If you want to watch a central banker turn pale, simply whisper the word “deflation” in his ear. Well, her ear.
Fear of deflation has informed central bank policy ever since the Great Depression, so much so that economists pretty much stopped thinking about it years ago. But that doesn’t mean that the rest of us can’t think about it.
Don’t worry, I’m not going to argue that deflation is a positive good. I’m merely going to argue that modest deflation is no better or worse than modest inflation. The reason this is important is that central bankers’ knee-jerk terror of deflation causes them to mount extraordinary efforts to counter even the hint of it, which presents all sorts of serious costs to society generally and the economy in particular.(1) Meanwhile, the hint of inflation affects central bankers like a cool breeze on a humid day outside the Eccles Building.(2)
Deflation occurs, of course, when the value of money actually rises. Although deflation was quite common in the distant past, it’s been a rare condition of modern economies, where we’ve been habituated to assume that the value of money always falls, i.e., inflation.
In an inflationary world, we know what to expect and how to behave:
* Whatever things cost this year, they will cost more next year.
* If we incur debt – to buy a car or a house, let’s say – we know that the difficulty of paying it off will get less and less over time, because, while the constant dollar value of the debt is fixed, the value of those dollars is declining.
* If we want to avoid having our capital invisibly eaten up by inflation, we need to put that capital at risk – by buying stocks, for example.
But in a deflationary world, all this is stood on its head:
* Whatever things will cost next year, they cost more this year.
* If we incur debt we know that the difficulty of paying it off will get worse and worse over time, because, while the constant dollar value of the debt is fixed, the value of those dollars is rising.
* We feel little need to put our capital at risk because, simply by holding it in cash, it becomes more valuable every year.
In other words, there are different winners and losers in inflationary and deflationary times. Inflation favors borrowers over lenders and risk-takers over savers. Deflation favors lenders over borrowers and savers over risk takers.
Setting aside extremes of both monetary conditions – hyper-inflation and deflationary spirals – wouldn’t a society be better off if it fluctuated more or less consistently between periods of modest deflation and periods of modest inflation? Wouldn’t that even out the playing field for borrowers, savers, risk takers, risk avoiders, rising and falling costs of goods and services? Wouldn’t that help tame the repeated asset bubbles whose inevitable collapse causes so much economic and social distress?
You might think so, but that’s because you’re not a central banker. Central bankers have such an instinctive horror of deflation that they intentionally set their monetary targets artificially high just to ensure that they don’t inadvertently deflate. Here’s Mr. Bernanke on the subject:
[C]entral banks with explicit inflation targets almost invariably set their target for inflation above zero, generally between 1 and 3 percent per year. Maintaining an inflation buffer zone reduces the risk that a large, unanticipated drop in aggregate demand will drive the economy far enough into deflationary territory to lower the nominal interest rate to zero. Of course, this benefit of having a buffer zone for inflation must be weighed against the costs associated with allowing a higher inflation rate in normal times.(3)
I supplied the emphasis there at the end because, since Group-Think is what central bankers do, every single one of them has “weighed the costs” and determined that higher inflation is to be vastly preferred.
Since the early days of the Great Depression the US has experienced almost constant inflation. We’ve never experienced hyper-inflation (although we flirted with it in the late 1970s and early 1980s), but even the modest inflation we’ve seen has encouraged a long and damaging series of asset and credit bubbles that have crippled the economy and helped give capitalism a bad name. Just in the last fifteen years the Tech Bubble and the Credit/Housing Bubble have led to the Tech Crash and the Great Contraction. Nine of the past fifteen years have consisted of crises, recessions or way-below-trend growth as we slowly recovered from those bubbles. And this is why central bankers prefer inflation over deflation?
As the central banker’s face reddens, he (excuse me, she) will stammer something like, ‘But… but, deflation is even worse!”
But is it? The two examples our central banker will give are the Great Depression and Japan over the last two decades. We’ll take a non-central banker-centric look at those examples in my next post.
(1) E.g., QE1, QE2, QE∞, etc.
(2) For those of you who don’t spend every waking moment obsessed with the Federal Reserve, it’s headquartered in the Marriner S. Eccles Federal Reserve Board Building in Washington, DC. Eccles, a Mormon millionaire and head of the Federal Reserve under FDR, was a Big Government, tax-and-spend, Treasury-centric, class-baiting lefty in the 1930s, though he later recanted. Eccles presided over 14% inflation in 1947 and another 8% in 1948 and he thought that was just dandy.
(3) See Deflation: Making Sure “It” Doesn’t Happen Here, available at http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm.
Next up: (On Deflation (Part 2))
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