No doubt, given a choice of the most worrisome of the ‘flations, you would say inflation. After all, what’s not to like about deflation? The deflation currently on display at the local filling station feels pretty good on the wallet. Every one penny decline in the price of gas puts $1 billion in the pockets of consumers. And yet, there are headlines like, “World Outlook Darkening as 89 in Poll See Europe Deflation Risk,”(Bloomberg) and “Why Deflation is so Scary” (Yahoo.)
So, which is it? Friend or foe.
I don’t think it’s difficult for one to see the friendly side of deflation. So long as our salaries and wages don’t go down, it’s a boost in our standard of living. If in one year we can buy New York Strip steak for the price of ground beef in the prior year, that’s a boost in one’s standard of living—assuming you eat meat and consider steak to be superior to ground beef. When at a former employer, it was announced that, in the aftermath of the 2008/2009 financial crisis, there would be no raises for the year, I attempted to lift the spirits of my colleagues by telling them that, relative to the price of gasoline—which had fallen sharply—they had, in fact, enjoyed nice raises.
In response, a freshly-minted economist might pull out his copy of John Maynard Keynes’, The General Theory of Employment, Interest and Money, and point out that deflation can depress consumption. This argument seems, to me, to be a rather flimsy one. The idea behind the theory is that, if consumers expect the prices of goods to fall, then they’re likely to postpone some of their consumption. For example, if you expect the price of a car to be cheaper next month, you might choose to postpone the car purchase until next month.
This doesn’t, however, seem to be a very robust argument for why deflation is a bane. We have been dealing with this phenomenon in electronics for many, many years, and yet video cassette recorders continue sold; iPhones continue to sell; and consumers still buy widescreen televisions, even though they seem to be some of the most dramatic examples of price deflation. In some product categories, this is something we’ve encountered over and over.
No, this is not the reason I’ve never seen the word “deflation” show up in Federal Reserve meeting minutes or its Beige Book report.
The real fear with deflation has to do with debt. When a consumer takes out a fixed-rate loan, the monthly payment never changes, so long as the consumer stays current on the loan. With some sort of inflation the usual state of things, the tendency is for debt service costs to decline in real—inflation-adjusted—terms over time.
But what happens if there is inflation in everything but wages? That’s a sort of deflation, as it’s the opposite of what I tried to cheer my colleagues with. So, if wages decline in relative terms and/or in absolute (wages are reduced) terms, debt becomes harder to service, and at the margin that means bankruptcies and the like. In turn, consumers can afford less goods, and standards of living are reduced.
Think for a moment, though, of who—or what—would have the hardest time servicing debts in a deflationary environment? Why, the most indebted borrower of all, the U.S. government.
Silly writer, the government doesn’t receive wages.
No; that’s true, but the government does depend on the equivalent of wages…taxes. With consumer incomes down, tax revenues would naturally fall, and the government could have trouble servicing its debt.
That’s the biggest risk with deflation, and with sovereign governments very indebted—Europe’s perhaps amongst the worst—the risk is especially high.