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.