Why is Deflation Considered Bad?

[Boots]

The theory is, if prices are falling, consumers realise that if they wait the things they want to buy will be cheaper. They rationally decide to stop buying anything and everything except for the essentials. The economy stops working.

That, is why economies tend to aim for a modest level of inflation, for fear of undershooting.

My entire career has been in and around a sector (technology) where prices have been falling rapidly for longer than I can remember. This gives us a real-life example with which to test that theory.

I could point to jobs I've done as examples. In the late 1980s, a precursor to today's satnav in vehicles: at a price such that only commercial fleets would ever contemplate it. In the 1990s, custom software to drive £millions hardware to manage terabytes of satellite image data - today obsoleted if not by £100 off-the-shelf drives then at least by business-grade versions of the same.

But, is it not possible that for many of those consumers they regarded their purchase of the technology as essential. This could be for a variety of reasons: the old tech broke or was made redundant by the technological tide of progress; the features available with the new technology were deemed to be of commercial or personal advantage; or even that they felt they "had" to have the latest kit (a "need" rather than a "want").

Perhaps we could turn the question around. Does anyone buy anything now just because the price is likely to be lower next month? In an inflationary world they certainly buy things now because they believe the price will be higher next month - an all too common sales pressure technique.

[1nvest]

My entire career has been in and around a sector (technology) where prices have been falling rapidly for longer than I can remember. This gives us a real-life example with which to test that theory.

I could point to jobs I've done as examples. In the late 1980s, a precursor to today's satnav in vehicles: at a price such that only commercial fleets would ever contemplate it. In the 1990s, custom software to drive £millions hardware to manage terabytes of satellite image data - today obsoleted if not by £100 off-the-shelf drives then at least by business-grade versions of the same.

But, is it not possible that for many of those consumers they regarded their purchase of the technology as essential. This could be for a variety of reasons: the old tech broke or was made redundant by the technological tide of progress; the features available with the new technology were deemed to be of commercial or personal advantage; or even that they felt they "had" to have the latest kit (a "need" rather than a "want").

Perhaps we could turn the question around. Does anyone buy anything now just because the price is likely to be lower next month? In an inflationary world they certainly buy things now because they believe the price will be higher next month - an all too common sales pressure technique.

I for one do. I keep McG's "currency" in my (e)wallet, spend using credit card (pay in Pounds), at the end of the month convert enough McG's into Pounds in order to pay off the credit card bill. I don't defer spending because prices will be cheaper tomorrow (trend slope line for US and UK both around -6% cheaper/year).



What are McG's, my pet name for 50/50 midcap stock total return/gold. Spending down the highest of the two each month to pay off the credit card is broadly enough rebalancing in itself.

Most common spending is on consumption items/products/services, most wont defer consuming something they need today until a later date, if I'm hungry I'll buy now, not defer that hunger, if I'm driving and need petrol I'll fill up now, not sit and wait or only partially fill the tank. Convenience/comfort.

[Urbandreamer]

Perhaps we could turn the question around. Does anyone buy anything now just because the price is likely to be lower next month? In an inflationary world they certainly buy things now because they believe the price will be higher next month - an all too common sales pressure technique.

That is a somewhat daft question when we ALL know that the supermarkets are full of out of season food. Are strawberries in November or January REALLY cheaper than in June/July? Are people buying out of season food because it's expensive?

People buy consumables to consume. They buy durable items for the use that they will get out of them now and in the future.

Talking tech, at the dawn of the personal computer age you could always wait for the next one. The period between the ZX81 and later models was not long, but people bought what was available. Why buy a ZX81, and not wait for a Spectrum, or a Spectrum and not wait for.......... Deflation, measured in terms of improved product for the same price was VERY real and high at that time with those goods.

A simple answer to your question is that sensible people don't buy ANYTHING just because it has a price. They buy for other reasons and pay what the price is. Sure price effects affordability and desirability but it's not a cause of the purchase as you claim in your question.

[SalvorHardin]

In a deflationary environment cash becomes more valuable over time. This provides a big incentive to hold onto cash instead of using it. So the number and rate of transactions in the economy falls over time, which is not good (particularly for those who place a huge importance on GDP).

It doesn't matter that some sectors are more used to deflation than others. It's the overall effect on the economy that counts. Once deflation gets baked into the economy it can become difficult to shift because people's attitudes change. Japan is a good example; it is emerging from a roughly 25 year deflationary period when governments have tried all sorts of things to encourage people to spend, with very mixed effects. Deflation also leads to negative interest rates, which introduces all sorts of weirdness and misallocation of resources in the economy.

This is why mild inflation is considered to be beneficial, because it slowly reduces the value of cash which in turn encourages people to use it rather than hoard it. As money flows from consumers to producers and back to consumers (wearing their producers' hats but also as the recipients of government welfare payments) this creates economic activity, whereas if the money wasn't spent in the first place then a whole lot of economic activity which flows from the first bit of spending would not occur.

