So apparently we’re all supposed to be worried these days about the specter of deflation. I am doubly baffled by this—I don’t see the problem in theory and I don’t see the problem in practice. Maybe there’s something I’m missing.
Start with the theory: We learned long ago from Milton Friedman (who might have learned it from Irving Fisher) that a little bit of deflation is a good thing. That’s because deflation encourages people to hold money, and people who hold money aren’t buying stuff, and when other people don’t buy stuff, there’s more stuff left over for you and me.
There are a couple of other ways to see this, though they all come down to the same thing. Here’s the first: falling prices are good for buyers and bad for sellers, but that all washes out. It washes out in the aggregate because each gain to a buyer is offset by an equal and opposite loss to a seller. And it more or less washes out for each individual, because each of us sells roughly as much as we buy (including the sale of our labor.) But over and above all that, deflation enriches the holders of money, because their money increases in value as it sits around. That part is pretty much (may Milton’s ghost forgive me for putting it this way) a free lunch.
Yet another way to see it is this: The only way to hang on to a dollar is to resist spending it, so the cost of keeping a dollar in your pocket is a dollar’s worth of forgone consumption. That’s the cost to you. But the cost to society of your holding a dollar is zero, because it costs us essentially zero to print that dollar up for you. Whenever an activity is costlier to you than it is to society, you’ll tend to do too little of it. (That’s why not many people spend their Sunday mornings picking up litter in the park.) Therefore people hold too little money. That means we ought to subsidize them to hold more, and deflation does exactly that.
So in that sense deflation is desirable. But a lot of commentators, including a few who are not economic ignoramuses, seem to be taking it for granted that deflation is something to fear. Which means they must see some offsetting disadvantage. And I’m not at all sure what they have in mind.
In this connection, you’ll hear the phrase “liquidity trap” a lot. A liquidity trap is simply a situation where interest rates are so close to zero that people are willing to hold vast amounts of money. As a result, when the authorities (wisely or unwisely) flood the market with money to encourage spending, it doesn’t work, because people just hang on to the new money. It’s alleged that this is some sort of a problem. But in reality, it’s a wonderful wonderful thing, because it means that the authorities can print money (at essentially zero cost) and use it to fund government operations like Social Security and Medicare without worrying about any of the usual consequences (at least until the liquidity trap eases and people start trying to spend that new money, at which point the government can simply call the money back in by selling bonds and destroying the proceeds). In a liquidity trap, government operations are effectively free.
(To put this another way: The government spends a penny to print up a dollar bill, uses that dollar bill to buy a widget, and the seller of the widget is perfectly happy to hold on to the dollar bill rather then demand any real resources in return. That’s total win-win.)
So much for theory. Now to the practical issue: Even if deflation is a bad thing, we know how to solve it. Print enough new money and people will eventually start spending it. It’s alleged that no matter how much you print, it can all just fall into the liquidity trap, and it’s alleged that this is what happened in Japan over the past decade. But I am sure the Japanese just didn’t try hard enough. Liquidity trap or not, I guarantee you there’s a central banker in Zimbabwe who knows how to fight deflation. If we really get into trouble, all we have to do is hire him.
Maybe they are worried about a lot of deflation. A lot of deflation could cause some real problems, right? I’m not sure what the cutoff is for a little vs a lot. Maybe its when lower prices lead to less production and then there is less stuff for you and me.
What economy has done as well over the long term with deflation as the US and Europe has done over the last 60 years?
Why hasn’t Japan had inflation when the debt has been so high for so long?
