Prophets of doom: fear the deflationary spiral!

Let’s get one thing out of the way: as things currently stand, we are very unlikely to see a period of general and sustained price deflation any time soon. Why, then, have I bothered to write about it?

Those more in-tune with economic and financial matters around the world would be aware that ‘economists’, central bankers, and the like often warn against what they perceive to be the catastrophe of decreasing prices. In turn, they argue, we must try to keep inflation positive – prices across the board must continue to increase.

The fear around deflation is based on pernicious assumptions and arguments that are seldom addressed – and precisely because deflation is unlikely to occur any time soon, people aren’t given much reason to look further into it. Nonetheless, the fear mongering around deflation is used to push (amongst other things) the agenda for damaging monetary policy that invariably affects everyone who uses the local currency.

The argument for avoiding deflation

So why do the prophets of doom warn us endlessly against deflation?

Firstly, the anti-deflation crowd claims that if the prices of goods begin to fall, consumers would rather wait for prices to reach a significantly lower level – and buy goods later on – than pay for those goods now at higher prices. This means that current consumer demand would decrease overall. In the view of mainstream Keynesian ‘economists’, demand alone is the key to a healthy economy; if it at all falters, it’s game over economically.

Secondly, they argue that falling prices would harm businesses by reducing their profits. This, in turn, would lead to business failure, and general economic contraction. Curiously, this is the only case (with the exception, perhaps, of subsidised businesses propped-up by government) for which big-government types are at all concerned about companies’ profits.

It is claimed that both of these elements will lead to a ‘deflationary spiral’, whereby the state of the economy continuously worsens, with no prospects of improvement as a result of ongoing deflation.

This argument is thus used to justify massive government spending and debt accumulation, especially as part of ‘counter-cyclical’ measures used to soften or reverse the course of economic recessions, during which deflation becomes a more prominent concern.

Why the fear mongers are wrong

Is it plausible that in an environment of generally falling prices, people would delay spending indefinitely?

For certain goods, this is completely implausible; nobody can say, for example, that they are only going to buy food to eat in a month’s time, because the prices may be lower then. Similarly, which car owner is able to say, “My fuel gauge may be near ‘E’, but I can hold out for a few months until petrol prices decline”? What about renting a place to stay – would people forego shelter because rent expenses may be lower in a year or two? These are some of the items that, for many people, make up the majority of household expenses. To suggest that people can afford to wait before spending money on them, even if prices are falling, simply defies common sense.

But what about goods that people could plausibly wait to purchase, knowing that the prices of those goods would later fall? Fortunately, we need not speculate, because we already see how people behave in such circumstances all the time. People buy gaming consoles, computers, and TVs today – despite knowing full well that better versions will come out next year, and that the current iterations would be much cheaper then. Perhaps the most extreme example is seen in the queues for iPhone releases in major cities around the world, where people willingly camp outside Apple stores to buy new iPhones as soon as they can.

The lesson from this is that people are often willing to pay more to have the object of their desire now, because they have a high time preference – that is, they prefer to have things now rather than later. It should be clear that even in a generally deflationary environment, the demand for present goods is unlikely to collapse, contrary to the repeated warnings. And even if the demand for present goods did ‘collapse’, the higher level of savings would simply lead to a different, long term-oriented structure of production – although this is a more complicated idea that is better explained in another article.

On the matter of the profits of businesses, it’s important to keep in mind that profits and the prices of goods are not one and the same. Profit is the difference between the selling price of a good and the cost to produce it. It’s quite possible for the prices of goods to fall and for companies to remain profitable; this is especially true if the costs of production are decreasing as well. There’s no reason to assume that businesses across the board would fail in a generally deflationary economic environment.

With the above in mind, it’s worthwhile considering the empirical evidence from one of the very rare periods of deflation in history. During the nineteenth century, the United States exhibited two long periods of general price deflation. This was a time of unprecedented economic growth and development, yet according to today’s learned minds, this should be impossible.

Of course, even if we assume that all of the predictions of the deflation doomsayers come true, prices cannot fall forever. At some point, prices will bottom-out; with perhaps a few select exceptions, nobody is going to give the fruits of their labour out for free, let alone pay others to take it. Perhaps because the doomsayers are so focused on avoiding the start of a deflationary period, they haven’t given much thought as to what would happen once we’re firmly in one.

Conclusion

When politicians and public intellectuals use the ‘looming threat’ of deflation to justify inflation rate targeting and loose monetary policy, they are being nonsensical at best, or grossly dishonest at worst. Deflation is not a grave threat to any economy – not even close. Of course, this leads one to speculate about why so much focus is placed on deflation; after all, it is remarkably convenient that the pre-emptive ‘remedy’ against potential deflation is invariably increasing government spending and printing more money.