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Deflation poses a couple of significant threats. Firstly, it acts as a disincentive to real investment: the rate of deflation is effectively an interest rate e

by Gormo 16y ago

Deflation poses a couple of significant threats. Firstly, it acts as a disincentive to real investment: the rate of deflation is effectively an interest rate earned on funds stuffed into mattresses. If deflation is at 5%, no one will want to invest in any project with less than a 5% return over the same period. Risk and liquidity premiums would also increase even for investments that do provide a higher return than the deflation rate. Secondly, existing long-term debts would become extremely onerous for borrowers. The implications for outstanding mortgages could make the recent default epidemic pale in comparison. However, it's worth pointing out that the 19th century was largely a period of sustained, gradual deflation, and was also a period of tremendous economic growth with little of the amplified boom-bust cycle we experienced in the 20th century. I'd conjecture that a climate in which a small amount of deflation is accepted as a given would foster economic decision making that tends to focus more on real wealth-creation, and less on the kind of financial abstractions which have led to the recent turmoil. As long as we could manage the transition from a slightly inflationary to a slightly deflationary economy (i.e. find a way to deal with the problem of outstanding debt), I'm not so sure it would be quite the disaster that the article portrays.

jbooth 16y ago
What? The latter half of the 19th century had ridiculous booms and busts.
- Gormo 16y ago
  Even in comparison to the great depression and the recent financial collapse? There are always booms and busts, but inflation tends to encourage much bigger booms, and thus much bigger busts. Could you imagine the kind of risk-taking behavior that led to the credit bubble happening in an environment of anticipated deflation?
  - jbooth 16y ago
    The great depression and recent collapse are 75 years apart. There were 4 major downturns in the 1800s, 3 in the later half, and they were much more severe than the typical recession in the 20th century, 2 were full-fledged depressions: http://au.answers.yahoo.com/question/index?qid=20080304215730AAbuqyC http://au.answers.yahoo.com/question/index?qid=2008030421573... This is in the context of the industrial revolution, so yes, very much boom or bust.
  - dillydally 16y ago
    http://en.wikipedia.org/wiki/Panic_of_1819 http://en.wikipedia.org/wiki/Panic_of_1819 http://en.wikipedia.org/wiki/Panic_of_1837 http://en.wikipedia.org/wiki/Panic_of_1837 http://en.wikipedia.org/wiki/Panic_of_1857 http://en.wikipedia.org/wiki/Panic_of_1857 http://en.wikipedia.org/wiki/Panic_of_1873 http://en.wikipedia.org/wiki/Panic_of_1873 http://en.wikipedia.org/wiki/Panic_of_1893 http://en.wikipedia.org/wiki/Panic_of_1893 http://en.wikipedia.org/wiki/Panic_of_1901 http://en.wikipedia.org/wiki/Panic_of_1901 Almost every 20 years, like clockwork.
1053r 16y ago
I agree with your reasoning as to why deflation is dangerous, but I feel compelled to point out that the 19th century most emphatically WAS a period with lots of boom bust cycles. There was the recession of 1802, the depression of 1807, the recession of 1812, the depression of 1815, the recessions of 1822, 1825, 1828, 1833, then a couple of depressions in 1836, and 1839... I could go on, but you can read the wikipedia page yourself. http://en.wikipedia.org/wiki/List_of_recessions_in_the_United_States http://en.wikipedia.org/wiki/List_of_recessions_in_the_Unite... These weren't small either. Many of them saw decreases in business activity of over 15%. Contrast this with the postwar growth period of the late 1940s through the late 1990s, where you see inflation and strong steady economic growth (there were recessions, but they were all under 4%, and they were quickly erased by the growth that followed). So without trying to start an economic flame war, whatever they were doing in the 19th century for the most part clearly didn't work, and whatever they were doing from the great depression to the late 1990s early 2000s clearly did, if what you are optimizing for is steady growth and to moderate boom / bust cycles.
nerfhammer 16y ago
The period of deflation in the 18th century was associated with the Long Depression, and overall it was probably more severe than the Great Depression though/because it took its course more slowly http://en.wikipedia.org/wiki/Long_Depression http://en.wikipedia.org/wiki/Long_Depression
flatulent1 16y ago
Actually, a 5% return looks BETTER not worse, when there's deflation - you're getting the return, plus the base value of the investment which later can buy MORE. In your example the investment would allow buying 10% more later, the mattress-money only 5%. Actually getting that 5% will likely be more difficult though. When there's inflation, you're return has to match the inflation rate for you to effectively break even in buying power terms and that's not counting being hit by taxes on the gain that wouldn't buy more. The real danger of deflation comes when people stop spending thinking it is better to buy later because things will get cheaper. Along with problems getting funds, that's the killer with home buying. If people think there's continued deflation in housing, they'll try to hold off buying. Of course behavior has to be adjusted for other factors too. Deflation from things like falling oil prices is good. Many consumers will buy more of other products if their energy costs fall. It would help others pay down debt. That's good, we don't want them to default. Of course those in the oil industry want things to fall just enough to kill/delay alternatives or improvements in efficiency. It's good if we reduce the percentage of our spending on imports if those prices fall, but bad if exchange rate shifts reduce demand for our exports. Deflation won't be flat across the board by wages, products, or region so analysis is very complex. Income is another issue. Considering that most worked-for incomes haven't kept pace with inflation for some time now, our value to the workforce has deflated. Deflation is bad in the sense of allowing those out of the country holding dollars to buy up more assets like real estate. We want people abroad buying our products and services, not our land. Not owning our land effectively makes us slaves.

by Gormo 16y ago

jbooth 16y ago

What? The latter half of the 19th century had ridiculous booms and busts.