There are a few significant errors here. First, the level of money balances a person holds only affects his rate of spending during the period when he is adjusting that part of his portfolio. Once the desired level of money holdings is attained, spending will equal income. Second, holding less money is not at all like picking up litter in the park. There are no external nonpecuniary effects of money balances; the “welfare cost” of a positive holding cost for money is simply a (slightly) greater use of non-monetary resources for making transactions. Third, falling prices that are anticipated are completely neutral in their effects on buyers and sellers; the only redistributive effects are from unanticipated deflation. Of course, price-level *uncertainty* is not neutral, since people will take actions to reduce their exposure to it. Finally, the problem in a liquidity trap is that the interest rate can’t equilibrate saving and investment, so that income must do the job. Saying that this allows the government the luxury of obtaining resources without driving up prices or interest rates is simply another way of saying that the economy is substantially below full capacity. I think that’s a bug, not a feature.
Isn’t the argument though really about the speed of effects? You describe a market quickly clearing. Maybe it would today, with our communications. But it did not seem to in the early 30s. So here is the scenario. Deflation causes a bank to call in loans (not rollover loans etc) causing a marginal business to fail. This can lead to a multiplier, especially if bank’s service small geographic areas and at a near monopoly level as was frequently the case in days of yore. All comes out in the wash eventually, but how long is eventually? That closed business means an available storefront cheap for a new business, but how soon? I think that is the argument: viscosity.
Doesn’t deflation also detract long term investments such as infrastructure and R&D? ie why borrow for 30 years if the fruits of investment mean lower nominal income to pay the same nominal principal back?
So yes the govt gets “rfee social security” but at the expense of better medication down the track?
Sandy:
First, the level of money balances a person holds only affects his rate of spending during the period when he is adjusting that part of his portfolio. Once the desired level of money holdings is attained, spending will equal income.
Yes, spending will equal income this period, but the resources you didn’t consume last period still remain unconsumed (by you). As long as a dollar sits in your pocket, you are continuing to forgo consumption.
Second, holding less money is not at all like picking up litter in the park. There are no external nonpecuniary effects of money balances; the “welfare cost” of a positive holding cost for money is simply a (slightly) greater use of non-monetary resources for making transactions.
This is not correct. There is a one dollar gap between the social and private costs of holding a dollar. That means there has to be a dollar’s worth of nonpecuniary external benefit when you choose to hold that dollar.
Third, falling prices that are anticipated are completely neutral in their effects on buyers and sellers; the only redistributive effects are from unanticipated deflation.
This is correct but irrelevant (and does not contradict anything in the post.)
What about under-utilization of the economy Steve? You addressed some of Sandy’s points and ignored the big one. What about the people who can’t find work? How does deflation affect them?
Your argument seems to have a basic logical flaw that makes it inconsistent with itself. You say “whenever an activity is costlier to you than it is to society, you’ll tend to do too little of it” – and therefore, people do too little of holding on to money, and this is bad. Then you talk about shifting the balance the other way – making it such that spending is costlier so people will do less of it. But surely there comes a point where people do too much of that? Why wouldn’t that be bad?
To echo Mark’s point, what you’re missing can be summed up in one word: “Jobs”. You seem to be assuming that everyone gets to keep their jobs in such a scenario, and that everyone gets to keep their salaries as well. That’s not what happens in deflation. Instead, fewer jobs are created than are lost, and instead of pay increases, people get pay cuts.
Imagine that tomorrow no one ever again buys a copy of your books, because they’re holding onto their money. What becomes of your income? Let’s make the example less extreme. What if they buy 10% fewer of your books (as in 10% less revenue), progressively, each year. What does that do to your income as an author?
And to point out one related problem it seems you’ve missed, if my income declines 2% next year, does my mortgage payment go down as well? What about car loans? Credit card balances? Of course not; your debts, and debt payments, don’t change. So now you’re forced to reduce your spending by 2%. Lower consumer spending will put more people out of work and lower wages further, contributing to a deflationary spiral.
“[…] At least until the liquidity trap eases and people start trying to spend that new money, at which point the government can simply call the money back in by selling bonds and destroying the proceeds.”
Well this sounds simple enough that the central banker in Zimbabwe should have known about it. The problem is that in the short-run a change in money supply doesn’t affect the price level, but in the long-run it does. So there is a delay between money policies and price stability which makes the things a bit more complicated.
