What is so bad about Deflation?

By Tim McMahon

The average annual inflation rate dropped again this month. At a monthly rate of -1.01% October’s drop was touted as “the largest monthly drop on a seasonally adjusted basis since 1947 when the Bureau of Labor Statistics first  started tracking seasonal adjustments” and it brought the annual inflation rate off its highs and down to a more reasonable 3.66%.

November’s monthly rate was almost twice as large at but it was hardly mentioned in the news.  This month the annual inflation rate has dropped down virtually zero–  0.09%  with a monthly drop slightly larger than the one two months ago.

Just a few months ago the annual inflation rate was 5.6% and now it is virtually zero.  The slightest decline in inflation this month will bring us into deflationary territory on an annual basis… the first time since 1955. 

The specter of deflation has thrown the news media into a tizzy and the central banks are panicking and cranking up the printing presses.

Over the last six months we have actually seen true DEFLATION.  Prices have fallen 3.92% over the last six months.

Everyone likes price deflation because things are getting cheaper. November’s  -1.92% monthly deflation rate would result in a 23.04% decrease in prices if it continued for 11 more months.  It’s like seeing a 25% off sale on everything every time you went to the store!

In 19th century, (prior to government meddling in the money supply) deflation was the norm. As productivity increased, things got cheaper to produce, prices went down, wages went up and everyone was richer.

So price deflation is a good thing from a consumer’s point of view.  In times of high inflation (think back a few months) when gas prices are higher every time you go to the gas pump, you hear a lot of complaining.  Funny, I haven’t heard a single complaint about falling gas prices. If deflation was bad you’d think someone would be complaining.

Maybe it’s businesses that are hurt by deflation (falling prices)? True the amount they can charge is less because money is becoming more valuable but their costs for materials and labor are falling too. So as long as they remain efficient producers they will remain competitive.

Let’s look at the computer industry for a moment, they have been in a deflationary market for quite some time now, i.e. as they became more efficient they charged lower and lower prices.  Did this hurt the industry? No actually it was one of the only truly profitable industries during a highly inflationary period.  Look at Microsoft and Dell do we feel sorry for them?  I didn’t think so.

So deflationary forces don’t hurt industry. and yet the news media says we should worry about the “destructive forces of deflation”.

A perfect example is Martin Wolk of MSNBC, who says: “As prices keep going down, money grows more valuable”   . . .   Sounds good to me, but he says this is bad because it creates “an enormous disincentive for consumers and businesses to spend money. Economic activity slows, unemployment rises and demand continues to decline.”

So he is saying, it is bad because… as your money becomes more valuable you might be more likely to save it, instead of throwing it away every chance you get? And as you save it your purchasing power will actually increase as it will get more and more valuable. And this will hurt who?

According to Llewellyn H. Rockwell, Jr. president of the Ludwig von Mises Institute in Auburn, Alabama, “It’s true that falling prices create incentives to save, but so long as the preference of consumers is to save instead of spend, that can only prepare the way for a future of economic growth. Consumers save for a reason, namely, to spend later”.

I seem to remember the media constantly decrying the low savings rate in this country which reduces our reserves and makes us less able to withstand an economic downturn.  Conversely, as the government increases the money supply, we see price inflation and the demand for money actually decreases, i.e. people don’t want to save it because if they do, it will buy less later. So the demand for goods increases and the demand for money decreases. But this is to the detriment of the consumer’s economic health and long term to the health of the country because people are encouraged to spend more than they would have under normal circumstances.

In a deflation the exact opposite happens,  people want to hold onto their money so the demand for money increases and the demand for goods decreases.  But this is just a short term effect, will they stop eating to keep their money? Of course not?  Will they reduce their lifestyle to keep more money in the bank? No.  Once they have a comfortable level of savings in the bank they will begin spending again, the only difference is that they will be able to get more for their money and actually have a savings cushion. The only thing they will reduce is their borrowing!  Who wants to borrow money if you have to pay it back with more valuable dollars? Better to save up your money, get more value for your money (and higher quality) and pay cash.

So a deflation actually promotes fiscal responsibility and higher quality. Hmm.

One problem for deflation is that it is tied very closely to the word depression in the minds of most Americans.  As a matter of fact, the majority of Americans think they are synonymous.  But that is hardly the case. One is the state of low economic growth and economic activity while the other is falling prices due to a decrease in the supply of money.

A depression as in “the Great Depression” is a major economic downturn, i.e. a recession on a massive scale.  It just so happens that  “the Great Depression” was also a time of deflation.  But deflation was not the cause of the depression actually it was the other way around,  depression caused the deflation.  See the chart in the upper right

What is worse than a deflationary depression?  An inflationary depression which happened around the world in Germany at the same time as our Great Depression.  Would you rather have a slow economy and falling consumer prices or a slow economy and rising consumer prices? Personally, if I had very little money I would prefer that it bought more (i.e. falling consumer prices).

The great economist Murray Rothbard said, “rather than a problem to be dreaded and combated, falling prices through increased production is a wonderful long-run tendency of untrammeled capitalism. The trend of the Industrial Revolution in the West was falling prices, which spread an increased standard of living to every person; falling costs, which maintained general profitability of business; and stable monetary wage rates—which reflected steadily increasing real wages in terms of purchasing power. This is a process to be hailed and welcomed rather than to be stamped out.”

One fear is that consumer price deflation is twin of falling asset prices.  The one price that people like to see increase is the price of their stock portfolio (i.e. their assets).  What we saw recently was massive asset deflation as the stock market crashed and everyone scrambled for liquidity.  This of course is another side of the increased demand for money.  As the supply of money (actually in this case it was the supply of credit) dried up people sold assets to raise liquidity (cash). Showing a classic sign of deflation i.e.  the demand for money increased while the demand for goods decreased.  But this is a short term result of a panic situation and a flight to quality, not the long term effect of deflation itself.

The main problem is the current system is a house of cards built on credit and the deflation is not the result of increased productivity but of decreased credit

So deflation helps consumers, businesses, savers, and the country as a whole… So who is fighting against deflation?

The answer is the central bank and bankers in general.  Why? Because in times of deflation their source of customers dries up.  You’d think banks would dislike inflation because they get paid back with cheaper dollars. But they factor that into their costs (i.e. they increase the interest rate they charge you to cover the cost of inflation).  So as long as inflation doesn’t get too high they see an increase in business and thus profitability  during moderate inflation.  But they can’t loan money when no one wants to borrow, so their profitability is zero. Thus the big push to “re-flate the economy.”

Today at the first whiff of deflation the  Central Bank (the FED) begins massive credit creation, and begins cranking up the printing presses.  They so worried about deflation that they have begun a policy of monetary expansion of historic proportions to correct it.

So the FED is fighting the implosion of credit by injecting massive amounts of money into the system rather than allowing the system to return to its natural state.

Robert Prechter of the Elliottwave Theorist is actually projecting that we will be entering a period of deflation.  To read his free report on on Why we are headed for Deflation Click Here.

Also see Elliotwave article Do You Know how to Preserve Your Wealth? for more information on investing for safety.

Olivier Garret, CEO of The Casey Report on the other hand believes that all of this massive inflation in the money supply will result in a hyperinflation.  See Why the Bailout Will Result in Hyperinflation.