What Is Deflation and How Can it Be Prevented?

Deflation Answers for the E-mailers

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Q: There is currently talk in the media about the possibility of deflation. I think I understand what deflation is, and the problems that deflation would entail. However, I also seem to recall that when the government prints money it causes inflation. It seems to me, given these two "facts", the government would only have to print money to avoid deflation. (Pretty simple minded approach!)

Is the problem that there is more to printing money than printing money?

Is in fact the way printed money gets into circulation, that the fed buys bonds, and thus gets money into the economy? What is the logical rabbit trail that leads to inflation from printing money? Would solving deflation this way work with today's low interest rates? Why or why not?

A: Deflation has been a hot topic since about 2001 and the fear of deflation does not look like it will subside anytime soon. Thanks for the topic suggestion!

What is deflation?

The Glossary of Economics Terms defines deflation as occurring "when prices are declining over time. This is the opposite of inflation; when the inflation rate (by some measure) is negative, the economy is in a deflationary period."

The article Why Does Money Have Value? explains that inflation occurs when money becomes relatively less valuable than goods. Then deflation is simply the opposite, that over time money is becoming relatively more valuable than the other goods in the economy.

Following the logic of that article, deflation can occur because of a combination of four factors:

  1. The supply of money goes down.
  2. The supply of other goods goes up.
  3. Demand for money goes up.
  4. Demand for other goods goes down.
Deflation generally occurs when the supply of goods rises faster than the supply of money, which is consistent with these four factors.
These factors explain why the price of some goods increase over time while others decline. Personal computers have sharply dropped in price over the last fifteen years. This is because technological improvements have allowed the supply of computers to increase at a much faster rate than demand or the supply of money. During the 1980's there was a sharp increase in the price of 1950's baseball cards, due to a huge increase in demand and a basically fixed amount of supply of both cards and money. So your suggestion to increase the money supply if we're worried about deflation is a good one, as it follows the four factors above.

Before we decide that the Fed should increase the money supply, we have to determine how much of a problem deflation really is and how the Fed can influence the money supply. First we'll look at the problems caused by deflation.

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Most economists agree that deflation is both a disease and a symptom of other problems in the economy. In Deflation: The Good, The Bad and the Ugly Don Luskin at Capitalism Magazine examines James Paulsen's differentation of "good deflation" and "bad deflation". Paulsen's definitions are clearly looking at deflation as a symptom of other changes in the economy. He describes "good deflation" as occuring when businesses are "able to constantly produce goods at lower and lower prices due to cost-cutting initiatives and efficiency gains".

This is simply factor 2 "The supply of other goods goes up" on our list of the four factors which cause deflation. Paulsen refers to this as "good deflation" since it allows "GDP growth to remain strong, profit growth to surge and unemployment to fall without inflationary consequence."

"Bad deflation" is a more difficult concept to define. Paulsen simply states that "bad deflation has emerged because even though selling price inflation is still trending lower, corporations can no longer keep up with cost reductions and/or efficiency gains." Both Luskin and I have difficulty with that answer, as it seems like half an explanation. Luskin concludes that bad deflation is actually caused by "the revaluation of a country's monetary unit of account by that country's central bank". In essence this is really factor 1 "The supply of money goes down" from our list. So "bad deflation" is caused by a relative decline in the money supply and "good deflation" is caused by a relative increase in the supply of goods.

These definitions are inherently flawed because deflation is caused by relative changes. If the supply of goods in a year increases by 10% and the supply of money in that year increases by 3% causing deflation, is this "good deflation" or "bad deflation"? Since the supply of goods has increased, we have "good deflation", but since the central bank hasn't increased the money supply fast enough we should also have "bad deflation".

Asking whether "goods" or "money" caused deflation is like asking "When you clap your hands, is the left hand or the right hand responsible for the sound?". Saying that "goods grew too fast" or "money grew too slowly" is inherently saying the same thing since we're comparing goods to money, so "good deflation" and "bad deflation" are terms that probably should be retired.

Looking at deflation as a disease tends to get more agreement among economists. Luskin says that the true problem with deflation is that it causes problems in business relationships: "If you are a borrower, you are contractually committed to making loan payments that represent more and more purchasing power -- while at the same time the asset you bought with the loan to begin with is declining in nominal price. If you are a lender, chances are that your borrower will default on your loan to him under such conditions."

