Why is deflation so difficult to deal with?

[sMiLeYz]

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

He is correct but being very vague, nominal interest rates in the US are at a zero lower bound. They're already super low, thus making them lower won't change anything.

Quite a few economists have been suggesting that the United States is in the very stages of this right now. A liquidity trap, where monetary policy right now has no effect on stimulating the economy and deflation is near certainty.

Alot of economists especially of those of the Keynesian school are calling for trillions of dollars in fiscal stimulus to head off a deflationary spiral like Japan. Because the consequences of high unemployment, and falling prices are certainly more dire than adding to the national debt.

 

[sandorski]

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

Ooh, I hadn't even considered this excellent point.

 

[soccerballtux]

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

alternatively we can penalize savers and efficient companies.

 

[3chordcharlie]

alternatively we can penalize savers and efficient companies.

*sigh*

It's so easy to mix in value judgements where they don't belong.

The trouble with deflation isn't 'you're getting screwed over'. It's systemic, and severe.

 

[sandorski]

*sigh*

It's so easy to mix in value judgements where they don't belong.

The trouble with deflation isn't 'you're getting screwed over'. It's systemic, and severe.

You are getting screwed over in that situation. It's just not The Man, but the Invisible Hand of the Market bitch slapping you repeatedly.

 

[Atreus21]

I have a terribly misinformed question:

Why can't deflation be combated by printing more money? Can inflation be used in this manner?

 

[CLite]

I have a terribly misinformed question:

Why can't deflation be combated by printing more money? Can inflation be used in this manner?

Printing more money is analogous to setting interest rates at 0%. You are essentially handing out free money. The problem is sometimes 0% interest isn't enough to spur people to take risks and expand the economy because the black hole of deflation can engulf even the most robust entrepreneurial spirits.

This is a very apolitical idea, and I'm not saying we need to punish penny pinchers. It's just a statement of fact that the deflation cycle is the most powerful self-reinforcing economic cycle out there.

*edit* also 0% is from the government to banks this gets bumped up from the banks to the consumers. Additionally you need to add the deflation rate to the 0% to determine the "effective" interest rate.

 

[Juddog]

The problem as I see it is that things cannot continue to grow forever. There are simply a limited amount of resources on this planet, and this ever-expanding view cannot last forever.

 

[dullard]

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.

Japan has been dealing with it for quite some time. But they haven't been doing well. Look at their GDP. Then look at their debt. Japan has been hanging on by a thread for nearly 2 decades and there is still no sign of them recovering fully. Their government debt is just about unsustainable, meaning soon they will have to completely destroy their fragile economy just to fix the debt. Of course, as stated above, Japan has other fundamental problems other than just deflation.

Deflation is a downward spiral. Why buy today if you can buy tomorrow cheaper. Why buy tomorrow if you can buy next week cheaper. Soon no one buys. No one buys, so businesses cut prices, so no one buys, so businesses cut prices. The spiral continues until it breaks. That break is the problem with deflation. Businesses are hurt so bad that they close. Then their employees can't buy. A fundamental shift happened. Instead of choosing not to buy, now they simply can't buy. If they can't buy, that hurts businesses even more. Who will hire them when no company has any profits?

Honestly, there is virtually nothing the government can do. As long as we have freedoms, the government can't force people to start buying. As seen by Japan the government can temporarilly keep the economy going but the debt will eventually end that bailout. Then what? The country literally has to hit rock bottom, and completely reinvent itself to recover.

This recovery is very, very painful. As mentioned earlier, sure, the savers are temporarilly helped. They can reap the rewards of their cash pile. That is, until they lose their job or even worse, until they have nothing to buy with their cash. Their cash stock pile becomes worthless if no buisness is selling. It is almost like being a billionaire on a deserted island. That money is useless. Only objects have value on a deserted island. The people with objects are the ones who spent when there were things to buy. That is, it eventually favored those who were most reckless. Again, the downward spiral is reinforced.

 

[Atreus21]

Printing more money is analogous to setting interest rates at 0%. You are essentially handing out free money. The problem is sometimes 0% interest isn't enough to spur people to take risks and expand the economy because the black hole of deflation can engulf even the most robust entrepreneurial spirits.