It’s fascinating to me how much top economists are disagreeing over macroeconomic issues. Macroeconomic issues seem much hazier to me than micro issues though I appreciate landsburg’s efforts here to clarify.
Hm, I think I’ll listen to the guy with the Clark Medal and Nobel Prize that teaches at a real school, over you.
To look at the comprehensive list of first-order and second-order effects would be difficult; then there are thirdoder — nth order effects.
You need to address where income will come from for companies making goods, then paying wages, if a large percentage of people decide to hold onto their money and not spend on cinsumption
You may say the average citizen will need “less money”, and certainly, he will have “less money” to spend.
Simple answers ain’t gonna fly.
Another way to express it is that the economists have a lot of valid equations that describe how things interact. Many of these equations have coefficients that need to be estimated, and change over time. These coefficients make a large difference in the ultimate outcome of an equation, and they may vary all over the place; ergo, the outcome is not predictable unless all of the underlying trends, attitudes, and beliefs about the future come true or do not come true [those are parameters that affect the value of the coefficients above].
So deflation could turn out to be a good thing or a bad thing for each individual, depending on their income, asset holdings, future commitments, etc.
Steve:
I don’t want to get involved in an endless exchange on this topic, so I will try to make my basic point from a different angle.
It is important to distinguish between stocks and flows in thinking about the opportunity cost of holding money. Friedman’s point was that the opportunity cost of holding money is the difference between the yield on interest-bearing assets that are substitutes for money and the zero yield on money. If the marginal cost of creating a new unit of fiat money is zero, then any positive opportunity cost of holding money is inefficient. But the opportunity cost of holding an asset is not its acquisition cost, it is the rate at which the asset loses value relative to the interest rate. Money is just another component of one’s portfolio of assets.
Friedman concluded that deflation at the real rate of interest (resulting in zero nominal interest rates but not zero real rates) would be efficient precisely because it resulted in a zero opportunity cost of holding money. There is a wedge between the marginal value of money and the marginal cost of producing it when deflation is absent, not when it’s present.
None of this means that it makes sense to worry about deflation such as we prospered through during the era of the classical gold standard. So I presume that what commentators are worried about is a deflation that represents a long, drawn-out period of adjustment in response to a severe contraction of money and credit.
“But the cost to society of your holding a dollar is zero” – wrong. Other people could borrow that dollar and use it. By holding on to cash you are doing your part to shut down economic activity and put people out of work. That is the cost to society.
Steve,
Deflation is feared because nominal wages are believed to be very rigid on the way down, and therefore deflation causes increasing real wages and increasing unemployment. (I think Friedman acknowledged this somewhere, but I could have dreamed it.)
I agree that a Zimbabwean Central Banker could always end deflation, but I don’t think you addressed the main reason why deflation, absent our Zimbabwean Central Banker, would be a very bad thing.
Cos: You are exactly right. You want just enough deflation so as to equate the social and private costs of holding a dollar. Since the social cost is zero, you want the private cost to be zero; for this, you want the nominal interest rate to be zero. For that, you’ll want a deflation rate equal to (minus) the real interest rate, but not more.
el chief: I’ll listen to the guy with the Clark Medal and Nobel Prize And what counter-argument is that guy making?
Sandy:
It is important to distinguish between stocks and flows in thinking about the opportunity cost of holding money. Friedman’s point was that the opportunity cost of holding money is the difference between the yield on interest-bearing assets that are substitutes for money and the zero yield on money. If the marginal cost of creating a new unit of fiat money is zero, then any positive opportunity cost of holding money is inefficient. But the opportunity cost of holding an asset is not its acquisition cost, it is the rate at which the asset loses value relative to the interest rate. Money is just another component of one’s portfolio of assets.
Friedman concluded that deflation at the real rate of interest (resulting in zero nominal interest rates but not zero real rates) would be efficient precisely because it resulted in a zero opportunity cost of holding money. There is a wedge between the marginal value of money and the marginal cost of producing it when deflation is absent, not when it’s present.
