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Deflation is bad and inflation good? Really?

brunodelepierre
Posts: 1
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11/17/2014 1:18:35 PM
Posted: 2 years ago
As a citizen of Belgium, our mainstream media often reports on the economic policies of the EU. The core message to explain the monetary policy which the ECB applies, is that a low inflation is good and deflation is bad for our economies.

There are 2 dimensions I would like to put up for debate:

individual level
I find it counterintuitive that inflation for individuals would be a good thing as the value that was built by them decreases in absolute terms (inflation). Oppositely, if the absolute value that was built is increasing (deflation) that would be horrific for the individual, although this raises his purchasing power. I do understand that people with debt, have less to pay when you have an inflationary policy.

company level

From a production point of view, the argument is made that without inflation, organisations do not have an incentive to innovate. I personally find this hard to believe in a globalising economy where those who stand still, fail eventually.

If companies have a decent profit margin, I would be surprised they would not be willing to invest this in future product or service improvements.

Also, on deflation, the common argument is that people will postpone their purchases as they expect to pay less in the future. I have Googled this to find any scientifically valid research on this topic, without any result though.

My questions

Are there any holes to be punched in the above logic? Do you have any angles to add?
Do you know any research papers that provide more detail between deflation and moment of purchase? The same thing for the link between inflation and innovation?
Benshapiro
Posts: 3,965
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11/19/2014 1:38:54 AM
Posted: 2 years ago
At 11/17/2014 1:18:35 PM, brunodelepierre wrote:
As a citizen of Belgium, our mainstream media often reports on the economic policies of the EU. The core message to explain the monetary policy which the ECB applies, is that a low inflation is good and deflation is bad for our economies.

There are 2 dimensions I would like to put up for debate:

individual level
I find it counterintuitive that inflation for individuals would be a good thing as the value that was built by them decreases in absolute terms (inflation). Oppositely, if the absolute value that was built is increasing (deflation) that would be horrific for the individual, although this raises his purchasing power. I do understand that people with debt, have less to pay when you have an inflationary policy.

A steady rate of inflation is a good thing because it keeps prices stable and encourages people to borrow money. If you take out a loan for $5,000 and you're expected to pay that over the next 5 years at 2% annual inflation, the real amount that you're paying back is effectively less than what you'd borrowed because the original $5,000 amount is discounted by 2% per year in terms of real purchasing power. With deflation, on the other hand, if you were to take out a loan for $5,000 over a 5 year term at 2% annual deflation, the real amount you're paying back is more than what you loaned it out for. You'd be better off saving your money. Of course institutions try to negate and compensate for inflationary/deflationary expectations as much as possible when loaning.

company level

From a production point of view, the argument is made that without inflation, organisations do not have an incentive to innovate. I personally find this hard to believe in a globalising economy where those who stand still, fail eventually.

If companies have a decent profit margin, I would be surprised they would not be willing to invest this in future product or service improvements.

Innovation = expanding the business with a huge loan. Is it wise to take out a huge loan if you know you'll be losing 2% of your purchasing power year over year to deflationionary costs and not even including interest on the loan?

Also, on deflation, the common argument is that people will postpone their purchases as they expect to pay less in the future. I have Googled this to find any scientifically valid research on this topic, without any result though.

They'll postpone their purchases because they have less purchasing power to pay off a fixed dollar amount that at one point in time represented an equal amount of purchasing power.

My questions

Are there any holes to be punched in the above logic? Do you have any angles to add?
Do you know any research papers that provide more detail between deflation and moment of purchase? The same thing for the link between inflation and innovation?

It has to do with borrowing money. I'd suggest looking at the loanable funds model to gain a greater understanding. All money is fiat money so money is basically created out of thin air whenever people demand loans. When people spend money the economy is stimulated. When nobody demands loans, the money supply contracts, inflation falls, and the economy is depressed.
wrichcirw
Posts: 11,196
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11/19/2014 3:48:44 AM
Posted: 2 years ago
At 11/17/2014 1:18:35 PM, brunodelepierre wrote:
As a citizen of Belgium, our mainstream media often reports on the economic policies of the EU. The core message to explain the monetary policy which the ECB applies, is that a low inflation is good and deflation is bad for our economies.