This is a very apolitical idea, and I'm not saying we need to punish penny pinchers. It's just a statement of fact that the deflation cycle is the most powerful self-reinforcing economic cycle out there.

*edit* also 0% is from the government to banks this gets bumped up from the banks to the consumers. Additionally you need to add the deflation rate to the 0% to determine the "effective" interest rate.

Interesting. Speaking for myself, if someone came up and lent me 100 grand at nearly no interest, I'd take it and buy an investment property.

 

[daishi5]

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

You should study Keynes a little more, he has some good points even if you don't agree with him. Many contracts and agreements do not have any method of dealing with deflation, so they prevent wages and prices from falling to account for deflation.

And deflation is easy to fight, but not with interest rates. I don't remember who said it, but to fight deflation, the Fed can just dump money out of a helicopter onto the streets.

 

[Narmer]

You should study Keynes a little more, he has some good points even if you don't agree with him. Many contracts and agreements do not have any method of dealing with deflation, so they prevent wages and prices from falling to account for deflation.

And deflation is easy to fight, but not with interest rates. I don't remember who said it, but to fight deflation, the Fed can just dump money out of a helicopter onto the streets.

Bernanke once made that infamous helicopter statement. But, by giving money to everyone for free, aren't we trying to maintain the status quo? Isn't the status quo the problem? Perhaps without expansionary action from the central bank, the deflation can be quick enough until people start seeing bargains again. But if the government slows down the problem people may just see it in slow-motion and assume it will last forever.

 

[CLite]

Interesting. Speaking for myself, if someone came up and lent me 100 grand at nearly no interest, I'd take it and buy an investment property.

Well you could use the 100,000 to buy a property, but if you wait a year that property might fall to 97,000.

You might have a shoe-salesman tenant who is going to get fired because even though everyone needs shoes they rather wait 6 months to buy one since they will decrease in cost. Now your tenant can't pay rent and your property is continuing to lose value, but you still eventually owe 100,000. Of course you didn't get that at 0% interest because banks bump up the rate that the feds give them, maybe you have 1-2% interest.

This kind of scenario is why the majority of modern economists have an abject fear of deflation as compared to inflation.

 

[dullard]

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.

The two extremes (Strong inflation and just about any deflation) are both serious problems. So, you are right to avoid them both. But, I don't think the proper balance point is right at 0%. There are many reasons.

1) 0% is right near the deflation zone, 0% is a very unstable location. A slight dip in that direction can take us to a far worse condition (deflation spiral).

2) Slight inflation doesn't cause much of any harm.

3) People want raises. In order to give raises, a business needs to bring in more money (ie raise prices). All of their supplier's employees want raises, so they raise their prices. Heck, even the shareholders want bigger and better returns, and so businesses raise prices. You can't have raises without inflation. And if we just keep wages at 0% growth, that gives very little motivation to work hard. No hard work means poor productivity, and we spiral into a recession/depression.

4) Psychology. People buy now because prices will be higher later. If people buy now, we can hire people now. So people now have more money to buy now. This is a strong positive upward spiral. Everyone gets better. But that all ends when you take away the incentive to buy now.

5) It isn't just about wages vs prices. There are other main factors such as loans. People are willing to have loans because they know that they'll make more money later to pay them off. Borrow now when money is dear, and pay it off later when you have plenty of money. You can't take away the wage/price issue and think that the remaining contracts will be fine. People have loans for 30+ years. Businesses have contracts sometimes for 100 years. These loans/contracts were all signed with the assumption of a reasonable inflation rate. Fixing wages/prices to 0% is a massive money shift from one party in the contract to the other party. We'd have to go and renegotiate all long-term contracts in order to do this even remotely fairly.

 

[Hayabusa Rider]

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

That's wonderful!

BTW, that home you bought for 400k (which was about as cheap as it got in your hypothetical market) is now worth 200K. Congratulations, you're married to it. Why? Because you have a whopping great negative equity now. The house is worth less, but you aren't paying on the value of the property, you are paying off what you borrowed.

Oh yeah, your wages just got cut.