Yes, this is all exactly right.
So I presume that what commentators are worried about is a deflation that represents a long, drawn-out period of adjustment in response to a severe contraction of money and credit.
Maybe. It’s seems a bit odd to me that no commentator (of those I’ve read) has made this explicit, or specified exactly what kind of adjustment costs they have in mind.
Josh:
It’s fascinating to me how much top economists are disagreeing over macroeconomic issues.
I think you might be overestimating the amount of real disagreement. Friedman’s analysis — the analysis that says the private cost of holding money is greater than the social cost, that this leads to too little moneyholding, and deflation can close the gap — is certainly correct and surely no economist disputes it. Those who are concerned about deflation are not denying that deflation is, in this sense, a good thing. Instead, they seem to be arguing that there is also a downside to deflation, which outweighs this advantage. What’s frustrating to me is that those commentators (at least the ones I’ve read) have not spelled out what that downside is.
Well here is some ABC News logic on the subject: http://www.youtube.com/watch?v=C4wHVkuuy78
I agree that people not buying as much stuff and leaving more left over for you and me is a good thing. What I’m confused about is whether deflation would cause less production overall, meaning there would be less stuff for everyone than there otherwise would have been.
Here’s Krugman on the topic: http://krugman.blogs.nytimes.com/2010/08/02/why-is-deflation-bad/
One of his points is the same as Ricardo’s above.
Clearly, deflation is feared because of its connection with excess capacity and not by itself. Certainly, excess capacity can cause deflation (although stagflation in not unheard of), but does deflation cause excess capacity? The standard argument is that falling prices will cause consumers to hold off spending, but can that be more than a transitional phenomenon? More important, what is the effect of deflation on investment spending? It seems it would have to be negative because borrowed money must be repaid in dollars of higher real value (unless nominal interest rates can be negative, but who would lend at negative interest rates instead of holding money?) How is excess capacity avoided and equilibrium restored?
Another great post as usual, Steven!
Now, while I’m not a professional economist, I’m surprised a search over the comments section for “sticky wages” yields no return.
Is it not the working assumption of macroeconomists that wages are downwardly sticky?
I thought the foundation of the Keynes revolution was that deflation is an extremely painful type of economic adjustment because most workers are too stupid to distinguish between nominal and real wage cuts, so you end up with a lot of surplus labor for a long time. (This was especially true during Keynes time, when unions had more bargaining power.)
In other words, the effects of deflation are like those of price controls (for wages), only eventually time will erode them, but that could take a good while (and, in the long run, …).
Coincidentally, Arnold Kling of econlog just posted on this phenomena:
http://econlog.econlib.org/archives/2010/08/the_macro_doubt_5.html
Ricardo Cruz: Yes, you seem to be right about what the main concern is. See my Tuesday morning post (scheduled to appear about one hour after this comment is posted), and particularly the addendum thereto.
chief: “Hm, I think I’ll listen to the guy with the Clark Medal and Nobel Prize that teaches at a real school, over you.”
Huh? Steve explicitly stated that he was following in Milton Friedman’s path. Do you think Steve is misrepresenting him?
Steve: “And what counter-argument is that guy making?”
I’m not sure about the exact details, but it fits on one computer screen and makes frequent use of the word “surely”.
There is a very important difference bvetween deflation driven by real supply (and especially productivity) growth and deflation driven by falling aggregate demand. The former type doesn’t necessarily involve any _wage_ deflation: output prices fall relative to input prices. Friedman’s OQM rule doesn’t necessarily avoid equilibrium wage deflation, and so could be very problematic, as Tsiang observe, and as Friedman himself seems to recognized in favoring other norms for monetary policy aimed at stabilizing P.
I discuss theses and other issues at some length in my IEA pamphlet Less Than Zero: The Case for a Falling Price Level in a Growing Economy.
George Selgin: Thanks for this pointer. I’m looking forward to reading this today.