There are 2 dimensions I would like to put up for debate:

individual level
I find it counterintuitive that inflation for individuals would be a good thing as the value that was built by them decreases in absolute terms (inflation). Oppositely, if the absolute value that was built is increasing (deflation) that would be horrific for the individual, although this raises his purchasing power. I do understand that people with debt, have less to pay when you have an inflationary policy.

company level

From a production point of view, the argument is made that without inflation, organisations do not have an incentive to innovate. I personally find this hard to believe in a globalising economy where those who stand still, fail eventually.

If companies have a decent profit margin, I would be surprised they would not be willing to invest this in future product or service improvements.

Also, on deflation, the common argument is that people will postpone their purchases as they expect to pay less in the future. I have Googled this to find any scientifically valid research on this topic, without any result though.

My questions

Are there any holes to be punched in the above logic? Do you have any angles to add?
Do you know any research papers that provide more detail between deflation and moment of purchase? The same thing for the link between inflation and innovation?

Neither nominal growth nor contraction really benefits the consumer in a real sense, so what you want to look at is something else. That something else deals with the mechanism for money creation, which in any society that has developed banking tends to be a fractional reserve system of some sort. Fractional reserve banking entails banks creating money by keeping only a fraction of their deposits on hand whereas they loan out the rest. So, if A deposited $100, and the bank loaned out $50 of it to B, A still has his $100 and B has $50, too. That right there is money creation. If you stretch out a bank's lending proportionally based upon the above example, the bank would be keeping 50% of its funds in reserve, thereby creating 50% more money out there than there was previously. This of course is inflationary, and on top of that is also subject to a multiplier effect (which for simplicity's sake I will omit).

Before the establishment of central banks, individual banks attempted to engage in this system based solely upon their own ability to meet demand for withdrawals if people wanted their deposits back. People making withdrawals is deflationary, and if enough people wanted their deposits at the same time, it would create a run on the bank and destroy the bank as a business, as the bank would become insolvent (it would still have loans outstanding while running out of currency to redeem deposits). Quite literally overnight you can have a situation where anyone holding paper originating from the bank would be holding on to worthless paper...so the deflation would not only result in the bank's loans being worthless, it would result in the remaining deposits becoming worthless as well. This is highly destructive to any economy.

Looking at this scenario, inflation encourages lending, indeed the very act of lending in a fractional reserve system is inflationary, and lending encourages economic activity. Deflation does the opposite. That's why productivity benefits from inflation. Your point on deflation is correct in that people will postpone their purchases, but if it was that simple deflation would not be particularly pernicious. It's the potential consequences of creating a run on a bank that makes deflation so pernicious.

We have a central bank today that can control inflation and deflation to an unparalleled degree, and our central bank in particular is scared sh!tless of deflation due to our experiences with the Great Depression. They feared a "run" on the overall US banking system in 2008, and to counteract it they have printed as much money as people wanted to make them happy/secure. Before, when currency was deemed to be something tangible like gold, banks could not do that, but with a fiat system like we have today, as long as people still have faith in the dollar, the Fed can print as much as it deems necessary to meet demand for cash.

Hyperinflation can also destroy the credibility of a bank's paper - the bank may become so irresponsible in issuing paper money (be it guarantees issued by a private bank ostensibly backed by hard currency or a central bank printing with impunity) that people begin to believe that the bank is going to continually act irresponsibly, and that the debasement of the bank's deposits (i.e. holding too small a fraction of funds on reserve) will continue unabated. This causes people to lose faith in the value of the currency, prices rise precipitously to such an extent that businesses can no longer function (say a baker buys flour at $1 a pound, makes bread to sell at $2 a pound, but when they want to buy more flour the next day it costs $5 a pound...this is hyperinflation), and the economy shuts down. This was Germany's experience during the Great Depression, which is why their central bank in particular has an acute fear of hyperinflation as opposed to deflation.

In the end, neither is particularly good or bad as long as it is controlled. The moment control is lost, then the underlying currency (whether it be bank notes or fiat) loses integrity, and any trading or exchanged based upon that currency no longer becomes possible. It creates severe disruptions in economic activity that economists seek to avoid as much as possible.

It's interesting how the perception alone of creditworthiness can either cause an economy to run smoothly or can cause panic and severe disruptions. That's how currency works...there's not much other than perception that determines value for that currency...after all, the last time I checked I couldn't eat or drink dollars, and without its use as a currency, most of the green in your wallet wouldn't be useful except perhaps for some minor kindling.
At 8/9/2013 9:41:24 AM, wrichcirw wrote:
If you are civil with me, I will be civil to you. If you decide to bring unreasonable animosity to bear in a reasonable discussion, then what would you expect other than to get flustered?