Economic Myths: Deflation

The Daily Mail compares and contrasts inflation and deflation (in the everyday meanings that nominal prices are either going up or going down, let's not get too technical):

The fear has been that with Britain's colossal debts, the authorities would collude to create inflation, which would steadily erode away the borrowing problem.

With more than £1 trillion of government debt and nearly £1.5 trillion owed by consumers, Britain is ranked just behind Japan on the world league table of debtors. But inflation is no longer doing the heavy-lifting on our debt problem.

Strange that he first uses the word "fear" suggesting that inflation is A Bad Thing, when he actually means "hope": he then explains why inflation is - from the point of view of the Home-Owner-Ists - A Very Good Thing indeed, because it reduces their "debt problem" (nearly all that £1.5 trillion owed by consumers is in fact mortgages secured on land and buildings). The borrower's gain is the saver's loss, so that's just the usual transfer of wealth to land owners and banks.

At the start of the financial crisis, deflation was regarded as the bigger danger. Once it takes hold, it can be difficult to reverse as consumers put off buying goods on the hope of buying them cheaper further down the line, especially economy-boosting, big-ticket goods like cars.

More menacingly, it also means those debts - and more than £1 trillion in mortgages, effectively grows relative to wages and other prices. Japan's experience is a parable for central bankers. The country had a property boom that peaked in 1989 and turned to banking collapse, followed by two decades of on-off falling share prices and property values.

The second paragraph is quite correct: nominal price and wage deflation is what the Homeys fear most. It's the first paragraph which irks.

As Drewster at HPC says: That's a bare-faced lie. Nobody who needs a new car waits 12 months for a measly 2.5% fall in prices. Just look at flat panel TVs or computers - they get cheaper every year, yet if anything we buy more of them!

It is conceivable that the cause and effect are the other way round. If people become more and more worried about the economy, they spend less and less each year and this leads to falling prices. This is because there is only a certain speed at which output will contract because manufacturers have high fixed costs and as long as they can at least cover their marginal costs, they will keep churning stuff out until the original capital investment is used up or worn out.

Once output has contracted to the new lower long term level of demand, prices will stop falling, and will then gradually return to their old higher level, because the old fixed costs have been amortised, used up, written off etc and prices now have to be high enough to justify new investment. Or you could say that the price elasticity of output is inelastic in the short term (when demand falls, output falls a bit and prices fall a lot) but elastic in the long term (when demand falls, output falls a lot and prices only fall a bit).

But it is more likely the case that with debts at a level which people simply cannot afford to service, the financial sector is just sucking the life blood out of the economy; people spend any spare cash they have on debt interest and simply don't have any money left over for spending on genuine goods and services.

This is a bit like what the banks do to developing countries, as Geldof once said: "They can't even afford to pay the interest on the interest." Prof Michael Hudson started his working life at a bank, and he says that their modus operandi was to work out how much a dictator could siphon off from his people every year, then they would lend that dictator whatever amount incurred enough interest to soak up that entire surplus.

Implicit in this is the assumption that the dictator just steals the money instead of spending it on infrastructure or education or anything which would grow the economy and enable the country to repay the principal) and that the interest (the entire steal-able surplus of the country) would thus be paid to the bank in perpetuity.