Deflation Mania

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If there is one conclusion that can be made from the past 7 years of economic turmoil it is this: Economists are not nearly as expert as they think. Economists, just like everyone else, are subject to fads and mania and root themselves in their own comfortable conventional wisdom.

The latest mania is fear of deflation. The possibility of deflation has given economists nightmares. Their solution is to manufacture inflation.

The fact is deflation is not the cause of economic problems; it is the consequence of underlying economics and can be either good or bad. Good deflation occurs when an economy becomes more efficient, producing more from less (e.g. increased energy efficiency) or when the supply of goods expands beyond demand. Bad deflation occurs when demand collapses as a result of malign economic conditions. Either way, deflation is an artifact of an underlying dynamic.

Good deflation results in prices falling over time. Your lifestyle gets less expensive, allowing you to spend the excess on new products and experiences. Market economies can be considered deflationary projects: businesses competing to provide better goods and services at lower prices. Deflation should be the natural result of innovation – as anyone making a free international phone call on Skype can attest.

Furthermore, there is some evidence that the 19th Century was mildly deflationary – and that century featured the most incredible growth in human history to that time.

Make no mistake, deflation can be problematic. Steady wages in the face of deflation increase spending power, but workers don’t recognize that. For some industries, wage cuts may be needed, as prices fall unevenly in the economy. The result can be significant labor unrest.

Deflation means very low interest rates, eliminating the income stream from safe haven investments. Retirees and middle class savers earn next to nothing on their "safe" investments. The result is either the liquidation of capital or a move into riskier investments.

But the biggest problem with deflation is its negative effect on debtors. Since deflation means future dollars are worth more than current dollars, debt in a deflationary environment rises in real terms unless the principal is paid down. If principal is tackled aggressively, then there is not a problem, but the less aggressively principal is paid down, the greater drag on consumption and investment. In a world awash in debt, this is a significant problem

The solution to these challenges is not manufactured inflation. A fundamental tenet of public policy is to deal with problems in the most direct fashion. For wage-earners, if productivity grows then wages can rise, regardless of deflation. De-regulation and encouraging investment can improve productivity. New financial products can be created to provide income streams in a low-interest environment.

As for debt, creditors and debtors have been restructuring and discharging debt for centuries. If a debt overhang becomes too onerous, then the principal can be reduced. Current lending will have to be more judicious and made to credit-worthy entities. Private companies deal with deflation (falling demand for their products and the consequent pressure on prices) all the time with debt restructuring, or sometimes bankruptcy.

Ironically, efforts to create inflation have failed. Japan has been mired in deflation periodically for over a decade and Europe’s slide continues. The trouble is that economists and central bankers, stubbornly clinging to their orthodox views, seem likely to try ever more risky and desperate politics to stoke inflation, resulting in unpredictable and possibly very dangerous consequences.

Given the last decade of missteps and poor predictions, perhaps it’s not such a good idea to give them the benefit of the doubt.

(Keith Naughton is a public affairs consultant specializing in messaging, policy analysis and policy development. He has a Ph.D. in public policy from the University of Southern California. He can be reached at [email protected] or @KNaughton711.)