As bad as inflation is deflation is much, much worse

September 27, 2009 10:38 AM

Why is deflation far worse than inflation? After all, prices are falling, goods and services get cheaper, what's not to like?

Modern Central Bankers are well armed to wage war against inflation; high interest rates effectively slows the circulation of money, extinguishing inflation as the United States did by raising the Fed Funds rate to a record 20% in 1981.

But these same tools don't apply to deflationary scenarios, as nominal interest rates can not be cut below zero, a barrier recognised by Fed Chairman Ben Bernanke who in 2004 concluded ¹ "the nominal policy interest rate may become constrained by the zero lower bound." [ .pdf ]

And one must not underestimate the destructive power of deflation; as deflation pressures drive down prices, as the demand for goods and services first drops, then accelerates as businesses layoff workers, leading to further declines in wages even as unemployment rises.

As deflationary expectations take hold defaults on loans of all types rise as the value of assets plummets and banks first curtail then totally stop lending, leading to the emergence of a vicious cycle much Japan's deflationary spiral.

Adding to contemporary deflationary pressures, we know bank lending is declining, even among firms receiving government funds. So the question is how can we incentivise banks to begin lending again?

Harvard Economist Greg Manikw has an idea - penalise banks for hoarding cash by canceling a percentage of currency held dormant in reserve and not lent to consumers and businesses; effectively achieving negative interest rates.

In a similar vein, last July Sweden starting charging interest for funds held dormant by banks, effectively penalising institutions for hoarding cash and driving an increase in personal sector lending, while The UK considers the same approach.

Will Bernanke and The Fed follow suit?

¹Bernanke, B., S., Reinhart, V., R., Sack, B., P., 2004, "Monetary Policy Alternatives in the Zero Bound"
Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C.

posted by Mutant (33 comments total)

Will Bernanke and The Fed follow suit?

If you thought the teabaggers got ugly after the health insurance industry organized them, wait till you see what kind of protests the big bankers will muster if the Fed tries to do it.
posted by deadmessenger at 10:44 AM on September 27, 2009

Will Bernanke and The Fed follow suit?

No.
posted by Sys Rq at 10:50 AM on September 27, 2009

So the question is how can we incentivise banks to begin lending again?

I agree that is a question, but on the other side, how do we convince people and businesses to borrow? US consumers have so much debt it is hard to image that they would want more, regardless of what the banks offer. The US economy has been powered by the consumer taking on debt since 2001. They are slowing down, so why should businesses take on debt, since it won't be needed to service consumer needs.

Are you starting to worry about deflation, Mutant? Last I saw you were buying precious metals as an inflation hedge.
posted by procrastination at 10:52 AM on September 27, 2009

procrastination: The US economy has been powered by the consumer taking on debt since 2001.

I assume you're being conservative w/r/t the date in which consumer debt began to power the economy. I'd say it goes back to the 1980s.
posted by SansPoint at 11:34 AM on September 27, 2009

So let's see if I understand, broadly, the problem with deflation: It's basically a death spiral.

How'd I do?
posted by fatbird at 11:35 AM on September 27, 2009

It seems as if there is an awful lot of editorializing in this post. Generally that's not a good thing.
posted by Chocolate Pickle at 11:43 AM on September 27, 2009 [1 favorite]

Hey Mutant. This is an interesting topic.

It seems that charging interest on reserves would be a complete reversal of Fed policy.

In October 2008, the Fed began paying interest on reserves of one-quarter of a percent. The excess reserves of U.S. depository institutions excess reserves ha now reached $765 million .

The banks have built up excess reserves because they found themselves undercapitalized and sought safe assets where they could weather the storm.

The problem is only the Fed can drain these reserves and it will have to do so when the economy recovers. This in turn depends on the quality of the assets the Fed is holding and the market's appetite for them. (See More Money: Understanding Recent Changes in the Monetary Base, Gavin.)

Now with the economy showing signs of recovery and subdued inflationary pressures, I'm curious whether you think gold is a good bet for the long-term.
posted by up in the old hotel at 12:00 PM on September 27, 2009

I don't think this post is overly editorialized. I mean he's just saying deflation is bad, and then bringing up an example of a possible solution.
posted by elwoodwiles at 12:01 PM on September 27, 2009 [2 favorites]

Buy cheap. Sell dear. Or is it Buy Deer, sell Sheep?..at least spring ahead.
posted by Postroad at 12:03 PM on September 27, 2009 [2 favorites]

It seems as if there is an awful lot of editorializing in this post. Generally that's not a good thing.

