An Argument 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.

Yesterday'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 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. But, 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. Can give you a headache 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 US who were born since 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 US 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!

But the Fed said yesterday 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.

Yesterday's post on deflation being the new normal is here.

A post on some of deflation's winners is here.

And this is a deflation primer.