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September 20, 2010

Deflation – Is It Really So Terrible?

Ben Bernanke and the Fed have vowed to battle deflation as if it were the plague; after all, there was deflation during the Great Depression, of which Bernanke is a student, and there was both deflation and low growth in Japan for all of the nineties and off and on during the last decade.

The Fed flooded the economy with cheap money after the dot.com collapse and 9/11 to avoid deflation. The result was the housing bubble - and subsequent very rapid deflation in home prices. What will we pay in the future for fighting deflation now? Is deflation necessarily a bad thing?

A 2004 paper by Andrew Atkeson and Patrick J. Kehoe of the Federal Reserve Bank of Minneapolis argues that history does not bear out a strong correlation between deflation and low growth despite the horrible example of the Great Depression, which may have taught us the wrong lesson. Just because deflation is a consequence of shrinking money supply and velocity (which happens in both recessions and depressions), it doesn't mean that deflation causes or even prolongs these events.

In the electronics industry, deflation is a fact of life. In 1968 I had to justify spending $250,000 to buy 256,000 bytes of memory for a mainframe. Today you can buy a 2 billion byte (2 gigabyte) SD memory card at Amazon for $7.87. The price per byte has declined 99.9999996%. Was this deflation bad? Should we have kept the price of electronics high even as technology drove it down?

In 1995 32kb (32,000 bit per second) dialup Internet access cost $19.95/month. Today, in most areas of the country (but not yet all of Vermont), you can get 5 megabit (5 million bits per second) access for less than $50. The cost per bit of Internet access bandwidth has come down 98.4% in fifteen years. We call that progress – not a catastrophe.

According to Wikipedia: "Rising productivity and reduced transportation cost created structural deflation during the peak productivity era of the last quarter of the 19th century until the establishment of the Federal Reserve in 1913." It's not always a bad thing when you can get more goods for less money!

In fact, any increase in productivity is deflationary since productivity makes more goods available for a given amount of money.

Inflation encourages consumption over savings by eroding the purchasing power of any money you've squirreled away. Conversely, deflation encourages savings. Even if you get low or no nominal interest, your savings will buy more when you withdraw them than when you deposited them. It's hard to get our heads around this because we haven't had deflation during most of our lifetimes.

The transition from inflation to deflation will be wrenching if it happens – and maybe it is happening. During the transition there will be slowdown in buying and an increase in savings – sound familiar. That's good for the future but it does mean factories idle and people without work, at least through the transition.

But buying will resume and even grow again from a lower base. Eventually we buy a new phone or a new computer because we decide we "need" it even though we know that next year we will be able to get the same capabilities for a lower price or even more capability for the same price. In the electronics industry, the branded companies have to make their product significantly better every year in order to keep up their dollar volume. They do that and we all gain.

Part of the reason the Fed hates deflation is the effect on borrowers. Inflation means you can pay a loan back with cheaper dollars – by refinancing your house, for example. Deflation makes it harder and harder to pay back a loan, particularly if it has a high interest rate and you haven't been paying down much principal and especially if the underlying asset has lost value. Again this sounds painfully familiar and is happening. But, after the pain of transition and recognizing that no one values our houses at what we could have sold them for three years ago, are we worse off if housing is more affordable? Are we worse off without loans that never can be paid back without continuing inflation?

Are we worse off in an economy which requires less credit? Banks certainly are; they're in the credit business. Does that effect the Fed's view of inflation?

Before we enlist in the Fed's war on deflation, it's worth asking both if the war is winnable and if we really prefer Fed-controlled inflation to deflation. Comments welcome and I'll keep exploring this in occasional posts.

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