Mutant's posts add a lot of value to MetaFilter.
posted by KokuRyu at 12:06 PM on September 27, 2009 [26 favorites]

i'd contrast credit-(implosion)led deflation with productivity deflation -- like what reigns in technology, e.g. w/ moore's law and the cost of computing or the price of illumination, cf. nordhaus -- the former being the kind where you'd want to stage an intervention, with all the moral hazard consequences that entails, and the latter (also arguably) you should leave alone...

re: sweden and negative nominal rates, i touched on that a bit earlier, but for more background and context on its significance definitely check out buiter and waldman, who describe a modern-day kind of demurrage :P

cheers!
posted by kliuless at 12:12 PM on September 27, 2009

read mish
hes all about the deflation camp
posted by robbyrobs at 12:17 PM on September 27, 2009

I agree that is a question, but on the other side, how do we convince people and businesses to borrow? US consumers have so much debt it is hard to image that they would want more, regardless of what the banks offer.

Cash for Clunkers? I'd assume most of those new cars sold were by loans and not cash up front.

Investors seem to have no trouble snapping up foreclosures here in Las Vegas, though cash transactions seem to be increasing because its a lot easier than trying to get a loan on a foreclosure...
posted by SirOmega at 12:21 PM on September 27, 2009

Whilst I belive the arguments about the danger of debt-deflation (a la Minsky), I really don't buy the argument that says that deflation per se is dangerous because people will put off purchases. We've had continuous deflation in computing costs for about 7 decades now: has that stopped people buying computers? No, of course not, because along the way they had problems that needed solving then, not in a years time.

Similarly, there are well documented periods of deflation in the past which were not particularly problematic economically. Prices fell, people got on with life.

Rather than be scared of deflation, we should be accepting it, and re-writing the debt of those unable to pay: converting it to some kind of equity. Instead the banks got a sweet deal out of the Fed/BoE/ECB, with all their losses backstopped so that's never going to happen & the rest of us get screwed over.
posted by pharm at 1:06 PM on September 27, 2009

I really hate it when Mutant gets pessimistic.
posted by nax at 1:53 PM on September 27, 2009 [1 favorite]

procrastination -- "Are you starting to worry about deflation, Mutant? Last I saw you were buying precious metals as an inflation hedge." -- No, but I'm curious about how The Fed sees the current state playing out.

I generally download most data The Fed makes available, and have been focusing (like lots of other folks I suspect) on the Flow of Funds data (current release September 17th 2009, next release December 10th, 2009).

The data is available here as a pdf or as a group of CSV files.

I've also uploaded the data to Google Docs as a single Excel sheet, should anyone else like to peruse the information provided. The only modification from The Feds's data is a summary page I created capturing quarterly changes for something I was working on, and otherwise (unless I messed up), it's The Feds data all the way.

Now I was curious about the sharp declines in lending we've been seeing, at the same time the increases in deposits held in reserve as up in the old hotel noted. Its an interesting problem.

And wouldn't you know it, right around the same time Sweden goes punitive on deposits (they are for lending, of course!!) some folks in Britain starting making noises about doing the same in The UK and my gosh I didn't see much at all in the US media about this experiment.

So, I've been curious about what might The Fed get up to in order to force banks to start lending cash again, to risky obligors (which is, of course, the story of banking, 'cause if you're not lending you CAN'T pay interest on and thus attract deposits, these "unusual times" aside) instead of holding it in essentially risk-free, cash reserves.

Bernanke, "Helicopter Ben", as some folks call him, has run a very, very agile and adept Fed. It will be interesting to see if they choose to deal with the problem of banks not lending via the front office (e.g., punitive interest rates on reserves) or the bank room ("you lend or else!").

Somehow, someway, banks must begin to lend embrace risk again. Question is how.

So inflation and gold? Yeh, I still think we'll see above trend inflation, below trend economic growth, above trend unemployment and I'm open to the idea of gold & silver.


fatbird -- "So let's see if I understand, broadly, the problem with deflation: It's basically a death spiral.

How'd I do?"

