What's wrong with deflation?

Things are getting cheaper. How can that be bad? Here are some thoughts from the Financial Times:

In theory, such deflation could be good for the economy, as it releases money for consumers to spend on other products. But... deflation can also take a malign form. “The risk is that people don’t spend because they think prices will be yet lower in the future and that sets off a negative spiral...”

Temporary drops in prices are unlikely to have that effect. But Mr Brigden thinks the combination of falls in commodity and house prices with weak demand means that US headline inflation is likely to go negative next spring and stay that way for months, dropping as low as minus 3 per cent. “When deflation goes on for the best part of a year, expectations are more likely to become entrenched,” he says.

Probably most people reading this blog have never experienced prolonged price deflation, so the implications may be hard to visualize. The best way to get one's head around the concept is to reverse the psychology of inflation, with which most of us have coped all our lives.

Living in inflationary economic times means goods and services will cost more in the future, so the rational psychologic (and economic) response is to buy things now, before they rise in price. Buy a house, because it will be worth more later. Buy collectibles, because they can be sold later. Buy stocks to sell in your old age. The best known extreme example is the "hyperinflation" that occurred in Hungary and Germany in the 1940s, when workers would literally cash and spend their paychecks the same day because food etc would cost more the following day.

Inflation encourages not only spending, but debt. It works in favor of the debtor. Buy something now, pay for it later when inflation will push your salary higher, or at least push the value of your purchase higher so you can sell it for a profit. The saver is frankly penalized. It's no surprise that for the past couple generations, in an environment of continual inflation, that the American consumer has totally lost the habit of saving.

Deflation of prices does the opposite. It encourages the public not to buy, because things will be cheaper later. Deflation rewards savers, who can get more goods for their saved money in the future. It penalizes the debtor. Our country has seen temporary deflation (and decreases in the rate of inflation, termed "disinflation") in the past, but not sustained deflation since the Great Depression. The fear now is that if deflation is permitted to continue, the public will stop spending, and the more that spending stops, the worse the economy becomes, and the more prices have to be lowered to tempt spending, which of course exacerbates the deflation.

So who fears deflation? Debtors fear it. And who is the biggest debtor? The federal government - to an extent never seen before in the history of this country. It doesn't matter if the president is Bush or Obama, whether the congress is Republican or Democrat - every national politican wants the country to have an inflationary trend. They want to print or authorize more money so that the current godawful deficit can be "repaid" with inflated, cheaper dollars in the future - perhaps by this generation's children.

And that is why the return of inflation is inevitable. If it doesn't occur from external causes (worldwide shortages of raw materials or food or whatever) it will be generated by internal policies. This country (and others around the world) will try to force inflation to reoccur. They will seek to have a modest inflation of a couple % per year. The risk is that by cheapening the currency they will eventually generate severe double-digit inflation, or the country-busting hyperinflation that is happening in Zimbabwe right now.

I'm not an expert on all this, so don't take what I say as gospel, but I do hope some rambling thoughts here will prompt some TYWKIWDBI visitors to think about this subject. We are living in interesting times. Potentially scary times. It's going to be vital to pay attention to what is going on, to be quick to respond to changes. Cruise the web for information. Get data and opinions from diverse sources. Don't blindly believe anyone - including Obama (and me). Stay flexible. Watch your back.