Could Deflation Help?

Who knew deflation could be so controversial? On Saturday, I wrote a post about why low inflation concerns the Federal Reserve. I explained that economists fear low inflation could lead to deflation, which has several negative consequences. That claim evoked many reader comments and e-mails disputing the claim that deflation would be bad. It is worth considering some of these, as this is not a simple question.

Before getting into any potential arguments for deflation, however, it's important to explain what both inflation and deflation do on a very fundamental level: they redistribute wealth. So whether you are an advocate for inflation or deflation really depends on your personal finances. If you have lots of debt, then you'll love inflation, because you can more easily pay back that debt. If you have lots of cash savings, then you'll love deflation, because it will make you relatively richer.

Is Deflation Is Good For Workers?

And that brings us to one e-mail I got from Stephen who says:

Deflation in a small way, would allow 'average' workers who have given up a lot of purchasing power over many years to reap a tiny benefit as prices fall. Given their meager wage increases, and more likely stagnation, over many years, deflation would help compensate for the many years of losses. But with inflation, wages never keep up.

This logic only works in the very short term. Eventually, during a deflationary period, employers will begin cutting pay. They won't be able to afford to pay workers as much if deflation forces them to cut their prices. Revenue declines, so their costs (including wages) must decline as well to continue to make a profit. If deflation lasted long enough, the government would even likely be forced to cut the minimum wage.

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Stephen, in particular, appeared to be advocating for lower-wage workers, who he believes have not seen their incomes rise as quickly as inflation over the years. Even if he's right, deflation won't benefit them nearly as much as it would the rich. Think about it: who benefits more from deflation -- someone with $1,000 in the bank or someone with $1 million in the bank? Obviously the latter person would get more benefit, because the more dollars you have, the richer deflation makes you. Moreover, poorer Americans are more likely to have more debt, which will be harder to pay with deflation.

Could Deflation Lead to More Consumption?

An e-mail from Jim states:

You said that deflation discourages consumption.... Although it sounds logical, I find it hard to see in real life. Two of the largest areas of "deflation" I can think of are TV's and computers. See Apply stock..... It doesn't seem like deflation discourages consumption in those areas. And I doubt anyone puts off buying a refrigerator for lower prices.

This is great point, because when specific types of products see their prices go down, it often encourages consumption of those products. A great example is high-definition LCD televisions, which are now more affordable for Americans due to years of declining prices.

But this isn't deflation. In a real episode of national deflation, most goods and services would see prices declining and so would wages. So consumption falls for two reasons. First, those products aren't really becoming more affordable, because wages would also fall. Purchasing power would not increase for all people -- just for those who have more savings. Indeed, for those who have more debt, purchasing power would decline.

Second, TVs seem more attractive to buy when their price declines in part because the price falls more relative to other goods. In deflation, all prices decline more or less in step, so consumption towards a specific sort of good would not increase. Instead, there would just be greater uncertainty about when the right time to make larger purchases would be, since no one could be certain for how long prices would continue to fall. Consumption would decline. See Japan.

Would Deflation Help U.S. Exports?

At least one commenter says that U.S. exports would benefit from deflation and thinks that's how we can better compete with developing nations. This might be true for a fleeting moment, but eventually floating exchange rates would adjust to reflect most or all of the deflation of the dollar.

For example, imagine if you could buy an ounce of gold for $1,300. Now imagine you could buy $1,300 for 930 euros. And let's say 930 euros is also the price for an ounce of gold (for simplicity). Crazy deflation occurs (just to make the numbers easier). Now you can buy an ounce of gold for $650, but the exchange rates remain fixed. So a European takes 930 euros and buys $1,300, which he exchanges for two ounces of gold. He then sells that gold for 1,860 euros. This is simple arbitrage. In a global market, floating exchange rates will eventually adjust to where $1,300 would cost $1,860 euros. Consequently, U.S. exports would not be more attractive, because their price would increase proportionally to the amount of the deflation the dollar experiences. This is essentially what economists call purchasing power parity.

But Isn't it Good if Deflation Encourages Saving?

Finally, a few comments argue that more saving would be a big positive for the U.S. That's absolutely true -- just not in the short-term. The reason why the U.S. economy is in such an awful funk is demand. Consumers aren't spending much money, because they're worried about their economic prospects. Consequently, firms aren't hiring more workers, because they don't sense enough demand to require more employees. Unemployment remains near double-digits.

This isn't to say that people should be spending money that they don't have, relying on credit. It also doesn't mean that saving is bad. But saving has already increased significantly since the recession began, and consumer credit has also declined steadily. So deflation would exaggerate these trends even more, as saving would rise further and more Americans would pay down their debt. That might be positive at some point; it just wouldn't be right now.

So deflation isn't necessarily any worse than inflation in theory. Both are just different ways that income is redistributed, providing benefit to opposite groups of people. What's import is that they are stable and predictable so that firms and individuals can make good business decisions. But in the U.S. at this time, deflation would make matters worse for the reasons described above and in my prior post.