Absolutely perfect, if they let it continue too long. Like inflation, a little deflation isn't bad. But too much of a good thing ...
posted by Mutant at 1:54 PM on September 27, 2009 [1 favorite]

As someone newly re-employed, at a much lower salary (almost 30%) than I was previously making, I wonder if some deflation doesn't come with the terrirtory of so many people unemployed/underemployed.
So, with some deflation, I (and many people like me)can still keep up with bills and even save some (living on unemployment helped us figure out where our excesses were in a hurry!). With too much deflation, I could lose my job again...
Any thoughts?
As usual, Mutant, I always enjoy your incisive comments/posts.
posted by dbmcd at 2:08 PM on September 27, 2009

I wonder if some deflation doesn't come with the terrirtory of so many people unemployed/underemployed.

The Phillips curve is a theory about the relationship between these two. Generally, a decrease in employment results in a decrease in inflation; your theory merely argues the curve can go negative.

It makes a certain amount of sense. In high unemployment, wages could fall to meet equilibrium. But "wages" is so general that in some sense the national gross income would fall even as output rises. Low wages, lots of goods means deflation.

To my mind the question is whether there's a difference between deflation and hyperdeflation, the way we come to live with inflation but not hyperdeflation.
posted by pwnguin at 3:20 PM on September 27, 2009

In Japan, deflation has been the big thing for most of the time I've been here. During that time, Japan has also seen, essentially, the end of guaranteed lifetime employment, resulting in 34% of the workforce being contract/part-time. The social net in Japan is meager, to say the least, but until last year, most of those workers were ineligible for any form of government assistance when they lost their jobs. On a more personal note, the last nine years I've been here, wages for teaching English have dropped dramatically (partly due to market flooding), in some cases hourly wages for business English courses are half what you could get in 2001.

It seems to me that in the span of a generation or two, Japan looks to be changing from a traditional Asian saving economy, where parents save money to help children get married, buy a house, etc, to a borrowing, debt based economy. The young, by and large, are still at home, unable to move out, unable to save. Mom and dad's savings are being used up, and when it's this generation's turn to provide for their own children, the savings just won't be there.

So, yeah, deflation isn't so good. Companies are looking to cut costs as much as possible, and wages and benefits, as well as jobs, seem to be the first things to go.
posted by Ghidorah at 3:37 PM on September 27, 2009

I know more than a bit of deflation is bad, but I can't help being a selfish bastard and hoping we get deflation instead of inflation. I don't have much debt and I have a bunch of savings. So deflation = win!
posted by Justinian at 3:57 PM on September 27, 2009

I can't help being a selfish bastard

That's our problem in a nutshell.
posted by adamdschneider at 4:37 PM on September 27, 2009 [1 favorite]

That's our problem in a nutshell.

Not really. The problem is that it appears to be government and corporate policy to screw over people like me in order to help people like those at Goldman Sachs. And then ask people like me to act in a way that isn't in our own self interest because it will help the economy as a whole.

Nope. They can ask again when they stop funneling my money to rich bankers.
posted by Justinian at 4:43 PM on September 27, 2009 [2 favorites]

In Japan, deflation has been the big thing for most of the time I've been here. During that time, Japan has also seen, essentially, the end of guaranteed lifetime employment, resulting in 34% of the workforce being contract/part-time. The social net in Japan is meager, to say the least, but until last year, most of those workers were ineligible for any form of government assistance when they lost their jobs.

Living in a no-inflation society like Japan is interesting, in that the appearance of wealth and relatively prosperity hasn't changed much, but society's actual wealth has declined precipitously. In my opinion, it is this gnawing, slow-motion destruction of wealth caused by deflation coupled with absolutely corrupt government and inept policy for the past twenty years (or even longer, really) that has done the most damage to this country. In spite of that, the Japanese have done the best they could to make the best of a bad situation, but being a weak, deflation-ridden, export-led economy almost became their undoing last year. I'm still not sure how they'll get out of this mess in the long term unless they can reverse deflation -- and that's tied into population growth (or at least no further population decline), stopping the decline in land prices, eliminating wasteful spending, dealing with a debt-to-GDP ratio upwards of 165%, etc.

