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Is deflation really such a bad thing?

June 27th, 2009 · Greg Atkinson · 10 Comments

Now that the world seems to have avoided falling into an economic heap, various pundits have switched their attention to life after the global financial crisis. Of course if you spend most of your life saying the world economy is doomed then there has to be a crisis after this current crisis and one scenario being talked about is where many developed nations will enter a period of deflation.

Deflation is a pretty abstract concept to many people in Australia because the chances are they have never experienced it…well not that they realised anyway. Most people understand inflation means rising prices for food, housing and petrol etc. but if the economy is growing, people are earning more and inflation can be kept relatively low then all is well according to most economists and the general population.

One of the main roles of the Reserve Bank of Australia is to keep inflation within a narrow range as can been seen from this extract from the RBA’s website:

“in the Statement on the Conduct of Monetary Policy issued in 2007 the Governor and the Treasurer agreed that the appropriate target for monetary policy is to achieve an inflation rate of 2-3 per cent on average, over the cycle, which is a rate sufficiently low that it does not materially distort economic decisions in the community. The inflation target is thus the centrepiece of the monetary policy framework. It provides discipline for monetary policy decision-making, and serves as an anchor for private sector inflation expectations.”

I have no idea how it was decided that an inflation rate of around 2-3% is the range the Australian economy should operate within, but some form of economic modelling was probably used so I live in fear. The question I have is why is inflation in that range ok but deflation of say 1% not good? Why do economists seem to be so worried about deflation?

First of all let’s look at what deflation is. If we use the definition of deflation as outlined on economywatch.com then:

“Deflation is characterized by a fall in the general price level over a specific time period. As an economic concept just opposite to Inflation, Deflation at times denotes a reduction in the size of money supply, from the economic viewpoint. It is this condition which is commonly known as the ‘Contraction’ of the money supply. Moreover, when Deflation affects the economy of a country, the demand for liquidity rises, followed by escalation in the purchasing power of money as well. In a modern economic condition, Deflation is considered a matter of deep and serious concern, due to a possible rise in deflationary spiral.”

So in simple terms deflation is the opposite of inflation but exactly what causes deflation and what impact it has on an economy is subject to debate. There are a number of theories regarding deflation but one thing they tend to agree on is that prices fall. However why modern economists think low rates of inflation are okay but deflation in any form is so serious is a mystery to me.

Deflation does not necessarily mean that an economy has some serious problem with money supply or consumer demand. Deflation can actually occur in a fairly normal economy

For example, prices for goods and services may fall because of intense competition and productivity improvements. In addition a country can import deflation by bringing in cheap imported products as happens in Australia, Japan and the U.S. for example. Over many years Australia has benefited from cheap imports from China and these have had a deflationary impact on the economy.

Many people complain about cheap imported products but the fact is they push down prices and help keep a lid on inflation. So what exactly is wrong with prices being pushed down further via increased competition or productivity improvements?

I have lived in Japan through some periods of deflation and I can tell you that many people were quite happy about it. The Japanese Government, investment bankers and many economists did not like falling prices but those who had retired and were living off their cash savings were comforted by the fact that prices fell and their cash stretched further. I am not suggesting that deflation is an entirely good thing, but it is not entirely bad either.

If oil prices remained low, food prices were pushed down because of bumper crop harvests and housing prices fell back a little then these would have a powerful deflationary impact on the Australian economy. Add a touch of more intense marketplace competition and the result may very well be that the Australian economy could enter a period of deflation.

What precisely would be so shocking about what I have outlined above? More importantly, what purpose would be served by trying to fight these forces? Do modern economists feel that cheaper energy prices, good conditions for farmers and more affordable housing are something we should be trying to avoid?

Often when deflation is discussed people mistakenly assume that deflation causes all prices to go down, asset values fall and wages drop. But this simply does not need to happen and would only be a major problem if deflation got out of control. Deflation does not need to lead to some doomsday scenario just as inflation does not need to lead to hyperinflation.

I am not suggesting that the RBA or any other central bank should have a monetary policy that aims to create deflation, but what I am asking is why do they seem so eager to fight it? The RBA’s current aim appears to be to support inflation so is it any wonder we end up creating economic bubbles? Maybe we need periods of deflation to keep the economy in check? Maybe deflation is part of the economic feedback loop and by cutting this loop we set ourselves up for a future economic overload?

Would a period of gentle deflation for the world’s major developed economies be such a bad thing? Instead of pushing money into the financial system perhaps governments should concentrate on helping their economies be more productive and encourage competition? As for developing economies I would say few people in India for example would complain about cheaper food or finding it easier to buy a car. I doubt the poor are fans of inflation either.

So is deflation really something we should be fearful of if it can be managed? Is the RBA and other central banks simply setting up future asset bubbles by constantly trying to keep economies out of deflation? Perhaps a better target for the RBA would be to allow or even encourage deflation when the economy becomes over heated instead of trying to slam on the brakes via higher interest rates?

Maybe, just maybe, modern economics is not all that modern and economists should reflect on their past failures and think of some more improved and flexible ways to manage economies in the 21st century. Deflation might be just the answer to some of their problems.


10 responses so far ↓

  • 1 8020 Financial // Jun 27, 2009 at 11:07 pm

    Hi Greg,

    Agree deflation is not necessarily a bad thing. As you point out it rewards the prudent; people who responsibly saved during the good years do not lose 2-3% or more during deflationary periods.

    I think the world economy needs currently needs some deflation in the same way the human body needs sleep after a big night out. But the apparatchiks in the government and central banks just want to keep the loud music playing via their fiscal and monetary stimulus.

