Is Deflation Really That Scary?

by: Bo Peng

Conventional wisdom: inflation motivates people to invest money, therefore creates growth -- good; deflation encourages people to hoard cash and save rather than invest and spend -- bad.

But look at where two decades of inflationary US monetary policy got us. The internet boom of the 90's was real, creative growth. But the excess capital (VC, all kinds of other private equity, the stock market) created a huge bubble and tremendous misallocation of capital -- waste and destruction. There's no question that the internet innovation would've taken place without the excess capital; it can be argued that it would have grown in a much healthier and more sustainable way. The last decade goes without saying.

For the investment encouraged by inflation to create healthy, sustainable growth, there must be a sufficient pool of hungry labor willing to work for it. It worked well in the post-war West. Regardless how you think about the New Deal, the effect is that there were tremendous amounts of investment, and a big pool of hungry people in America who worked and saved their way out of relative poverty. The middle class emerged as a result.

Now that America (and most of the developed world) has the healthy socioeconomic structure of a bulging middle, there is a degree of investment saturation. Hi-tech innovation remains a potential growth, with fundamental advantages that are hard for emerging markets to acquire. But hi-tech suffers from a major macroeconomic deficiency: its participation is limited by nature, therefore tends to cause dispersion of wealth distribution, i.e., pulling the rich and upper middle class away from the poor and lower middle class.

Forced investment in such saturated society will have diminishing return, though not necessarily in the financial sense, but in the socioeconomic sense, in terms of creating sustainable growth and limiting economic polarization. And it tends to cause one or more of the following damaging effects:

  • Asset bubbles. If investments cannot find meaningful growth in economy, it will create asset bubbles one way or the other.
  • Excess social welfare. The excess investment and asset bubbles create a false sense of wealth, encouraging overly generous and unsustainable welfare.
  • Over-growth of service and intermediaries, e.g., financial sector. Financial return gets decoupled from real economic growth and becomes a goal on its own, rather than a means as it should be.
  • Economic polarization. Bubbles and the subsequent bust invariably increase economic polarization, because the majority of the populace invariably get the most nominal benefit from bubbles and take heavy losses during busts.

We simply don't know what to do with excess investment. If it's forced upon us through manufactured inflation, then we have no choice but to blindly throw it around and chase rainbows. We go on perpetual M&A binges without creating any real value but only as accounting tricks. We do leveraged buy-outs to destroy jobs but somehow end up creating value. We don't manage, but do management consulting. We don't even invest, we give investment advice. We charge 6% for matching buyer and seller, with relatively little real work, and we feel absolutely entitled to it. We create risk for risk's sake just so that we can sell it. It all boils down to collective financial masturbation.

Inflationary monetary policy has failed across all of the developed world in at least the past two decades. I hope somebody will wake up to this simple fact soon.

But the conventional wisdom on inflation still applies well in emerging markets. They are capital-poor and resource-rich (resources include natural and willing/able labor). As long as the economic policy is more or less right, inflation-encouraged investment can translate into meaningful, healthy real growth.

On the other hand, deflation is devastating to capital-poor and labor-rich societies, but can be a good thing for investment-saturated ones. Japan has supposedly suffered the horror of deflation for two decades now. But I can't find much evidence of horror beside the words used by economists and pundits to describe it.

Deflation in saturated society encourages savings, reduces debt/credit, and eliminates bubbles (at least in the narrow domestic sense), all of which are exactly the structural improvements the deficit countries need to accomplish, but so far have not found the motivation to do. Why? The developed world has been stuck in the conventional inflationary dogma.

How would deflation impact the society? Some economic structural adjustment is necessary. Some excess service and intermediary jobs will disappear for good but new jobs may be created or some old jobs will find new willing/able labor, which is a great thing. But business will not collapse because the growth expectation will be dialed down. Executive pay will come down, though, which is a great thing (at least according to most people). Consumption will not collapse because there's always China, plus cheap commodities -- remember, we still have a sizable middle class. The poor will be better off with lower prices.

And this is the real solution to global imbalance. If deficit countries stop pursuing the failed inflationary policy, savings will go up and debt down, and surplus countries will either ramp down production or increase domestic consumption, or more likely a combination of both.

Disclosure: None