Deflation Is Horrible

Great article in Minyanville last Friday. Agree with author on almost everything. Yes, world economy is in big trouble. Yes, people and businesses are taking on less debt and this is going all the way to the top, i.e. Fed. As a result, inflation in current situation is close to impossible, despite all attempts by Fed and Treasury. The only thing I disagree with is the premise that deflation is good.

OK, everybody might agree that prices going down make you feel better. And in some sectors of economy it's decades long reality (computers, for example). Unfortunately, what's good for a person is bad for economy, and as a result, for everybody. In deflationary environment, everybody tries to delay purchases. Why hurry, this thing will cost less later! Economy slows down, companies cut expenses the usual way: laying off employees. Less paid employees means less demand for goods, creating positive feedback, or as it's known since Great Depression, deflationary spiral. Eventually economy might find equilibrium in deflationary environment, but this equilibrium will not be happy one, with unemployment much higher than in inflationary environment. Empirical rule known to economists as a Phillips Curve, defines inverse relationship between inflation and unemployment. There is only one example of deflationary economy after World War II: Japan. In 1990s it experienced deflation. Surprise, it was also a period of almost constant recession. This paper suggests that Phillips Curve flattens in the negative inflation (deflation) zone. The problem with it, Japan is a quite unique example. Businesses there are not eager to lay off employees at a drop of a hat. It just might be that Japanese corporations kept extra workforce on their payroll because they used to do that (remember lifetime employment?). In US example (Great Depression), picture was very different. Unemployment jumped to 25% and stayed there for a long time.

Some people can argue that world lived mostly in deflation since invention of money. True. But world also lived in economy which wasn't growing much and most people had subsistence living standard. They couldn't cut expenses even if they wanted to. Great Depression showed us for the first time what can happen when deflation hits economy in which significant part of spending is discretionary. Our current economy has much higher discretionary part than in 1930s.

My take on it: be afraid of deflation, be very afraid. I applaud Fed and Treasury efforts to stop deflation. And I'm afraid that they are too late.