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This is NOT why deflation is bad. If there is a deflation rate D and (nominal) interest rates R, you can still get a real return of D+R by investing your money.

This is NOT why deflation is bad. If there is a deflation rate D and (nominal) interest rates R, you can still get a real return of D+R by investing your money. If you want "risk free" income, you can put your money into AAA fixed income just like you would do in an inflationary economy. The effects on the allocation of investment in a deflationary world are mathematically identical to an increase in interest rates. I.e., D=0, R=5 is the same as D=2, R=3. The only notable economic effect is that black money can now earn interest (it's hard to invest black money in fixed income or other such things). [edit: "Black money" is Hinglish for un-laundered money, i.e. cash profits from crime.] The problem with deflation is nominal rigidities, i.e. sticky nominal wages or the prideful worker effect. Namely, workers will irrationally refuse to accept work below their previous nominal wage. People's real productivity fluctuates, and sometimes goes down. In an inflationary economy, you can wait a little and not give them pay raises until their real wage drops below their real productivity. In a deflationary economy, the problem gets worse over time. Hence you'll need to fire the workers with wage > productivity, and those workers will refuse to accept new employment since new offers will have lower nominal wages than their previous job.

YZF 12y ago
But over the last while we've had negative nominal interest rates. This is impossible in a deflationary environment and so one problem in a deflationary environment is that the central banks can't use things like QE or lower interest rates to stimulate spending or investment. The other thing is that from a behavioral/psychological perspective having an inflation of 1.5% with interest rates at 2% doesn't feel the same as having an interest rate of 0% with a deflation of 0.5%. In the latter people are probably going to be spending less/waiting for prices to come down. [EDIT: Your salary example is the same effect. It's basically loss aversion. Either loss of income when your salary is decreased or loss of $ when paying more for something today than it will cost tomorrow. The fact that your salary reduction may be less than deflation or that what you're paying is more than if you'd invest doesn't matter to the way our minds treat loss, unless we try to trick it]
- yummyfajitas 12y ago
  QE does not fail when interest rates are zero. Further, there are a variety of tools the central bank can use besides interest rate manipulation. See the blog of Scott Sumner - he covers this in extensive detail. http://en.wikipedia.org/wiki/Nominal_income_target http://en.wikipedia.org/wiki/Nominal_income_target From a behavioral/psychological perspective, interest rates seem more likely to affect consumption choices. All of Keynesian and monetarist economics is predicated on the idea that people are ignorant of real prices and focus on nominal prices. So 2% nominal interest - 0.5% inflation looks like a 2% rate of return (invest more!) whereas 0% interest + 0.5% deflation looks like a 0% rate of return (consume more!). [edit: the salary example is NOT loss aversion. If you lose your job for $100, and turn down a job paying $90, you "lose" $100. If you accept the job you "lose" $10.]
  - bokonist 12y ago
    Scott Sumner is wrong about the impact of QE. Read Winterspeak and Warren Mosler. Or just use simple logic. How does QE improve the balance sheet of the average person? All it does is swap one piece of government paper for another piece. If my balance sheet is not improved, why would I spend more money and drive up the prices of goods? QE does lower interest rates. If lending is limited by interest rates, than QE could increasing lending. But at a certain point, interest rates are low enough that lending is limited by the lack of creditworthy borrowers or by bank capital requirements, and so further reductions will have very limited impact.
    - YZF 12y ago