Colin Asher, an economist at Nomura Securities, told Radio Free Europe that the problem with deflation is that "in deflation [there's] a declining spiral. Businesses make less profits so they cut back [on] employment. People feel less like spending money. Businesses then don't make any profits and everything works itself into a declining spiral." Deflation also has a psychological element as it "becomes rooted in peoples' psychologies and becomes self-perpetuating.

Consumers are discouraged from buying expensive items like automobiles or homes because they know those things will be cheaper in the future."

Mark Gongloff at CNN Money agrees with these opinions. Gongloff explains that "when prices fall simply because people have no desire to buy -- leading to a vicious cycle of consumers postponing spending because they believe prices will fall further -- then businesses can't make a profit or pay off their debts, leading them to cut production and workers, leading to lower demand for goods, which leads to even lower prices."

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While I haven't polled every economist who has written an article on deflation this should give you a good idea of what the general consensus on the subject. A psychological factor that has been overlooked is how many workers look at their wages in nominal terms. The problem with deflation is that the forces causing prices in general to drop should cause wages to drop as well. Wages, however, tend to be rather "sticky" in the downward direction.

If prices rise 3% and you give your employees a 3% raise, they're roughly as well off as they were before. This is equivalent to the situation where prices drop 2% and you cut the pay of your employees by 2%. However, if employees are looking at their wages in nominal terms, they'll be much happier with a 3% raise than a 2% pay cut. A low level of inflation makes it easier to adjust wages in an industry whereas deflation causes rigidities in the labor market. These rigidities lead to an inefficient level of labor usage and slower economic growth.

Now we've seen some of the reasons why deflation is undesirable, we must ask ourselves: "What can be done about deflation?" Of the four factors listed, the easiest one to control is number 1 "The supply of money". By increasing the money supply, we can cause the inflation rate to rise, so we can avoid deflation.

In order to understand how this works, we first need a definition of the money supply.

The money supply is more than just the dollar bills in your wallet and the coins in your pocket. Economist Anna J. Schwartz defines the money supply as follows:

"The U.S. money supply comprises currency -- dollar bills and coins issues by the Federal Reserve System and the Treasury -- and various kinds of deposits held by the public at commercial banks and other depository institutions such as savings and loans and credit unions."

There are three broad measures economists use when looking at the money supply:

"M1, a narrow measure of money's function as a medium of exchange; M2, a broader measure that also reflects money's function as a store of value; and M3, a still broader measure that covers items that many regard as close substitutes of money."

The Federal Reserve has several options at its disposal in order to influence the money supply and thereby raise or lower the inflation rate. The most common way the Federal Reserve changes the inflation rate is by changing the interest rate. The Fed influences interest rates causes the supply of money to change. Suppose the Fed wishes to lower the interest rate. It can do this by buying government securities in exchange for money. By buying up securities on the market, the supply of those securities goes down. This causes the price of those securities to go up and the interest rate to decline. The relationship between the price of a security and interest rates is explained on the third page of my article The Dividend Tax Cut and Interest Rates. When the Fed wants to lower interest rates, it buys a security, and by doing so it injects money into the system because it gives the holder of the bond money in exchange for that security.

So the Federal Reserve can increase the money supply by lowering interest rates through buying securities and decrease the money supply by raising the interest rates by selling securities.

Influencing interest rates is a commonly used method of reducing inflation or avoiding deflation. Gongloff at CNN Money sites a Federal Reserve study that says "Japan's deflation could have been dodged, for example, if the Bank of Japan (BOJ) had only cut interest rates by 2 more percentage points between 1991 and 1995." Colin Asher points out that sometimes that if interest rates are too low, this method of controlling deflation is no longer an option, as currently in Japan where interest rates are practically zero. Changing interest rates in some circumstances is an effective way of controling deflation through controlling the money supply.

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We finally get to the original question: "Is the problem that there is more to printing money than printing money? Is in fact the way printed money gets into circulation, that the fed buys bonds, and thus gets money into the economy?". That's precisely what happens. The money the Fed gets to buy government securities has to come from somewhere. Generally it is just created in order for the Fed to carry out its open market operations.

So in most instances, when economists talk about "printing more money" and "the Fed lowering interest rates" they're talking about the same thing. If interest rates are already zero, as in Japan, there is little room to lower them further, so using this policy to fight deflation will not work well. Fortunately interest rates in the U.S. have not yet reached the lows of those in Japan.

Next week we'll look at seldom used ways of influencing the money supply that the United States may want to consider in order to fight deflation.

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