Deflation is bad and inflation can be good.

Most people hate inflation and think that deflation would be a wonderful thing because deflation means that the value of money is rising.  It sounds like money for nothing because your money grows in value as it sits in your pocket.  But deflation tends to cause recessions and unemployment.  We have seen this over and over throughout history and it is one of the main reasons why the gold standard was so harmful.  There was regular deflation during the gold standard which contributed to recessions including the Great Depression.

Krugman explains a few reasons why deflation is worse than inflation: “Inflation and deflation are not symmetrical. Four percent inflation does very little harm; four percent deflation is a disaster.”  There are several reasons why this is true:

  1. The problem in a recession is that people want to hoard more money and buy fewer goods and services.  Deflation gives consumers, more incentive to wait to buy stuff because it means that prices are coming down.  Hoarding cash becomes more attractive during deflation because it is going up in value.  If there is 4% deflation, that means people can earn a safe 4% real return on their hoardings by burying cash in their backyard.  So deflation compounds the hoarding problem during a recession.
  2. Deflation redistributes wealth from debtors to creditors.  That reduces spending because debtors tend to spend (which is one reason they are in debt) and creditors tend to save (which is why they are creditors).  In a recession, this just increases hoarding because if there is more savings without more borrowing, the money just sits in a hoard somewhere.
  3. Banks become less interested in lending money during deflation when they can earn a real interest rate by simply hoarding cash rather than lending it out to someone who may not pay it back.  The increased real interest rate burden of a loan (nominal interest rate plus the absolute value of the deflation rate) also makes borrowers more hesitant to borrow during deflation because it tends to increase the real interest rate.
  4. An increase in deflation increases the real interest rate of fixed loans which increases the real debt burden and increases bankruptcies.  Bankruptcy reduces the spending of both the debtor and the creditor until it is sorted out because during bankruptcy proceedings, there is no owner.  During the housing crisis of 2008, it sometimes took years to sort out who really owned houses after the mortgages defaulted.  During that time, millions of houses sat vacant and deteriorated due to lack of maintenance (frozen pipes and animal infestations) and vandalism.  Too much bankruptcy can paralyze legal and financial systems and this contributed to the severity of the 2008 financial crisis.  Even when bankruptcy can be sorted out quickly, it is an expensive process with high transactions costs (high cost lawyers, judges, auctioneers, appraisers, etc.) and reduces the productivity of an economy because it wastes resources which sit idle (and deteriorating) while ownership is sorted out.
  5. Deflation can make monetary policy worse during a zero lower bound problem.  The Fed can always raise interest rates, but it is impossible to cut interest rates below zero, so deflation means real interest rates will likely be higher than the Wiksellian equilibrium during a recession.  This was a problem from 2008-2015 when the Fed would have liked to reduce the Federal Funds rate which was stuck at zero.  Meanwhile, there was deflation at times which pushed up real interest rates. In the graph below, the real interest rate is in green and the nominal interest rate is blue.  The Fed wanted the real interest rate to fall even farther, but it couldn’t make the nominal rate drop below zero, so the only way to further stimulate the economy was to get higher inflation.  real fed funds rate
    1. FRED
  6. Nominal wages are sticky.  It has always been hard to get workers to accept nominal wage cuts, but in some situations (like Spain in 2008) wages can be too high.  Higher inflation can reduce real wages in a circumstance like this, whereas deflation just messes up labor markets even more.
  7. Deflation rewards criminals.  This is a fairly trivial concern, but it is a concern.  Who keeps millions of dollars in cold cash?  Big criminals, that is who.  It is hard to launder money because banks ask a lot of questions and so criminals keep a lot more cash on hand than normal people do.  Deflation rewards people for keeping cash on hand which helps criminals more than legitimate businesses that normally keep as little cash on hand as possible.  breaking bad

Although most people don’t believe it, during a recession, higher inflation is almost always better for reducing unemployment and getting people (and capital) back to work.

Posted in Macro

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