deflation, iii

Finale …

The previous post spoke of rates of change.  One of the two major problems with allowing monetary/credit driven deflationary pressure in 2008 (and to some extent still today, especially if European banks start going belly-up causing more of the same) is pulled from that discussion.  Such deflation is bad because it would be a major change to get there.  We fear the change in the rate of inflation if it turns quickly negative.

I’ll second major issue is “real interest rates”, and this is an endemic problem with deflation.  In response to the above paragraph we can say, “Okay, but let’s say we moved to deflation slowly.  Once we learned the different coping mechanisms (demanding from your boss a raise by having your salary cut only 3% in a 5% deflation economy … seems weird, but not intrinsically so), then we would be fine?”

In Econ 101 we learn about inflation being good for debtors and bad for creditors, and deflation vice versa.  IN the real world, however, the creditors have a coping mechanism.  If the inflation rate is 5%, and you want to borrow money from me, I’m going to charge you, say, 7.5%.  That is, when you accept the money, you are also accepting that you are going to pay the inflation rate plus a 2.5% real interest rate on that money.  I, as the loaner, am not being hurt by the inflation rate.  No one is, really, so long as that rate is a stable 5% that we can all count on.  The real interest rate for any particular loan is just tacked on to the interest rate.  The same is true for raises at work.  Maybe i get a 10% raise in some year in that economy, but it is really just a 5% raise.

It is hard to see how this clears in the 5% deflation economy.  If i have the money stuffed in my mattress, i’m making a real rate of return of 5% without doing a thing.  If you want to borrow that money from me, you need to make a better offer than that, paying me a real interest rate of 7.5%.

Borrowing money is very expensive in a deflationary economy.  The deflationary economy doesn’t just favor savers to debtors, it favors savers to those who need capital to get their businesses off the ground as well.


There is a third category of retort to the idea of a deflationary economy has less sway over me, though it is probably the most common retort:  wages are sticky in one direction.  The idea makes intuitive sense, but i’d have to see real historical (macro) evidence of it.  What evidence i have seen is non-committal, or even negative.  I suspect that there are some goods, however, that are price sticky in one direction.  I’ll have to think more on that, and do some research, and see if i can find some examples.  Off the top of my head … monopoly markets, maybe, including the quasi monopoly market of branded goods like soda.  We have to think in terms of real returns on investment, however, not nominal returns, so i need to think more about that.