Why Deflation Used To Be Scary

by Inya Ivkovic, MA

For the most part, during the recent economic downturn, central bankers, economists, analysts and even politicians debated and worried about deflation. What kept most of them up at night, myself included, was an Economics 101 teaching that falling prices prevent the economy from fundamental functioning; whereby the best scenario would be curbing of the recovery and the worst scenario could potentially lead us into a 1930s-style depression.

But that teaching fell flat this time around. Granted, there was nothing usual about the Great Recession of 2008/2009, from its causes, to underlying factors, to driving forces. And if there ever was a silver lining, it would be that, in the current economic environment, deflationary pressures could not only have little to no impact on the global economy’s functioning and its eventual recovery, but it could also help heavily indebted economies get back on the right track.

Sounds like an oxymoron, doesn’t it? Particularly after hearing dire warnings from bankers, such as U.K. Chancellor of the Exchequer, Alistair Darling, saying that, “The Bank of England must be prepared to act to prevent price deflation,” or European Central Bank’s president, Jean-Claude Trichet, saying that, “We are very keen on avoiding deflationary risk.”

However, trying to put policy where their mouths are proved to be a little tricky. Economics 101 on staving off deflation prescribes releasing a fresh influx of printed money into global financial systems aggressively through something called “quantitative easing.” As I wrote abundantly about it before, there was no shortage of quantitative easing in the past year or so. The trouble is, old teachings simply do not add up, considering that deflation has already arrived and is doing rather fine, thank you very much!

According to statistics coming from Europe, prices have already posted record declines in July, dropping 0.7% compared to July of last year. In Germany, Europe’s largest economy, consumer prices dropped for the first time year-over-year in more than two decades, while wholesale prices literally plunged by a whopping 11%. In other words, should Europe be falling into the deflationary abyss never to emerge again? Not quite. In fact, it appears that Europe may be leading the world out of the recession.

According to recently released figures by the European Union’s statistics offices, Germany and France were pulling more than their weight hauling the region out of the global downturn, after both economies expanded 0.3% during the second quarter and after four quarters in a row of painful contraction. Apparently, the dangers of deflation never panned out in that corner of the world.

Deflation used to be scary, but only because we were so conditioned by the Great Depression to think of it as the cause of most economic evil. In reality, economic history suggests that the whole deflation story might be blatantly oversold. For example, during the Industrial Revolution, the UK became the greatest economic power in the world; yet, most of those years were deflationary years. In fact, the fall from grace did not happen until the hyper-inflationary years right after WWII had gripped the country.

Furthermore, according to a study conducted by the Federal Reserve Bank in 2004, which studied the price data of 17 countries over a period of 100 years, although the Great Depression of the 1930s was linked to falling prices, there was virtually no evidence that deflation caused it. Additionally, similar links between deflation and great economic crises were not found for any other historic period under review.

So, why have we been taught to be so afraid of deflation? The dogma is that if prices are falling at a steady pace, consumers are likely to postpone their purchases, thinking that the stuff they want will be even cheaper a day, a week or a month later. But that may be a silly premise upon which to base an entire theory.

By all means, everyone knows that a laptop or an “iPod” is likely to be better and cheaper in six months to a year. But who can wait that long? A student may want his laptop now, because school starts in about three weeks, and he can’t wait that long. And he certainly cannot be seen walking around with a “Walkman.” The impulse to have what you want and need when you want it and when you need it (in that order, I’m afraid), is likely to trump the expected deflationary behavior of waiting for prices to fall further. This is true of the electronics industry and it is true of other industries as well.

Perhaps the reason behind touting deflation as the big, bad, scary wolf is that there are interest groups for which deflation certainly does not work. For example, chief executives do not like falling prices, because they are keeping their profits down. Unlike the slightly inflationary environment, when they can enjoy steady profits and even jack them up by holding wages steady. The banking industry also dislikes deflation, because declining house prices, for example, make it exponentially more difficult to sustain highly leveraged loans. Joining the deflation bashers are governments as well, which often rely on moderate inflation to decrease the value of their debts.

But if you are a saver, this is good news, because you gain just by holding onto your cash. Deflation is also good if you are a consumer, because you can get stuff you want and need at favorable prices. And it is also good for workers, because deflation holds value of their wages much better than inflation.

When you compare the two groups of losers vs. winners on the deflation front, guess which one is more powerful? That will certainly explain why we hear so much about the dangers of deflation and so little about positive effects it has on the economy as a whole. On the balance of things, in the current economic environment and having in mind the travesty that brought us to the brink of disaster, defaming deflation might be a travesty in and by itself, particularly since it encourages finding the right balance between saving, consumption, and taking on debt.