Arguing Against Monetary Deflation

Today's parable is the one about the master who gave each of three servants some talents and what they did with said talents. In times of monetary deflation, burying the talents in a bushel basket turns out to be the right answer - and that's a problem.

Tuesday's post argued that deflation might be the new normal for much of the economy – just as it has been the norm for high tech at least since Moore's law took effect. I also argued that deflation might not be as bad as many economists make it out to be despite the fact that it is usually associated with recessions and depressions.

Very good comments both on Fractals of Change and on Seeking Alpha, where there was a repost, have convinced me of two things: 1) there's a need to distinguish between monetary deflation and lower real prices; and 2), monetary deflation is a bad thing.

It's easy to tell whether a commodity's price has gone up or down denominated in a particular currency. It's a little tougher to track the prices of products like computers, which get better over time but it can reasonably be done. However, if the price of an item goes down, is that an indication that the value of the currency has gone up (deflation) or that some factor has driven the real price of that item or many items down in relation to some other items? Moreover, the world has more than one currency so the price of an item can go down in one currency while it goes up in another. This can give you a headache – and quickly. So, for the remainder of this post let's just stipulate that we're talking about monetary deflation – the value of currencies going up over time in relation to a general basket of things those currencies are being used to buy. Monetary inflation is, of course, the opposite: the value of the currency or currencies going down compared to the basket of items.

Suppose we have general monetary deflation – those of us in the U.S. who were born after the great depression have never experienced that although those of in high tech and communication have lived with rapidly falling prices for our products.

Let's suppose that the deflation rate is ten percent annually. That means that it will only take ninety dollars a year from now to buy what now costs one hundred dollars today. If you want something badly enough – food, for example – you'll go out and buy it. But how does this affect your investing? If you're at all risk adverse, it really means you don't have to invest at all. After all, you'll be 11.1% richer in purchasing power a year from now if you just put your money in the mattress (That's not a math error – if $100 buys 100 widgets today, with 10% deflation those same widgets 100 will cost $90 next year and you can use the remaining $10 to buy 11.111… widgets next year for a total of 111.111… widgets.).

If you think the mattress isn't safe, you might even pay someone a small fee to guard your cash for you; you still come out ahead. That is, of course, why people are accepting negative interest on very short term U.S. Treasury notes today. Someone would have to promise you extremely high real interest to get you to take any risk at all – remember, even if they pay you no interest, their cost is 11% because they have to pay you back with dollars whose purchasing power has increased. Almost no legitimate business investment is lucrative enough to justify that kind of payback without huge risk that you have no incentive to take.

That's where we are today. Because of deflation (and other fears), we're better off holding onto our investment money than taking any risk with it for a "reasonable" return. That is a good reason for the Fed to be afraid of deflation. We only lend money to the government or entities whose credit the government has guaranteed; the government then has to continue being the lender or the guarantor to all other enterprises because they can't get unguaranteed money on their own. Yuk!

However, on Tuesday the Fed said that it was uncomfortable with the low level of INFLATION. Maybe that's because a low level of inflation can tip into deflation more quickly than a high level of inflation; maybe the Fed was just using a euphemism for deflation; or maybe, the Fed meant just what it said because inflation does force capital to be invested.

In inflationary times, money in the mattress loses purchasing power. You get poorer, not richer, if you don't invest. We're willing to take some risk (often more than we should) to put our money to work because that's the only way we can preserve or increase its value while inflation is eating away at it. There is a stream of capital available for investment, which is a good thing. The higher the inflation rate, the more we're forced to invest in some way – even if it's just seeking a high-yielding bank account.

So, it turns out we probably do need some level of monetary inflation to keep capital from getting too lazy. The rich shouldn't just get richer without taking any risk. The economy stops when that happens.

In inflationary times, the servant who put his talents in the bushel basket found it didn't buy as much when he unburied it as it would have when he first got it. Besides, his master beat him.

A post on some of deflation's winners can be found here, and a deflation primer can be found here.

Comments

[Chitownclark:]

....<i>There is a stream of capital available for investment, which is a good thing....</i>

Not so! Why do we need investment? To make more of those abundant widgets, of which we all have plenty, falling out of our closets and under foot in the kitchen?

Those of us that have been searching for an anti-consumerist economic model it seems, would do well to consider the merits of Deflation. Just keep the money in a mattress, and it will grow. No stock tips, brokerage commissions, investment risks, capital gains taxes....etc, etc.

Isn't there a case to be made for Deflation?

Jan 08 09:19 AM

[Asbytec:]

On Jan 08 09:19 AM Chitownclark wrote:
>
> Those of us that have been searching for an anti-consumerist economic
> model it seems, would do well to consider the merits of Deflation.
> Just keep the money in a mattress, and it will grow. No stock tips,
> brokerage commissions, investment risks, capital gains taxes....etc,
> etc.
>
> Isn't there a case to be made for Deflation?

We may not have a choice. Yes, a case can be made for deflation, but our banking system thrives on inflation. (I am sure you know that.)

Some deflation is good. So is some deleveraging. And the combination cleans the bread crumbs from the economy. But, it can go too far, and that's when the fun ends. If folks hold onto cash because it grows under the mattress, well...then the economy slows down, recesses, and may even dive into depression if deflation persists.

I think the Fed saw the threat long before we (I) began to realize it. At first, this was just another economic down turn...a housing slump. It's far more than this now. Money is vanishing into the same thin air whence it came...and at a faster rate than it was created. That's not good.

Jan 09 09:26 AM

[carey_jim:]

As you point out, the deflation/inflation problem is enormously difficult to analyze, even from an economic perspective.

When you throw in religion, psychology/sociology and all the other 'ologies' it becomes even more difficult.

I've been harping away (at least now and then :) on Seeking Alpha that we shouldn't confuse our very necessary maps with reality itself which is complex and usually full of surprises.

To cite an example from another area, unemployment, most economists tell us that World War II finally solved the unemployment problem of the 1930s.

From the end of 1937 until the United States entered the war at the very end of 1941, there was a fairly vigorous economic growth which ended the Great Depression, EXCEPT for unemployment which remained around 15%.

But if you analyze 'employment' just a little more carefully, it isn't clear that 8 million people wearing uniforms and learning how to kill people were really employed doing 'productive work!'

So maybe the unemployment problem wasn't solved by World War II, anymore than rounding up the unemployed, putting them in prison and classifying them as 'no longer seeking work' would solve the unemployment problem today!

As you hint in your article, there are several ways of looking at deflation, using various models.

For example, saving for the future is necessary to increase productivity and Americans save virtually no money at the moment. A few years of deflation would probably solve that problem.

Also, as you point out modern economists have never seen deflation and therefore have not thought about it much or studied various models that were developed in the 19th century and early 20th century.

Maybe its time to go back to the library and get down those books written by earlier economists such as Walras, Pareto, Menger and Robbins. They all witnessed both periods of deflation and inflation and their models took both into consideration.

But, (harp, harp) models are models and reality is reality which is full of surprises, surprises ....

Jan 09 01:26 PM

[Kunst:]

Bernanke has spent his whole career focusing on how awful deflation is. He is not going to let it happen. Since he controls the printing presses, my money is on inflation.

Jan 10 02:21 AM