Fears of deflation are tremendously overstated. A persistent mild deflation would not be harmful. A stronger deflation would not be a catastrophe. Massive inflation is a more present danger than massive deflation; massive inflation is not only more likely but it would be harder to recover from than massive deflation. Neither situation is desirable. Persistence in monetary status is more desirable than either, and a persistent rate of change counts as persistence as surely as would absolute stability.
It must be understood that the oft-stated ‘chaotic consequences’ of inflation and deflation come in two forms. The first form is the question of who benefits directly from them and who is pained by them, while the second form is an economic calculation problem. I will address the question of who benefits first; it is the simpler of the two. The economic calculation problem will be addressed in a future post.
Holders of assets benefit from deflation and are harmed by inflation. If you are holding a thousand dollars in cash, and there is 2% deflation, those thousand dollars are worth 2% more than they were before. The same is true for all assets one possesses. If you have stocks, they are worth 2% more than they would have been without the deflation (which might not be the same as being worth 2% more than they were, stocks being what they are). Even your car is worth 2% more than it would’ve been, although it’s pretty sure to have lost value anyways. Cars are fast-depreciating assets. Finally, if someone owes you a thousand dollars at the start of the year and pays you at the end of the year, the debt at the end of the year will be 1020 dollars (effectively). Therefore those who control assets are benefitted by deflation. All of these things are reversed if there is inflation; the thousand dollars, the stocks, the car, and the debt you hold against someone else all lose value from what they would have had.
Holders of debts are harmed by deflation and benefit from inflation. If you buy a house for $200,000 and there is 2% deflation that year, the debt will increase by $4,000. If you are going into business and you fund your start with debt, that debt will become more onerous if there is deflation. If you buy a car or use your credit card too much, these too will escalate in cost over time due to deflation. Therefore debtors are harmed by deflation. All of these things are reversed if there is inflation; the $200,000 house debt becomes effectively a debt for $196,000 from one year’s 2% inflation. Although it bears noting that banks try to take account of inflation (and their own profit) by using interest, and that excessive or unpredictable inflation makes banks entirely afraid to offer loans.
There is one other, less often addressed arena in which some group directly benefits or is harmed by changes in the value of money and the way it changes incentives in favor of saving and holding assets. Provisioners of staples are benefitted from deflation. Provisioners of luxuries are harmed by deflation. Staple goods are ones that must be consumed at regular intervals. The desire to save money is not going to make a family go without toilet paper; deflation is often stated as something that will reduce the demand for consumer goods and that is true, but only for frivolous consumer goods. People will still need to eat and they will still require certain consumer goods at regular intervals. This is not going to increase sales of these goods. However, the increased saving is not simply going to pool in people’s mattresses. That money will go to capital goods, and thusly to lengthening the capital structure of the economy. In what areas will it lengthen most? It will lengthen most in staples. Companies who provide staples will find investment sources more willing to deal with them, while companies which provide frivolities will find investment sources less willing to deal with them. This effect is indirect but I propose it is nevertheless stronger than commonly held.
Now that we have addressed this, deflation looks different from how it looked when we began, and different from the common view. We see that the modern credit card economy and general policies of debt-financing in large organizations are severely hindered by deflation, and in that extent deflation would indeed cause chaos. However, we might notice if we are alert to the procession of cause and effect, that deflation is not strictly harmful per se. It encourages savings and discourages consumption, which in turn should promote economic stability and capital formation.
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