Why is deflation bad?

During this credit crisis, you keep hearing talking heads act as if deflation is the worst thing that could hit an economy. Just a few years ago we kept hearing people talking about inflation as if it were the thing to avoid. Now suddenly, it’s deflation. I think this is confusing.  What gives?

Here’s my take: on a visceral level, people don’t like inflation. When you go to the grocery store and milk costs 10% more or when you go to the gas station and you pay $2.75 instead of $2.55 (or the $1.75 you paid a few years ago), you’re not happy. It’s even worse when you are looking to buy a house and have to fork over tens of thousands more than you thought you could afford. You came expecting one price and you got another. It’s as if someone reached into your pocket and stole money from you. That’s how inflation feels.

So people don’t like inflation and policy makers understand this. There are some very real reasons beyond this to hate inflation; but just looking at the psychology of inflation, policy makers are pre-disposed to getting it under wraps.

Then there’s deflation. What if when you go to the grocery store and milk costs 10% less or when you go to the gas station and you pay $2.25 instead of $2.55 (or the $2.75 you paid a few months ago). I bet you’d be pretty happy about it. If you’re buying a house that sold for $200,000 and is now selling for $175,000, you’d be over the moon. There’s absolutely nothing wrong with this picture.

The problems come when you add debt into the mix. Let’s look at the house. When prices decline, the person who owns the house has a mortgage that is suddenly greater than the value of the house. In worst case scenarios, that’s an individual who can’t move house because she is stuck with a mortgage she can’t pay off. So that’s a person who’s job opportunities have just shrunk dramatically and a person who knowing this cuts back.

Contracts are always set in nominal terms, not in real terms. So when real prices change, there are winners and losers. When prices go up, sellers are winners as are debtors. Buyers are losers, as are creditors. When prices go down, the sellers and the debtors turn into losers. So beyond any real economy effects inflation has on business through accounting, inflation and deflation act as transfers of income, creating winners and losers.

Despite perceptions that the Austrians were deflationists, Friedrich von Hayek famously said: "I am not only against inflation but I am also against deflation."  As such, the goal of economic policy making is to prevent price volatility – to prevent high levels of inflation or deflation.

But, all prices in any given economy do not move in concert. Some will rise or fall faster than others at any given point. Some could even be rising while others are falling. Gas prices are going down while milk prices are rising for example. How do you use monetary policy without exacerbating those differences, without creating winners and losers? You can’t; monetary policy is a blunt instrument.

The question for policy makers then goes to bias. Do they have a deflationary or an inflationary bias? Typically, a deflationary bias is seen as biased toward lower short-term growth and employment. An inflationary bias favours higher growth and employment in the short-term. But the flation bias also affects buyers and sellers of assets by making those assets worth more or less in nominal terms while still holding the debt used to purchase them constant. The guy who buys a house on credit doesn’t like deflation. The guy who has a lot of accumulated debt hates a deflationary bias. So central bankers fear deflation more than inflation because of how it changes consumer psychology. Central banks therefore look to keep inflation rates positive but low and stable.

And ultimately that’s why deflation is considered bad. America has become a highly indebted society. In an indebted society, deflation creates debt revulsion and ushers in an environment in which people switch priorities from income growth to debt reduction. Consumption levels decline and a long period of economic malaise develops. The U.S. is either already in this malaise or right on the precipice. Policy makers will tell you they have seen this video before and know what to do. But, they don’t and that’s what has me worried.