Deflation

Previously, I have talked about inflation, what causes it and why it’s bad. Most people intuitively grasp the problem with inflation, particularly when it’s rapid. Prices are higher. Everything costs more. And because pay tends to lag prices, you end up being able to afford less of the things you want.

Deflation is the flip side of that coin. Now, it’s tempting to think that if inflation is bad, that deflation must be good. Unfortunately, that’s not the way it works.

Remember what I said earlier that inflation was what happens when money supply grows faster than economic output (the production of goods and services)? Deflation is the reverse. Money supply gets smaller relative to economic output.

What happens when the money supply shrinks (or economic output grows faster than money supply)? Well, in inflation, a growth in money supply mean people buy more stuff, retailers order more from wholesalers, who order more from manufacturers, who end up wanting to ramp production and so bid up the price of raw materials (including labor), and then the prices work their way down the chain. This process can masquerade as economic growth. But prices catch up and in the end you have the same goods and services, the same real wealth, being produced, just at a higher price point.

Deflation works the other way. People and businesses have less money. They buy less stuff. Retailers order less from wholesalers, wholesalers buy less from manufacturers. Manufacturers have less need of raw materials, including labor. Producers of raw materials can’t sell so they end up being forced to reduce prices in order to recoup anything. If allowed to run its course, you, again, end up with the same goods and services, just at a lower price point.

There are two problems, however. One is the time taken to run its course. Time matters, particularly with things like credit and debt and on things that require considerable time between when expenses are incurred and when returns are received. Consider a couple of examples.

Few people are able to buy a home outright. Most have to take a mortgage, a long term loan with the house as collateral. In a deflationary economy, the income of the person holding the mortgage falls. The mortgage payments, however, are based on the pre-deflation value of money. So the mortgage payments become a larger portion of the homeowner’s income. And since that income is a “scarce resource that has alternative uses” the other things the person could have done with that income–new shoes, the kid’s braces, dance lessons, nicer meals, whatever–must fall by the wayside. In some more marginal cases, the homeowner will end up defaulting on the mortgage losing the house. All of this means a reduced standard of living for the people in the economy. If the deflation rate is small, this effect will be modest and, perhaps, not even noticed. Things won’t be quite as prosperous as they would otherwise have been but people are rarely very good at judging how prosperous they would have been and so the negative effects of deflation remain unmarked.

Another example is farming. Farms are an excellent case of the time lag between the inputs–seed, water, land, fertilizer, all the myriad activities involved in producing and raising a crop–and getting the crop to market. This can be enough time for deflation to reduce the sale price of the crop relative to the cost of producing it. The costs are at pre-deflation prices while the crop sells at post-deflation prices. The result is less money in the farmer’s hands at the end of the year. And, again, in some marginal cases the farms fail. The farmers go bankrupt and are no longer able to continue. However, that cannot continue too far because people still need to eat. And so prices on food don’t fall quite as much as other prices because, since people do still need to eat, resources (in this case people’s spending money) will be shifted from other things to food. Food will become relatively more expensive meaning, once again (“scarce resources that have alternative uses”) people will have less to spend on other nice things they want.

In addition, the farms that will be better able to survive the deflationary times will be the more economically efficient ones–generally the big agribusinesses. The small family farms tend to be more economically marginal and will be the hardest hit.

These examples illustrate the problem which will be echoed all up and down the economy in greater or lesser magnitude.

The problem is made worse by many attempts to mitigate the problems of deflation. The Stock Market Crash of 1929 caused a major contraction in the money supply. Businesses, right along with everyone else, did not have cash to spend. They had to reduce costs. The problem was there was strong government pressure starting with the Hoover administration to keep wages at pre-deflationary wages. The result was rapidly rising unemployment that turned what could have been a simple, albeit large, economic correction into The Great Depression.

Both inflation and deflation cause harm to the economy. When the rates, whether of inflation or deflation, are small, the harm is usually small enough to be ignored, generally expressing in the form of somewhat reduced economic growth. What matters most is a stable money supply that grows at close to growth in economic output. Vary much from that in either direction and things get bad.

It’s like walking a tightrope without being able to see the rope.