      As long as interest rates are above 0% QE pumps money into the system. If you bought a 10% yield 10-year bond last year and that yield went to 0% it means you can sell that bond today for the same price you'd get in maturity. So that's a pretty good deal. The government or the central bankers are basically giving free money to bond holders on the assumption they will go use that money to stimulate the real economy. I think the last few years prove that it works to some degree but definitely a lot of that money gets stuck in various places, e.g. the banks. During QE the central bank can also acquire other assets that are riskier than bonds and take risk off other people's balance sheet, again hoping that money will be used to stimulate the real economy. At 0% it pretty much stops working. Up to 0% some bond holders are still holding on because they are betting on that being the better investment. The other problem is how do you exit QE. We're going to find out how that works over the next few years...
Retric 12y ago
No bonds are free of risk. Further deflation can be extremely high with real world examples hitting 50% per year. Remember at 50% deflation your zero risk cash is makeing an effective 100% ROI. So those AAA bonds need to make an effective 100+% ROI or there going to default and nobody with a true AAA raiting is going to pay that kind of interest. Worse places that had a AAA raiting often fail in those kinds of shocks. PS: Basically, the root cause of that kind of deflation is rolling defaults contracting the money supply.
- nkcpiytdhauwuhc 12y ago
  Sure, but the risk premium is generally independent of risk-free rate.
- yummyfajitas 12y ago
  If you have a bond which costs $100 and pays $101 in a year's time, and a 50% deflation rate, then the real return on the bond is 102%. The real return on cash is 100%. Inflation or deflation with magnitudes exceeding 20-30% is generally a very bad thing, and is also not what the article is discussing.
  - Retric 12y ago
    The issue is 3% deflation is already bad and can easily spike to 50% vary quickly.
pcurve 12y ago
You guys are both correct actually, covering all 3 reasons Krugman provided. krugman.blogs.nytimes.com/2010/08/02/why-is-deflation-bad/
bokonist 12y ago
The problem with deflation is nominal rigidities, i.e. sticky nominal wages or the prideful worker effect. Hence you'll need to fire the workers with wage > productivity, and those workers will refuse to accept new employment since new offers will have lower nominal wages than their previous job. Contra mainstream academic economics, sticky wages are not actually the main reason deflation causes unemployment during recessions. A sharp, unexpected deflation causes unemployment because of the non-neutrality of money. When deflation occurs, people first stop buying durable goods like cars or new homes or architectural blueprints. The reason workers get fired is because there is simply nothing for them to produce, because they are not worth being employed at even zero dollars. Many workers are quite willing to pay cuts in hard times, but get fired anyway because there is a glut of inventory and lack of buyers, so they are not worth employing at any price. You'll absurd that in a deflationary recessionary it's the workers in industries where spending is easy to cut that get hit the hardest. Also, is also when wages are deflating or balance sheets are deflating that this is a problem. If nominal wages are steady, but the prices of goods are gradually decreasing due to technology driven productivity increases, then there will be no general ill effect on unemployment.
- yummyfajitas 12y ago
  Why would a sharp, unexpected deflation cause people to stop buying durable goods? Concretely: One day, the price of everything has dropped 10%. After that day, things return to normal. Why would I not buy a new laptop? I'd feel bad if I bought one before the drop, but that's a different matter. This is also quite unrelated to the article which discusses consistent and expected low deflation rates. Many workers are quite willing to pay cuts in hard times, but get fired anyway because there is a glut of inventory and lack of buyers, so they are not worth employing at any price. This is clearly not true. During the entire recession, I was happy to pay people $5.15 or even $7.25/hour to clean my house. Yet maids cost far more than that. In any case, your claim that workers are fired because they have nothing to produce is the ZMP (Zero Marginal Productivity) theory. This falls into PSST/Austrian/Structuralist theories and is quite outside the purview of monetary economics. If a worker has zero real productivity, they will be unemployed regardless of monetary conditions.