Those of you living in the US (and by extension, everyone on Earth): be very afraid of this. In Japan, there was at least a modicum of unity on attempting to deal with the problem. Although there are structural differences between the two countries, in the current political climate even the fear of a deflationary spiral would make the dollar sink like a mafia murder victim encased in concrete and bring about another "lost decade" for the entire world, not just Japan.
posted by armage at 5:43 PM on September 27, 2009 [2 favorites]

Way back in Econ 101 somebody asked the prof to explain why there is inflation, most of the time. He couldn't come up with an answer. Gradually over the years, I've figured out that the answer is basically that central banks, while predisposed to avoiding inflation, tolerate a little inflation because they want to avoid deflation even more. This would also seem to be an argument for central banking and money supply management, because in economies without effective central banking, deflation is a more frequent phenomenon. In any case, the challenge is, if I understand it right, that when you've pulled out all the stops to beat back a capital R Recession, you may have gone beyond tolerating a little inflation and proceeded into wiping all of it out, settling into a deflationary spiral, and having no way to bring it back.
posted by beagle at 6:34 PM on September 27, 2009

Mutant's posts add a lot of value to MetaFilter.

More accurately, Mutant's posts produce positive upward pressure against a zero-bounded relative boredom index.
posted by rokusan at 6:42 PM on September 27, 2009 [10 favorites]

Mutant's posts add a lot of value to MetaFilter.

Seconded.

Living in a no-inflation society like Japan is interesting, in that the appearance of wealth and relatively prosperity hasn't changed much, but society's actual wealth has declined precipitously

This is also true in a lot of the low-inflation Western nations; how much of the apparent wealth of the last decade in the United States, the UK, NZ, etc, have turned out to be dumb shit like people borrowing money on unrealised increases in house values to buy cars, holidays, new kitchens, etc?
posted by rodgerd at 7:14 PM on September 27, 2009 [1 favorite]

So the question is how can we incentivise banks to begin lending again?
Not at all if you see money as credit which is created not out of thin air, but out of property rights. If the creation of credit out of property rights stops (intellectual property/ new marker bubble, real estate bubble) then there is no reason, not even a possibility for the bank to give credit. No matter how much money the central bank will pump into the banks, they won't, they can't lend. This may be one of the reasons why the Japanese economy never really recovered. Instead of pumping money into the banks, the central banks should pump money into the consumers or invent a new bubble. CO2 rights?
posted by yoyo_nyc at 8:26 PM on September 27, 2009

"that's tied into population growth (or at least no further population decline)"

Not to derail, but Japan has two big factors going against it there -- they don't want immigration (unlike the English-speaking "new world" for example), and society is too patriarchal to support working mothers (unlike the countries in Northern Europe that are still holding close to replacement).
posted by i_am_joe's_spleen at 8:51 PM on September 27, 2009

All you need to know is...just buy gold
posted by PhotoFilter at 9:01 PM on September 27, 2009

It seems as if there is an awful lot of editorializing in this post. Generally that's not a good thing.

Some opinions are simply better than others. Not in their position, but in the consideration that's gone into them.

being a weak, deflation-ridden, export-led economy almost became their undoing last year.

Hey now, let's not lump in export-driven with those other things. There's only one non-export-driven economy in the world that I'm aware of and it's the subject of this post.
posted by GuyZero at 10:13 PM on September 27, 2009

Did I miss something? Can you eat gold now? Or are we talking Rold Gold?
posted by chavenet at 4:11 AM on September 28, 2009

I'd just like to point out that Krugman has been warning about the liquidity trap for almost a decade now. Glad to see the memo finally got around.
posted by Civil_Disobedient at 6:20 AM on September 28, 2009 [1 favorite]

I've come to significantly distrust such figures. I'm in complete agreement that deflation is in general a bad thing, but I think the index we use to measure inflation/deflation is deeply flawed, and at best gives us a very general trendline while frequently missing some very important information.

For example, I'd argue that inflation for the past decade has been far, far higher than the single-digit official figure. The problem is that the CPI, for whatever reason, does not adequately reflect the housing bubble or the tuition bubble. Both of these have produced and are continuing to produce massive economic distortions, but because inflation figures were stable, this went largely unnoticed. Until the housing bubble burst and all of a sudden we're in danger of deflation.

I'm deeply skeptical of economics' ability to adequately describe or predict the world we live in, and discussions like this one don't alleviate my skepticism even a little bit.

To reiterate: I completely agree that deflation, as popularly described, is a bad thing, but I believe that the CPI is not nearly as useful as it purports to be and that it contains unjustifiable assumptions about economic reality, which is to a certain extent inherently unmeasurable.
posted by valkyryn at 9:53 AM on September 28, 2009 [1 favorite]