‘The Economist’ magazine has a heritage of a certain type of editorial anonymity where most authors and columnists don’t sign their articles. There are different opinions on the purpose of this tradition but one certain benefit of editorial anonymity is ability to save your reputation in case you write a complete non-sense mumbo jumbo. The editorial anonymity certainly saved face of the author of latest edition of “The Economist explains” series titled “Why deflation is bad?”.
Below you can find the link to the original article. In black you can see excerpts from ‘The Economist’. In blue you can see my comments. I recommend you go to the official Economist site, read the article and come back here.
Why deflation is bad
Why deflation is good
PRICES in the euro zone are falling. Figures released on January 7th showed that consumer prices in the year to December fell by 0.2%, marking the return of deflation for the first time since 2009.
Weak demand, driven by austerity, debt and a lack of economic growth is dragging down prices. The falling oil price is making things cheaper, too. One might think falling prices would be something to celebrate. But concerns about deflation traps and downward spirals abound. The European Central Bank may launch a programme of quantitative easing this month to fend off the threat. Why do economists so dread falling prices?
One common explanation is that in anticipation of falling prices, consumers delay purchases, causing them to fall still further.
Assumption that anticipation of falling prices would delay consumers’ purchases is wrong and can be proved in at least three ways:
- It is widely known that prices of electronic goods have been falling every year in the last two decades due to technological progress in electronics industry. Even though the consumers know that price of their new laptop/smart phone will be slashed in half in a year or so they still buy it and the sales growth in electronics industry rarely drops below two digits number. Lower price(which is a consequence of deflation) means that more people can afford to buy certain goods. If iPhone costs 400CHF then more people can afford to buy it comparing to 800 CHF iPhone, right? You may have heard about widespread use of mobile phones in Africa. It’s happening because the price of mobile phones are going down every year. We haven’t seen much deflation in price of Louise Vuitton bags and that’s why you don’t see much of them in Africa. Falling prices mean more purchasing power for consumers. If consumers’ monthly expenses decreased by 100CHF because of lower prices(deflation), then these consumers have extra 100CHF to buy extra goods they couldn’t afford to buy before.
- When making purchases for most goods (food, petrol, clothes, etc) most people don’t even think about the possible price in the future. They almost never think in a way ‘Oh I will buy this bread next month and not today because it will cost 0.2% less’. The only purchase they may analyze this way is real estate but only when bought for investment purposes. Even if some home buyers postpone purchasing, the aggregate demand would still be higher because lower real estate price means more availability for more consumers. It’s clear that more people could afford to buy a house in Switzerland if it costs 500k CHF rather than 1m CHF. Lower prices of housing, more demand, more construction jobs, more prosperity for everyone.
- Falling prices are also good for business (especially exporters) because the cost of materials would lower, therefore margins would increase. For businesses selling to local customers, lower sales price(due to deflation) would be compensated by lower costs of goods and materials, therefore keeping margins on the same level. Taking the effect of increased availability and higher demand businesses operating in the deflationary environment would be able to keep or even increase their revenues.
This argument is a simplification; it can be made with equal power in reverse to argue that inflation will inevitably run upwards as consumers bring purchases forward to avoid being stung later.
It seems like the author presented an argument, criticized his own argument for being a simplification and kept proving how true it is. Hmmm…
But the argument hints at the right problem: deflation’s effect on interest rates. Generally speaking, the interest rate reflects the price of consumption today relative to consumption tomorrow. When interest rates are high, savings are worth more tomorrow, and vice-versa. The return in money terms (the rate advertised by banks) is called the “nominal” interest rate.
Nominal interest rates has nothing to do with ‘the rate advertised by the banks’. Nominal interest rate is a theoretical term used mainly to distinguish it from a real interest rate (nominal rate + inflation). Talking about interest rates used by banks we can either talk about central bank interest rates, interest rates set by commercial banks to borrow/lend between each other, and market interest rates set for borrowing/lending to/from non-banking businesses and retail consumers.
But inflation also matters. Subtracting expected inflation from the nominal rate produces the real interest rate—the expected return after inflation—which is what people respond to in most models of the economy.
People do not respond to any models. 95% of people do not even know what an economic model is.
Low inflation or deflation constrains this crucial variable. The nominal interest rate cannot fall below zero, because that would mean reducing savers’ bank balances every month, and would prompt them to withdraw their deposits from banks and stash cash under the bed.
This is obviously not true since the short term nominal rates in EUR and CHF are below zero today(2015-01-10).
Also, after withdrawing a deposit consumers may decide to:
- spend it on consumption
- invest it in
- starting a business
- real estate
- mutual funds
They could also be saved/invested in several other ways. There is absolutely no causal relationship between withdrawing deposits and ‘stashing it under the bed’.
Together with inflation, this puts a floor on the real interest rate too. If inflation is low and real rates can’t fall far enough to boost demand and perk up prices, demand will weaken still further.
In this sentence the author assumes that the demand is boosted by credit. Credit is only necessary when consumers do not possess enough of their own cash to fund their spending. And they do not have enough cash because of inflation in previous years has decreased their purchasing power. During deflationary periods prices are going down, therefore a bigger chunk of consumers spending can be satisfied from their own income and less from credit. Great for consumers, bad for lenders(banks).
This is the dreaded deflation trap.
The only people to be scared of deflation trap are bankers. This is because during deflationary periods people can afford to buy more with their own money, and so their reliance on bankers’ money decreases.
There are other problems, too. Lower-than-expected inflation increases the real burden of debts. Lenders benefit, but because they are more likely to save than borrowers, demand is sapped overall.
It’s exactly the opposite. Deflation(read lower prices) means consumers can afford more with their income therefore rely less on credit. Lenders(banks) live from lending money, therefore they want more inflation so consumers have to borrow more, which makes more business for lenders.
Deflation also increases rigidity in the labour market. Workers are resistant to wage cuts in cash terms, but inflation lets firms cut real wages by freezing pay in nominal terms.
What this sentence really means is: “With inflation we can decrease the real income of workers without them realizing that”.
Deflation, by contrast, makes this problem worse.
Deflation, by contrast, makes me buy more with the same salary.
To avoid the trap, central banks can resort to unconventional policies such as quantitative easing, although there is debate over their fairness and efficacy.
There is no debate here. Quantitative easing is nothing else than printing money. Printing money causes inflation. Inflation equals higher prices. Higher price and stagnant wages means less purchasing power. Less purchasing power means more poverty.
In the long run, some economists think inflation targets should be higher.
Translated to English: “Some economist think even more people should be poorer and we can easily do it by convincing central bankers to set inflation targets higher.”
That would give more room for real interest rates to fall when economies are hit by negative shocks. But in a few decades, the problem may disappear: in a cashless economy it is impossible to stash money under the bed.
Nothing to be worried. If central banks continue creating high inflation, in few decades normal people will have very little money, therefore very little to stash under the bed.
That would allow nominal interest rates to go negative, as everyone’s bank balance could simply be reduced simultaneously.
Is this happening for real? Is the author of this article hoping for times of cashless economy when “everyone’s bank balance could simply be reduced simultaneously”? In English that probably means: “I hope in the future all transactions will take place in the banking system so banks can take as much money of people’s money as they wish to”.
But that might be easier said than done.
So far Keynesians are doing pretty well convincing people that ‘reducing their bank balance simultaneously’ is good for them…
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