cash and credit to facilitate the transfer of goods and services?

Hell, lots of people were reduced to barter in the early 30's because there simply wasn't enough currency to make up the difference when the credit system collapsed. Try to remember that barter offers no portability of value, no way to facilitate anything more than simple 2 party trades...

 

[sandorski]

Uhh-huh, you bet. What about the 25 years left to pay on the mortgage? Other debt outstanding? What about liquidity in the general economy, the use of cash and credit to facilitate the transfer of goods and services?

Hell, lots of people were reduced to barter in the early 30's because there simply wasn't enough currency to make up the difference when the credit system collapsed. Try to remember that barter offers no portability of value, no way to facilitate anything more than simple 2 party trades...

Yup, his is where the problems really come in, everything Needs to Deflate during a time of Deflation or else all kinds of crap will threaten to topple everything. Should be easy enough, right? Everyone will be fine with it, until they are directly affected. That's when Tea Party like movements begin, Politicians latch on for Votes, and Policy is put into place that begins to diverge parts of the Economy from Deflation that ultimately prove disastrous.

 

[jman19]

This is exactly what's happening in Japan. The reason I ask is because their debt ratio has gone from an excellent 20% to a scary 200%. In other words, they've thrown as much money as they could at it and it is still there. I would assume that the real problem is structural and the policymakers should just let prices fall until they stabilize (eventually). That would mean that there is little that can be done about inflation from the monetary policy toolbag.

Not quite, Japan's unemployment rate is pretty low.

 

[Narmer]

Not quite, Japan's unemployment rate is pretty low.

Relatively speaking. Usually it is 2-3%. These days it is around 5%. But those numbers hide the fact that Japan has a European-style labor problem where the labor market is highly rigid and there is a growing temporary workers problem (especially among the young).

 

[Narmer]

Here is a response I received from one of the economists:

Dear XXXXXX,
One important reason for an asymmetry between the two cases is that it is always possible to bring down inflation (reasonably quickly, if need
be) by raising nominal interest rates to a sufficient extent (as was done in the US in the period 1979-82, for example). But one cannot similarly end deflation by sharply lowering nominal interest rates, because no amount of monetary expansion can push nominal interest rates below zero (a constraint that had already been reached by the Bank of Japan in the late 1990s).
It is hard for me to suggest readings without knowing more about your background in economics.
Sincerely,
YYYYY

 

[CLite]

Deflation is the death knell that it is because money that is horded increases in value. When people plan to invest money / expand business/etc. it is all usually to make money because they know if they keep money in the savings account it will decrease in value. This paradigm shifts when money in savings accounts increases in value.

It's a very vicious downward cycle, far worse than inflation which spurs people to invest and use money.

 

[sMiLeYz]

Deflation is the death knell that it is because money that is horded increases in value. When people plan to invest money / expand business/etc. it is all usually to make money because they know if they keep money in the savings account it will decrease in value. This paradigm shifts when money in savings accounts increases in value.

It's a very vicious downward cycle, far worse than inflation which spurs people to invest and use money.

This ^^

A central bank can control inflation, but a deflationary spiral is extremely hard to control. Prices start dropping, firms aren't making as much money, they stop hiring or cut workers, workers stop buying, leading to lower prices, etc... vicious cycle.

To answer OP's question the Fed influences money supply through Open Market operations, such as selling of treasuries or changing banks cash reserve rate ratio. Only to influence inflation, and to be honest they really don't have that power in that regard either. The FEDs have no control over price levels.

 

[sMiLeYz]

There's nothing wrong with deflation. You just lower prices and wages.

It's safe to say you have no idea what you're talking about.