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This is the standard story about deflation, but the idea that a slightly deflationary environment will suddenly change purchase behavior has always struck me as

by gfodor 12y ago

This is the standard story about deflation, but the idea that a slightly deflationary environment will suddenly change purchase behavior has always struck me as a bit academic. The average consumer doesn't buy stuff because they think inflation is going to cause it to become more expensive in the future, they buy stuff because they need it. It seems borderline absurd to suggest that consumers are going to reconsider buying something because in a year it will be a few % cheaper in price. However, I do agree that a persistent deflationary economy (and the corresponding expectations that it will continue) will have... interesting effects on interest rates, debt, and corporate spending. But I still am not sold on the idea that it's a de facto negative thing. I think saying "deflation = bad" oversimplifies the lessons to be learned from the Great Depression but unfortunately that's the lesson we're taught.

harryh 12y ago
Of course it won't change consumer behavior for everyone all the time. At some point I'm just gonna have to buy that dishwasher. But it will change consumer behavior at the margin and what happens at the margin is what economic thinking is all about. Also, it's not just about consumer behavior but also investor behavior. Why should I take the risk of investing my money in a new product or company if I can earn a profit by hiding my money under my mattress?
- gfodor 12y ago
  On your former point I actually agree, but that's not the way the 'deflation = bad' argument is usually presented. It's usually presented that "people will defer purchases", full stop, and that would be terrible but it's hard to believe. I agree it will happen on the margins, but that might not be a huge deal. Investment wise, it always comes down to risk and inflation adjusted returns. Hiding your money under your mattress results in a risk free positive real return in a deflationary environment, but this just the same as buying a short term treasury bond. It's self evident that just because you can get a risk free positive return, it doesn't mean capital won't take on risk for a higher one. If that were the case, nobody would invest in anything other than government bonds.
  - ChrisLomont 12y ago
    Deflation shifts the returns, making holding cash more attractive, so it reduces investment. Reduced investment likely results in lower long term growth as less new businesses and ideas can be funded.
    - deleted 12y ago
      [deleted]
    - gfodor 12y ago
      Deflation effectively increases the risk free real rate. So the same effect of seeing the rate on the 10yr rise will be seen with disinflation. The difference being that you get some yield for "free" by just holding the cash and not buying bonds, but this is just incidental. The effect on risk-taking should be the same. So the point is I don't understand why it's treated as a deathblow for investment when we accept interest rate rises all the time without widespread panic about investment coming to a halt.
      - harryh 12y ago
        Cash you spend on buying bonds is actually being put to use by someone. Cash you stuff under your proverbial mattress isn't.
      - ChrisLomont 12y ago
        There is a huge difference between interest rate changes, which are set in large part by the Fed, versus deflation, which is not set by the Fed. The return on a 10yr (govt bond I assume?) is set by the market - this is not just picked or changed arbitrarily, although returns there are likely influenced by Fed rates. People control the interest yield for many products through the Fed, so we can avoid a deflationary spiral just by having the Fed change the interbank loan rate (among other things they can do). Deflation (caused by many types of things from demand shocks to economic fears to war) is often not easily dialed back, and can lead to a deflationary spiral, which cannot be simply tuned by the Fed. This is the reason the Fed targets slight inflation instead of zero inflation; the controls are not magic and the inflation/deflation tends to hover around where the Fed targets, and by staying away from zero we avoid possibly triggering a deflationary spiral we cannot control. In short, we have good tools for dealing with inflation. We do not have equivalently good tools for dealing with deflation.

by gfodor 12y ago

harryh 12y ago

Of course it won't change consumer behavior for everyone all the time. At some point I'm just gonna have to buy that dishwasher. But it will change consumer behavior at the margin and what happens at the margin is what economic thinking is all about. Also, it's not just about consumer behavior but also investor behavior. Why should I take the risk of investing my money in a new product or company if I can earn a profit by hiding my money under my mattress?

gfodor 12y ago
On your former point I actually agree, but that's not the way the 'deflation = bad' argument is usually presented. It's usually presented that "people will defer purchases", full stop, and that would be terrible but it's hard to believe. I agree it will happen on the margins, but that might not be a huge deal. Investment wise, it always comes down to risk and inflation adjusted returns. Hiding your money under your mattress results in a risk free positive real return in a deflationary environment, but this just the same as buying a short term treasury bond. It's self evident that just because you can get a risk free positive return, it doesn't mean capital won't take on risk for a higher one. If that were the case, nobody would invest in anything other than government bonds.
- ChrisLomont 12y ago
  Deflation shifts the returns, making holding cash more attractive, so it reduces investment. Reduced investment likely results in lower long term growth as less new businesses and ideas can be funded.
  - deleted 12y ago
    [deleted]
  - gfodor 12y ago
    Deflation effectively increases the risk free real rate. So the same effect of seeing the rate on the 10yr rise will be seen with disinflation. The difference being that you get some yield for "free" by just holding the cash and not buying bonds, but this is just incidental. The effect on risk-taking should be the same. So the point is I don't understand why it's treated as a deathblow for investment when we accept interest rate rises all the time without widespread panic about investment coming to a halt.
    - harryh 12y ago
      Cash you spend on buying bonds is actually being put to use by someone. Cash you stuff under your proverbial mattress isn't.
    - ChrisLomont 12y ago
      There is a huge difference between interest rate changes, which are set in large part by the Fed, versus deflation, which is not set by the Fed. The return on a 10yr (govt bond I assume?) is set by the market - this is not just picked or changed arbitrarily, although returns there are likely influenced by Fed rates. People control the interest yield for many products through the Fed, so we can avoid a deflationary spiral just by having the Fed change the interbank loan rate (among other things they can do). Deflation (caused by many types of things from demand shocks to economic fears to war) is often not easily dialed back, and can lead to a deflationary spiral, which cannot be simply tuned by the Fed. This is the reason the Fed targets slight inflation instead of zero inflation; the controls are not magic and the inflation/deflation tends to hover around where the Fed targets, and by staying away from zero we avoid possibly triggering a deflationary spiral we cannot control. In short, we have good tools for dealing with inflation. We do not have equivalently good tools for dealing with deflation.