YZF 12y ago

But over the last while we've had negative nominal interest rates. This is impossible in a deflationary environment and so one problem in a deflationary environment is that the central banks can't use things like QE or lower interest rates to stimulate spending or investment. The other thing is that from a behavioral/psychological perspective having an inflation of 1.5% with interest rates at 2% doesn't feel the same as having an interest rate of 0% with a deflation of 0.5%. In the latter people are probably going to be spending less/waiting for prices to come down. [EDIT: Your salary example is the same effect. It's basically loss aversion. Either loss of income when your salary is decreased or loss of $ when paying more for something today than it will cost tomorrow. The fact that your salary reduction may be less than deflation or that what you're paying is more than if you'd invest doesn't matter to the way our minds treat loss, unless we try to trick it]

yummyfajitas 12y ago
QE does not fail when interest rates are zero. Further, there are a variety of tools the central bank can use besides interest rate manipulation. See the blog of Scott Sumner - he covers this in extensive detail. http://en.wikipedia.org/wiki/Nominal_income_target http://en.wikipedia.org/wiki/Nominal_income_target From a behavioral/psychological perspective, interest rates seem more likely to affect consumption choices. All of Keynesian and monetarist economics is predicated on the idea that people are ignorant of real prices and focus on nominal prices. So 2% nominal interest - 0.5% inflation looks like a 2% rate of return (invest more!) whereas 0% interest + 0.5% deflation looks like a 0% rate of return (consume more!). [edit: the salary example is NOT loss aversion. If you lose your job for $100, and turn down a job paying $90, you "lose" $100. If you accept the job you "lose" $10.]
- bokonist 12y ago
  Scott Sumner is wrong about the impact of QE. Read Winterspeak and Warren Mosler. Or just use simple logic. How does QE improve the balance sheet of the average person? All it does is swap one piece of government paper for another piece. If my balance sheet is not improved, why would I spend more money and drive up the prices of goods? QE does lower interest rates. If lending is limited by interest rates, than QE could increasing lending. But at a certain point, interest rates are low enough that lending is limited by the lack of creditworthy borrowers or by bank capital requirements, and so further reductions will have very limited impact.
  - YZF 12y ago
    As long as interest rates are above 0% QE pumps money into the system. If you bought a 10% yield 10-year bond last year and that yield went to 0% it means you can sell that bond today for the same price you'd get in maturity. So that's a pretty good deal. The government or the central bankers are basically giving free money to bond holders on the assumption they will go use that money to stimulate the real economy. I think the last few years prove that it works to some degree but definitely a lot of that money gets stuck in various places, e.g. the banks. During QE the central bank can also acquire other assets that are riskier than bonds and take risk off other people's balance sheet, again hoping that money will be used to stimulate the real economy. At 0% it pretty much stops working. Up to 0% some bond holders are still holding on because they are betting on that being the better investment. The other problem is how do you exit QE. We're going to find out how that works over the next few years...

Retric 12y ago

No bonds are free of risk. Further deflation can be extremely high with real world examples hitting 50% per year. Remember at 50% deflation your zero risk cash is makeing an effective 100% ROI. So those AAA bonds need to make an effective 100+% ROI or there going to default and nobody with a true AAA raiting is going to pay that kind of interest. Worse places that had a AAA raiting often fail in those kinds of shocks. PS: Basically, the root cause of that kind of deflation is rolling defaults contracting the money supply.

nkcpiytdhauwuhc 12y ago
Sure, but the risk premium is generally independent of risk-free rate.
yummyfajitas 12y ago
If you have a bond which costs $100 and pays $101 in a year's time, and a 50% deflation rate, then the real return on the bond is 102%. The real return on cash is 100%. Inflation or deflation with magnitudes exceeding 20-30% is generally a very bad thing, and is also not what the article is discussing.
- Retric 12y ago
  The issue is 3% deflation is already bad and can easily spike to 50% vary quickly.

pcurve 12y ago

You guys are both correct actually, covering all 3 reasons Krugman provided. krugman.blogs.nytimes.com/2010/08/02/why-is-deflation-bad/

bokonist 12y ago

The problem with deflation is nominal rigidities, i.e. sticky nominal wages or the prideful worker effect. Hence you'll need to fire the workers with wage > productivity, and those workers will refuse to accept new employment since new offers will have lower nominal wages than their previous job. Contra mainstream academic economics, sticky wages are not actually the main reason deflation causes unemployment during recessions. A sharp, unexpected deflation causes unemployment because of the non-neutrality of money. When deflation occurs, people first stop buying durable goods like cars or new homes or architectural blueprints. The reason workers get fired is because there is simply nothing for them to produce, because they are not worth being employed at even zero dollars. Many workers are quite willing to pay cuts in hard times, but get fired anyway because there is a glut of inventory and lack of buyers, so they are not worth employing at any price. You'll absurd that in a deflationary recessionary it's the workers in industries where spending is easy to cut that get hit the hardest. Also, is also when wages are deflating or balance sheets are deflating that this is a problem. If nominal wages are steady, but the prices of goods are gradually decreasing due to technology driven productivity increases, then there will be no general ill effect on unemployment.

yummyfajitas 12y ago
Why would a sharp, unexpected deflation cause people to stop buying durable goods? Concretely: One day, the price of everything has dropped 10%. After that day, things return to normal. Why would I not buy a new laptop? I'd feel bad if I bought one before the drop, but that's a different matter. This is also quite unrelated to the article which discusses consistent and expected low deflation rates. Many workers are quite willing to pay cuts in hard times, but get fired anyway because there is a glut of inventory and lack of buyers, so they are not worth employing at any price. This is clearly not true. During the entire recession, I was happy to pay people $5.15 or even $7.25/hour to clean my house. Yet maids cost far more than that. In any case, your claim that workers are fired because they have nothing to produce is the ZMP (Zero Marginal Productivity) theory. This falls into PSST/Austrian/Structuralist theories and is quite outside the purview of monetary economics. If a worker has zero real productivity, they will be unemployed regardless of monetary conditions.