Therein lies a problem. Debt remains, however asset values drop.

 

[Narmer]

Well you could use the 100,000 to buy a property, but if you wait a year that property might fall to 97,000.

You might have a shoe-salesman tenant who is going to get fired because even though everyone needs shoes they rather wait 6 months to buy one since they will decrease in cost. Now your tenant can't pay rent and your property is continuing to lose value, but you still eventually owe 100,000. Of course you didn't get that at 0% interest because banks bump up the rate that the feds give them, maybe you have 1-2% interest.

This kind of scenario is why the majority of modern economists have an abject fear of deflation as compared to inflation.

The thing with deflation is that it isn't that obvious. No one really knows deflation is occuring because prices may not change for years, and they rarely go down. Hence, you have deflation because of a lack of inflation, not necessarily because there is an explicit lowering of prices. That is why I believe that deflation is simply a symptom and not the underlying problem. Hence, if other parts of the economy are corrected and deflation is allowed to do its own correction, then the economy may return to normal.

I honestly believe that, while inflation can be easily resolved by increasing the nominal interest rate, deflation must be solved by other means and the end result may mean a new normality where the economy is supposed to be rather than where it's expected to be.

 

[zephyrprime]

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.

There are only two reasons it's difficult to deal with.

The only solution to deflation is inflation. This should be obvious. However, inflation shafts everyone with a lot of money. Guess what? These people have political power.

Secondly, once a government figures out that it has the power of the printing press, it might go crazy and hyper inflate like Weimar Germany or Zimbabwe did.

 

[evident]

in a deflationary economy, would interest rates on savings accounts be at or near 0%?

 

[CLite]

The thing with deflation is that it isn't that obvious. No one really knows deflation is occuring because prices may not change for years, and they rarely go down. Hence, you have deflation because of a lack of inflation, not necessarily because there is an explicit lowering of prices. That is why I believe that deflation is simply a symptom and not the underlying problem. Hence, if other parts of the economy are corrected and deflation is allowed to do its own correction, then the economy may return to normal.

I honestly believe that, while inflation can be easily resolved by increasing the nominal interest rate, deflation must be solved by other means and the end result may mean a new normality where the economy is supposed to be rather than where it's expected to be.

I agree that it can be obscured and that the underlying problems can be difficult to identify.

I personally think the best macro-economic solution to deflation is to spur government grants on research and industrialization. Create a marquee product for your country that other countries need and employee your citizens.

 

[daishi5]

Bernanke once made that infamous helicopter statement. But, by giving money to everyone for free, aren't we trying to maintain the status quo? Isn't the status quo the problem? Perhaps without expansionary action from the central bank, the deflation can be quick enough until people start seeing bargains again. But if the government slows down the problem people may just see it in slow-motion and assume it will last forever.

The reason that you need to fight deflation is to maintain the time value of money. In a deflationary economy the time value of money takes on very different values, creating an environment that makes investments and work less valuable than laziness. Printing more money means that just holding onto the money is costly, and makes laziness expensive, which is what we need.

I have only read a few of Friedmans papers and books, and not his big work on monetary history, but from what I understand Friedman advocates that the governments job is to maintain the normal status quo of an expanding money supply at a constant rate. Too little expansion, leads to depressions like we have. So, we would want the government to be printing money forever, just at a constant rate. The status quo we want to maintain is the status quo of the good years. I checked the federal reserves report on monetary values a while back, and posted a link in another thread, recently the growth of m2 has stagnated, that is the status quo we need to get away from.

 

[Narmer]

The more I think about this the more I believe that deflation and inflation are similar. However, the problem is that most economists are trained to fight inflation. Hence, they presume that monetary expansion and contraction are the two tools that is needed. However, when an economy experiences something akin to hyperinflation, the one real solution is to simply start over with a new currency. I think, with deflation, something similar must happen. Not start over with a new currency but start in a new (heavily reformed) state. If there is a liquidity trap then there may be other underlying problems not necessarily associated with money but with prices. Perhaps, for too long, the government has been intentionally keeping interest rates lower than they're supposed to be; the currency lower than it's supposed to be; and wages higher than they're supposed to be? Well, when deflation comes, it should deal with all these problems, which can be difficult, if not impossible, because that would mean the entire economy would have to take a hit, in some form or another. Of course, this amplifies the problem but the solution is in the cutting of prices across the board.