Gormo 16y ago
Even in comparison to the great depression and the recent financial collapse? There are always booms and busts, but inflation tends to encourage much bigger booms, and thus much bigger busts. Could you imagine the kind of risk-taking behavior that led to the credit bubble happening in an environment of anticipated deflation?
- jbooth 16y ago
  The great depression and recent collapse are 75 years apart. There were 4 major downturns in the 1800s, 3 in the later half, and they were much more severe than the typical recession in the 20th century, 2 were full-fledged depressions: http://au.answers.yahoo.com/question/index?qid=20080304215730AAbuqyC http://au.answers.yahoo.com/question/index?qid=2008030421573... This is in the context of the industrial revolution, so yes, very much boom or bust.
- dillydally 16y ago
  http://en.wikipedia.org/wiki/Panic_of_1819 http://en.wikipedia.org/wiki/Panic_of_1819 http://en.wikipedia.org/wiki/Panic_of_1837 http://en.wikipedia.org/wiki/Panic_of_1837 http://en.wikipedia.org/wiki/Panic_of_1857 http://en.wikipedia.org/wiki/Panic_of_1857 http://en.wikipedia.org/wiki/Panic_of_1873 http://en.wikipedia.org/wiki/Panic_of_1873 http://en.wikipedia.org/wiki/Panic_of_1893 http://en.wikipedia.org/wiki/Panic_of_1893 http://en.wikipedia.org/wiki/Panic_of_1901 http://en.wikipedia.org/wiki/Panic_of_1901 Almost every 20 years, like clockwork.

1053r 16y ago

I agree with your reasoning as to why deflation is dangerous, but I feel compelled to point out that the 19th century most emphatically WAS a period with lots of boom bust cycles. There was the recession of 1802, the depression of 1807, the recession of 1812, the depression of 1815, the recessions of 1822, 1825, 1828, 1833, then a couple of depressions in 1836, and 1839... I could go on, but you can read the wikipedia page yourself. http://en.wikipedia.org/wiki/List_of_recessions_in_the_United_States http://en.wikipedia.org/wiki/List_of_recessions_in_the_Unite... These weren't small either. Many of them saw decreases in business activity of over 15%. Contrast this with the postwar growth period of the late 1940s through the late 1990s, where you see inflation and strong steady economic growth (there were recessions, but they were all under 4%, and they were quickly erased by the growth that followed). So without trying to start an economic flame war, whatever they were doing in the 19th century for the most part clearly didn't work, and whatever they were doing from the great depression to the late 1990s early 2000s clearly did, if what you are optimizing for is steady growth and to moderate boom / bust cycles.

nerfhammer 16y ago

The period of deflation in the 18th century was associated with the Long Depression, and overall it was probably more severe than the Great Depression though/because it took its course more slowly http://en.wikipedia.org/wiki/Long_Depression http://en.wikipedia.org/wiki/Long_Depression

flatulent1 16y ago

Actually, a 5% return looks BETTER not worse, when there's deflation - you're getting the return, plus the base value of the investment which later can buy MORE. In your example the investment would allow buying 10% more later, the mattress-money only 5%. Actually getting that 5% will likely be more difficult though. When there's inflation, you're return has to match the inflation rate for you to effectively break even in buying power terms and that's not counting being hit by taxes on the gain that wouldn't buy more. The real danger of deflation comes when people stop spending thinking it is better to buy later because things will get cheaper. Along with problems getting funds, that's the killer with home buying. If people think there's continued deflation in housing, they'll try to hold off buying. Of course behavior has to be adjusted for other factors too. Deflation from things like falling oil prices is good. Many consumers will buy more of other products if their energy costs fall. It would help others pay down debt. That's good, we don't want them to default. Of course those in the oil industry want things to fall just enough to kill/delay alternatives or improvements in efficiency. It's good if we reduce the percentage of our spending on imports if those prices fall, but bad if exchange rate shifts reduce demand for our exports. Deflation won't be flat across the board by wages, products, or region so analysis is very complex. Income is another issue. Considering that most worked-for incomes haven't kept pace with inflation for some time now, our value to the workforce has deflated. Deflation is bad in the sense of allowing those out of the country holding dollars to buy up more assets like real estate. We want people abroad buying our products and services, not our land. Not owning our land effectively makes us slaves.