It's known as the "Circular Flow". Deflation slows the rate of flow of money and thus seriously damages the economy. This is where Keynesian pump priming comes from (increase government spending to boost the flow of money and thus economic activity).

https://en.wikipedia.org/wiki/Circular_flow_of_income

The problem here is that when inflation gets too big it wrecks people's confidence in the currency, which seriously undermines the economy. IMHO very high inflation is far worse than deflation.

[Urbandreamer]

In a deflationary environment cash becomes more valuable over time. This provides a big incentive to hold onto cash instead of using it. So the number and rate of transactions in the economy falls over time, which is not good (particularly for those who place a huge importance on GDP).

Does not that argument hold for ANY savings? Possibly saving should be discouraged.

The rate of transactions fall because people put money into their pension rather than spending it. They then die before they exhaust their pension because they save enough to not worry about running out.

Of course the converse, people trying to dispose of their cash for real assets can be seen in all places that have high inflation, so there may be some truth to the argument..

[vand]

In a deflationary environment cash becomes more valuable over time. This provides a big incentive to hold onto cash instead of using it. So the number and rate of transactions in the economy falls over time, which is not good (particularly for those who place a huge importance on GDP).

Does not that argument hold for ANY savings? Possibly saving should be discouraged.

The rate of transactions fall because people put money into their pension rather than spending it. They then die before they exhaust their pension because they save enough to not worry about running out.

Of course the converse, people trying to dispose of their cash for real assets can be seen in all places that have high inflation, so there may be some truth to the argument..

The velocity of money has been falling for a long time in our current inflationary/elastic money paradigm, so if it there is any credence to the claim that falling transactions are bad for the economy, then an inflationary paradigm doesn't appear to be a cure.

But the assertion that growth comes from spending should be reexamined and challenged; the Austrian economists argue that this is the wrong way around - they argue that growth comes first from savings and underconsumption, which free up real resources to be deployed to then create the capital and infrastructure required to then spur higher future production

[GoSeigen]

But the assertion that growth comes from spending should be reexamined and challenged; the Austrian economists argue that this is the wrong way around - they argue that growth comes first from savings and underconsumption, which free up real resources to be deployed to then create the capital and infrastructure required to then spur higher future production

Which begs the question.


i.e. why have higher production if no-one is going to spend anything to buy it. Just produce stuff and chuck it in the bin?

GS

[Nimrod103]

But the assertion that growth comes from spending should be reexamined and challenged; the Austrian economists argue that this is the wrong way around - they argue that growth comes first from savings and underconsumption, which free up real resources to be deployed to then create the capital and infrastructure required to then spur higher future production

Which begs the question.


i.e. why have higher production if no-one is going to spend anything to buy it. Just produce stuff and chuck it in the bin?

GS

As long as somebody abroad buys it.
It's been the foundation of the Japanese, Chinese and SE Asian Tiger economies, so I wouldn't knock it.

[Bubblesofearth]

In a deflationary environment cash becomes more valuable over time. This provides a big incentive to hold onto cash instead of using it. So the number and rate of transactions in the economy falls over time, which is not good (particularly for those who place a huge importance on GDP).

It doesn't matter that some sectors are more used to deflation than others. It's the overall effect on the economy that counts. Once deflation gets baked into the economy it can become difficult to shift because people's attitudes change. Japan is a good example; it is emerging from a roughly 25 year deflationary period when governments have tried all sorts of things to encourage people to spend, with very mixed effects. Deflation also leads to negative interest rates, which introduces all sorts of weirdness and misallocation of resources in the economy.

This is why mild inflation is considered to be beneficial, because it slowly reduces the value of cash which in turn encourages people to use it rather than hoard it. As money flows from consumers to producers and back to consumers (wearing their producers' hats but also as the recipients of government welfare payments) this creates economic activity, whereas if the money wasn't spent in the first place then a whole lot of economic activity which flows from the first bit of spending would not occur.

It's known as the "Circular Flow". Deflation slows the rate of flow of money and thus seriously damages the economy. This is where Keynesian pump priming comes from (increase government spending to boost the flow of money and thus economic activity).

https://en.wikipedia.org/wiki/Circular_flow_of_income

The problem here is that when inflation gets too big it wrecks people's confidence in the currency, which seriously undermines the economy. IMHO very high inflation is far worse than deflation.

All very theoretical with no evidence base. Contrary to popular opinion Japan has not suffered any significant deflation over the past few decades. You have to go back to the days of the gold standard if you want to look at any prolonged deflationary periods. The Great Depression is an example that is often trotted out to justify expansionary monetary policy but the causes were multi-factorial and still debated. The correlation between consumer spending and inflation/deflation prior to that is equivocal AFAICS.

IMO consumer behaviour is more culturally driven. We live in a consumer culture where consumption tends to take precedence over saving. In Japan the opposite is the case. I don't think this has anything to do with the level of inflation. Prior to the GFC it was perfectly possible to keep up with inflation by saving money in deposit accounts, i.e. interest rates were higher than the inflation rate. Post-GFC and pre-covid inflation was very low so, again, the argument that it influences consumption via erosion of the value of money is weak.

BoE