In a true economy with no artificial limitations, these problems could be easily corrected in real time. However, with politicians, trade barriers, tariffs, currency manipulation, etc..., it is easy to see how an economy can set itself up to fail in such a manner.

 

[Narmer]

Also, we encourage and take deflation for granted in certain parts of our economy but are afraid of it in other parts. For example, technology lowers prices over time and everyone loves that. But no one can tolerate the lowering of house prices or their wages. Technology increases efficiency and replaces people. This is cheered until it means the loss of your job. This is a strange dichotomy that needs to be futher explored.

Hence, isn't it odd that deflation is a central part of the real economy right along with monetary expansion? The irony is rife in Japan where many young people have a temporary workers status and yet the Japanese are building robots to replace human workers.

 

[CLite]

Also, we encourage and take deflation for granted in certain parts of our economy but are afraid of it in other parts. For example, technology lowers prices over time and everyone loves that. But no one can tolerate the lowering of house prices or their wages. Technology increases efficiency and replaces people. This is cheered until it means the loss of your job. This is a strange dichotomy that needs to be futher explored.

Hence, isn't it odd that deflation is a central part of the real economy right along with monetary expansion?

Ah a classic misconception that we should focus on. There is good deflation and there is bad deflation.

Good deflation is the increase in supply of products due to efficiency which lowers their price. This increases the "wealth" of a nation.

Bad deflation is the decrease in supply of money versus demand. This is the deflation we talk about when referencing the great depression, and it is what everyone fears.

 

[daishi5]

The more I think about this the more I believe that deflation and inflation are similar. However, the problem is that most economists are trained to fight inflation. Hence, they presume that monetary expansion and contraction are the two tools that is needed. However, when an economy experiences something akin to hyperinflation, the one real solution is to simply start over with a new currency. I think, with deflation, something similar must happen. Not start over with a new currency but start in a new (heavily reformed) state. If there is a liquidity trap then there may be other underlying problems not necessarily associated with money but with prices. Perhaps, for too long, the government has been intentionally keeping interest rates lower than they're supposed to be; the currency lower than it's supposed to be; and wages higher than they're supposed to be? Well, when deflation comes, it should deal with all these problems, which can be difficult, if not impossible, because that would mean the entire economy would have to take a hit, in some form or another. Of course, this amplifies the problem but the solution is in the cutting of prices across the board.

In a true economy with no artificial limitations, these problems could be easily corrected in real time. However, with politicians, trade barriers, tariffs, currency manipulation, etc..., it is easy to see how an economy can set itself up to fail in such a manner.

Deflation is a monetary issue a lot like inflation, but it is different. The root of deflation is there is not enough money, just like inflation is too much money. The economy needs enough money to be used in every transaction in the economy. With too little money the amount of money exchanged per transaction must shrink. However, prices don't go down, so if you cannot lower the amount of money per transaction, the only other choice is to lower the amount of transactions. A lower number of transactions basically means less people working because there is just not enough money available for them to be paid and make purchases.

 

[Narmer]

Ah a classic misconception that we should focus on. There is good deflation and there is bad deflation.

Good deflation is the increase in supply of products due to efficiency which lowers their price. This increases the "wealth" of a nation.

Bad deflation is the decrease in supply of money versus demand. This is the deflation we talk about when referencing the great depression, and it is what everyone fears.

You can qualify it but that does not change the fact that it is still deflation. We must admit that deflation, no matter what it's called, lowers wages and kills jobs. As with everything in life, there will be winners and losers. The only way to win is to stay ahead of the game. This means education, research, and so on. However, if others do the same, within and without the country, then that just means your new specialization will turn into a commodity, essentially lowering wages. Therefore, unless the population is decreasing (as it should in an advancing economy) deflation is inevitable in the economy. However, monetary economic policy advocates constant inflation. This is not sustainable if everything else doesn't follow the script.