  • 2 Ned S // Jun 29, 2009 at 11:04 am

    I’ve been having a bit more of a think about this/quick read on same – I’ve got a sneaky suspicion it has something to do with the Money Multiplier effect??? Will comment more if/when I feel more confident in that statement.

    But either way, it seems drops in US prices of 4.5% in 1930, 12.0% in 1931, 11.5% in 1932 and 1.3% in 1933 (a drop of 26.7% overall from 1929) were tied in with the world economy becoming very unwell.

    Stats were worked out from figures in the following:
    http://www.friesian.com/money.htm
    (Don’t know if it is a good article or not – Didn’t have time to read it in full.)

  • 3 Greg Atkinson // Jun 29, 2009 at 6:58 pm

    8020 – I do think that deflation is all simply part of economic life and like all things in moderation it is okay. Imagine if we could never get that good nights sleep…it would surely catch up with us one day!

  • 4 Greg Atkinson // Jul 1, 2009 at 10:52 am

    Ned S thanks for the link. I am always a touch cautious about the correlation of economic trends. It is bit like saying every time I see the doctor I am sick so I should stay away from the doctor… if you get my twisted logic 🙂

    So what we do know is that deflation was present when an economy was struggling..sometimes. But was it a symptom or a cause of the problems? How about cases where deflation was present and an economy was doing okay? I will dig into this.

  • 5 Ned S // Jul 2, 2009 at 11:23 am

    Agreed Greg – By saying “tied in with” I was consciously hoping to avoid attributing a cause and effect relationship – In the absence of more information at least. Haven’t had time to read more, but did find some stuff that looked like it could be promising when I goggled “money multiplier deflation”.

    I guess one thing to be careful of when looking at deflation in an economy that is doing OK is if the broader global economy does not have deflation. I’m thinking specifically of Japan. And just wondering to what extent (if any?) inflation in the global economy (and the ability to invest outside the county through things like the carry trade [plus general trade]?) might have dampened any negative effects of deflation in Japan itself.

    I’m no fan of inflation as you know. But must admit it was a rude shock to see deflation as “low” as 26.7% in US prices over 4 years sitting side by side the years 1930 through 1933. It gave me cause to ponder. As in if there was a cause and effect relationship, those numbers could be seen to argue against my previous assumption that equal(ish) amounts of inflation and deflation would balance each other out over time – The original thought being that I’d find it hard to imagine about 26.7% inflation over 4 years “tied in with”(?) global unhappiness like the world saw in the 1930s. And on looking a bit deeper, I can’t even bring myself to put it down to the fact that mathematically a 26.7% decrease requires an increase of about 36.5% to unwind it – Even that only equates to about 8.1% pa over 4 years – Very painful for many individuals, but other things being equal (which they probably weren’t – Smile), I wouldn’t think it would be catastrophic globally?

    Of course the bulk of the deflation in the 1930s occurred in less than 4 years – So it could have been some sort of economic “shock” effect? But given the unknowns, it did make me back off singing the possible praises of deflation until I reckoned I just might know a bit more. And the thought came to me that a better understanding of how it worked could be tied to the money multiplier – Because basically the problems seem to come back to debt and I got the feeling the money multiplier ties in with that?

    One could end up chasing red herrings in this! But either way, I am questioning an assumption I made.

    On a related note, I hear the delightful Ms Bligh just put Qld car regos up by 20% – Definitely no chance of price deflation surfacing here anytime soon.

  • 6 Greg Atkinson // Jul 3, 2009 at 10:31 pm

    Ned S – first in terms of QLD all I can say is I am sure most other state governments will be putting up state changes and taxes. We will all pay for the way they have mismanaged the boom times.

    Regarding deflation and the Great Depression I would say I do not tend to see that being all that relevant to the situation now. Way back then when you lost your job you were really in deep, deep trouble. There was no social security as exists today and the chances were the money you had in a savings account also vanished when the bank went under. A few million penniless people would really send prices tumbling!

    What we also need to remember is that the Great Depression came not long after WW1 and the Spanish Flu so the preceding decades weren’t exactly great times for people to be building up vast savings. The rough sequence of events were: WW1, Spanish Flu, a bit of doing the Charleston and then whack…hello Great Depression. (then followed soon after by WW2) Not exactly a great run of decades in that little part of the 20th century!

  • 7 Ned S // Jul 5, 2009 at 6:36 am

    All good points Greg – Ta. But even so, the determination of central banks to avoid/mimimise deflation is certainly extraordinary. And they have pretty obviously been thinking in terms of avoiding another Great Depression type scenario – Albeit one where the effect on the populations of the West are muted by virtue of their various social security networks.

  • 8 Greg Atkinson // Jul 5, 2009 at 9:21 am

    Ned S – I can certainly see why central bankers want to avoid a depression but I wonder if they will be able to avoid deflation anyway. Maybe they should try moderate the prevailing forces of the day rather than determine them?

  • 9 Ned S // Jul 5, 2009 at 3:58 pm

    I don’t think moderating rather than determining is part of the mindset Greg. Smile!

  • 10 Greg Atkinson // Jan 31, 2010 at 8:28 am

    Here is a view on deflation in Japan written by Hiroko Tabuchi for the New York Times: http://www.nytimes.com/2010/01/30/business/global/30deflation.html?src=tptw

    Personally I don’t think deflation is something to panic about. In Japan if they spent money on childcare centres instead of funding bowling alleys on U.S bases the they would probably see the population creep up again and consumer demand as well.

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