December 2, 2014

Deflation: Welcome Visitor or Unwanted Guest?

       In his 1958 lecture “Economic Policy:Thoughts for Today and Tomorrow” that we read earlier in the semester, Ludwig von Mises elaborates on why governments and central banks have a tendency to encourage inflation. Basically, because national governments hold the greatest amount of debt, they benefit the most from a devalued currency that makes paying debt easier.  Defenders of such policies usually point to an increase in exports as well as short term bursts of increased consumption and growth that occur before prices catch up to the greater supply of money in circulation. However, these kinds of explanations tend to ignore the long term recessionary effects that Austrian economists focus on and therefore only tell part of the story.
       Another part of the story that has been gaining more attention is inflation’s counterpart, deflation. The Economist recently published an article on their website titled “The Dangers of Deflation: The Pendulum Swings to the Pit.” In it, an alarmist tone is taken regarding the failure of several countries (our own included) to meet the 2% inflation targets set by their respective central banks. It is feared that their inability to hit such low targets is a sign that deflation, of the sort Japan recently spent nearly two decades dealing with, is just around the bend. Several reasons are listed as to why deflation should be avoided: investment levels will drop as people fear money made tomorrow will be worth less than money made today, consumption levels will drop as people continually expect lower prices in the future, as wages and tax revenues fall- consumers and governments will have a harder time paying back the already growing burden of their debt, and finally; with interest rates already so close to zero, and politicians wanting to appear tough on spending, there is little that governments or central banks can do to stop it once it begins.
       But is stopping deflation a good idea? From the perspective of Austrian economics, perhaps it is not. Though it is recognized that what most mainstream economists refer to as deflation can be harmful, this isn’t necessarily true in all cases. One reason for the difference in opinion is definitional. Austrian economists do not define inflation and deflation as changes in the overall price level. Instead, the terms’ definitions are rooted in changes in the money supply. According to Dr. Eubanks, this leaves room for decreases in the price level that should be welcomed, such as those brought on by widespread increases in productivity. Furthermore, when the money supply does decrease, and deflation in the Austrian sense sets in, interventionist attempts to stop it can easily make matters worse. The Great Depression provides a good example of this; instead of increasing liquidity, interventionists like Hoover and FDR thought it would be wiser to keep wages and prices up- which wound up increasing unemployment and decreasing output.
       Despite this current bout of low inflation (i.e., lowflation) being explained by significant drops in energy prices, the writer of The Economist article has nothing but gloomy predictions regarding current deflationary trends. Reasons such as Japan’s problems originating from a burst housing bubble, the highly leveraged national debts that followed in the wake of the 2008 crisis, and even the low energy prices themselves (viewed as a reflection of depressed demand) are all convincingly pointed to as reasons to believe that lower price levels justify strong government action. But is this a knee-jerk response? Given that the largest contributor to low inflation rates is low energy prices, and that lower prices tend to increase consumer demand, perhaps this is deflation of the more welcomed sort- driven more by an increase in supply than a decrease in demand (after all, we are producing a lot more of our own oil now which does affect global energy prices). Only time will tell if this recent emergence of lowflation is good or bad, but Austrian insights do provide a rosier alternative to neo-classical interpretations of what’s happening- as well as a defensible position against the potentially massive fiscal interventions suggested in The Economist article.

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