Thursday, November 20, 2008

Word of the Week: Deflation

. Thursday, November 20, 2008

Before Will gets us all freaked out about deflation, we should consider what is it, whether we are in it, and whether we should we care?

What is it: a sustained decrease in the general price level.
Are We in it:
Exhibit 1: The CPI fell by 1 percent in October relative to September. This is the largest decline since February 1947. Wow, that sounds scary.
Exhibit 2: Energy prices fell by 8%; transportation prices (cars) fell by 5.4%; clothes prices fell by 1%. Other prices rose slightly. This is neither general nor sustained.

On balance, no, we are not in deflation. We are seeing relative price changes; energy prices are down (that's good news) and the auto industry just had about its worst month ever.
Yet, we are at the risk of falling into deflation.

Should We Care? Yes
1. Debtors suffer as the real value of their debt rises. Hence, more difficulties to service loans (think about housing price collapses and mortgage foreclosures). Rising debt service problems can harm financial institutions (that's an ironic understatement).
2. Creditors benefit as the real value of their assets rises. Of course, this assumes that debtors continue to pay.
3. Consumers benefit, because things get cheaper every day.
4. Not so good at the aggregate level. If we expect everything to be cheaper next month, we won't buy it this month. If we all defer our purchases in expectation of lower prices in the future, we aggregate demand falls and we produce less--which means we employ fewer people. With less income from lower production, prices fall further, so we push our big purchases off to the future again. And so on and so on. Deflationary spiral, I believe it is called. This is pretty much what happened in 1929-1933.

So yes, we should care. Will's point, I think, is that monetary policy is increasingly of little utility because nominal interest rates are close to zero. I might point out to Will that the good Lord had the sense to create Sir JM Keynes in order to alert us to the utility of fiscal policy in precisely this circumstance.


Anonymous said...

Thomas, nice post but you make the same mistake many economists and all journalists make: deflation is not a decrease in prices. It is a decrease in the money supply (money+credit). The decrease in prices is the result, not the cause, of deflation.

As for Keynes, I had hoped you weren't infected with his flawed theory. keynesianism never worked, and never will. What we need is to suffer big time, but quickly. Keep throwing money in the system at will, and you'll keep distorting the signals we need to see clearly if we want to get out of this mess and avoid a «lost decade».

(And don't forget who put us in this mess: the Fed and the easy credit. when a bubble burst, the cure is not to reflate it. At least it SHOULD not be.)

The stock market keeps tumbling down because nobody knows anything about which firm is healthy, and which firm is a dead horse. When government will let the healthy ones survive and the bad ones go bust, that will be your first step towards recovery.

Word of the Week: Deflation
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