Thursday, November 18, 2010

Why deflation is a Very Bad Thing part 1

In the long run, inflation and deflation (negative inflation) don't matter. At all. In the short run, though, they do matter. A lot.

Macroeconomic inflation, remember, is a change in aggregate price levels; by "aggregate", economists mean all prices, including wages, rent, interest and profits. If the price of beef goes up, but all other prices stay about the same, that's not inflation. There are a lot of reasons why the price of some individual good can change without any change in overall price levels. For example, market forces or government regulations might require beef producers to spend more money on healthier feed or veterinary examinations, causing the absolute cost of producing beef to rise. There might also be a temporary shortage of beef, causing supply to be allocated to those who prefer beef the most, i.e. those are willing to forego more of other goods and pay more for beef. Similarly, improvements in efficiency can lower the absolute cost, or a temporary surplus would cost the cost to fall until the supply was adjusted. None of these phenomena have much to do with macroeconomic inflation. Inflation is a change in all prices and wages, not just one price or another.

This is an extremely critical point. A person can go into the grocery store and observe that the price of beef has just gone up, and say, "Wow! inflation is killing me!" He would often be wrong. When economists measure inflation — and I must repeat: inflation means changes in all price levels, the aggregate price level — they tend to exclude (at least in the short run) products with a lot of price volatility, such as, well, food. The price of food is dependent on an enormous number of factors: weather and climate conditions, consumer tastes, government policy; inflation — changes in the aggregate price level — is only one factor out of many. It is possible to have the price of food, oil* and other volatile prices go dramatically in directions other than the overall aggregate trend in prices. There are a lot of ways to measure inflation (core inflation, trimmed mean levels, rolling multi-year averages) but all of these measures try to factor out extremely volatile prices.

*And derivative products such as gasoline.

In the long run, inflation doesn't matter. The long run is by definition as long as it takes for all prices to adjust. We can see that inflation doesn't matter in the long run by imagining that the "long run" is instantaneous. Imagine that the government decides to add a zero to everything: to all prices, all wages, all bank accounts, all loans... everything. Yesterday, Alice makes $20/hour, has a $100,000 mortgage at 6% interest for which she pays $800/month, a $1,000 credit card bill at 10% for which she pays $80/month, and buys bread in the store for $2.50 a loaf. Today, Alice makes $200/hour, has a $1,000,000 mortgage at 6% and a $8,000 payment, a $10,000 credit card bill for which she pays $800, and bread costs $25/loaf. Nothing at all about Alice's standard of living, nothing about her real economic situation, will have changed. The same is true if we have instantaneous deflation, if we knock a zero off of everything. So if we define the "long run" as "the time it takes for all prices to adjust", inflation doesn't change anything about the real economy.

But as Keynes notes, in the long run we're all dead. Inflation and deflation matter a lot in the short run. Inflation matters in the short run because all prices and wages do not change all at the same time. Not only do they not all change at the same time, there's a pattern to the changes, and this pattern itself has an effect on the real economy.

Inflation essentially "measures" the relationship between the present and the future, or more precisely our expectations about the future. Very high inflation "says" that the present is much more important than the future; very low inflation (or deflation, i.e. negative inflation) "says" that the future is much more important than the present. Moderate levels of inflation, unsurprisingly, represent a balance between the present and the future. When inflation is very high, consumers want to spend their money as quickly as possible; they will be induced to save only with very high interest rates or rates of return on profit. Because interest rates are high, businesses, which shoulder the bulk of planning for the future by investing in physical capital, will borrow or invest less. (Note that even though prices will be higher in the future, increasing the nominal return on any investment in the present, other factors, especially wages, will also have increased, also increasing the costs.)

When inflation is very high, everyone spends. When inflation is very low or negative, everyone saves. But economics is built on trade. We want the people who want to save to trade with people who want to spend. If everyone wants to spend or save, there's no trade happening, which is (usually) bad.

I'll go more into the dynamics of inflation and deflation in another post.

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