Deflation – who does it really hurt?

For many economists, deflation is a dirty word. It is an economic state that should be fought by central bankers with all the ammunition at their disposal. Does it actually hurt the majority of the populace though and should it really be avoided at all costs, in particular with inflation creation..?

It is always interesting to read many newspapers and blog sites where concerned with the effects of deflation. They almost always refer to it as a ferocious animal that should be fought with all our strength as it is likely to result in a protracted recovery period. The example they use is Japan over the last 25 years but what they fail to take account of there is the demographics that create natural deflationary forces in that country. At the grass roots level, is it really problematic to pay the same price (or modestly less) for a coffee, a meal or a holiday package every year?

Truth is that for the very vast majority of us, it doesn’t actually hurt that much to pay the same price for almost all goods and services year in year out, let alone a cup of coffee. In fact, if wages stay more or less the same, it doesn’t hurt at all and could indeed be thought of as favourable economic planning. Just look at one of the last bastions of price stability in the Western world – Switzerland. This could be deemed to a model country from an economic stability perspective and they have largely been in a state of price stability for a generation. The country has more millionaires per 1000 of populace than anywhere else on earth. That’s what I call good planning!

As it stands at the moment, if I want to save for my future, one of the worst enemies I have to fight against is, without any doubt, the increase in the cost of living. If inflation is 3% per year, I need my savings to return at least 3% just to retain the same living standard. The lower the inflation, the easier it is to maintain the standard of living for any saver. To me, instead of hurting, the lack of inflation is a cause for celebration.

If, as many would have you believe, a little inflation does not hurt, high unemployment rate and a low growth rate most certainly do hurt.

In Spain and Greece the unemployment rate is presently just above an almost unbelievable 25%. Put another way, it means that fully one quarter of the economically active population is frustratingly without a job. That is a tragedy for supposedly developed economies and one that will have, as yet unseen, sever social consequences going forward. These people could be contributing to their country’s wealth but politicians are more intent on covering up the past excesses of spending with deep austerity measures still being implemented some 6 years after the GFC.

While economists and in particular politicians and policy makers thump the line that deflation and depression go hand in hand, in fact in-depth research that has been conducted on the link between the two reveals mixed results at most. Inflation and deflation are just the price of money and depend on the money supply which, is actively managed by a central bank.

If the demand for goods decreases, while the money supply remains at same level, the price of goods must decrease for demand and supply to rebalance. In such a case we could associate deflation with a decrease in demand (or recession) but, deflation itself was not the cause. What is happening in Europe currently is a similar situation. Demand is decreasing because of the massive austerity package being implemented in many countries at the same time. Faced with a decrease in income, households must thus decrease their expenditure (demand). They simply don’t have any other option left available to them. So, deflation is the consequence of austerity. However, under certain conditions, deflation may actually be a problem. As prices are expected to decline over time, the consumer has an incentive to save instead of consuming. You may say “wasn’t this the aim of the massive austerity being implemented”? Well, there’s a missing link. If deflation isn’t that bad for many of us and it is mostly a consequence of the current fiscal policy, why be concerned with it?

The problem with deflation is that it hurts all agents that live on the edge, in particular those near bankruptcy. By that I mean governments and indebted companies. These don’t want inflation to stay low but would rather prefer prices to increase faster and faster to allow them to perpetuate their zombie state. If prices double, for example, half their debts effectively just vanish without any effort. That is because doubled prices correspond to halved debts – it’s the other side of the coin.

Inflation acts as an invisible hand helping the indebted, paying off part of their debts. But, it does so through stealing from lenders. So, in terms of policy making, when someone speaks of “reflating” an economy, fighting deflation, and increasing the money supply, what they are really saying is that they will steal from those who have don’t have debts and have been working save money for the future and then give the proceeds to those with huge debts.

The problem in Europe is of course related to massive austerity. A lack of demand is causing deflation. The only sensible way to avoid it is to reverse the huge tax loads imposed so far. This way demand would recover and prices would potentially increase again but without stealing from savers. But the only certainty is that, as far as the embattled and indebted government are concerned, they simply won’t allow for deflation to take hold. This is because it hurts… not you… it hurts them.