21 December 2008

Deflation is not inevitable

London Banker wrote a piece recently on the inevitability of deflation and I just wanted to say that deflation is not inevitable at all. Inflation seems more likely.

London Banker says,

“I’m now coming down on the side of deflation for a very simple reason: there is no longer any incentive to save or invest, and so debt and investment cannot increase much beyond current bloated levels”.

But this line of argument just makes no sense.

Deflation is caused not by decreases in saving and investment, but by a fall in the circulation of money—i.e. by a failure to spend.

Come to think of it, saving is nothing more than that part of income which doesn’t get spent, so the idea that less saving at this point might somehow be deflationary is just plain wrong.

In his article, London Banker mentions Fisher’s debt-deflation theory of great depressions reading—and his conclusion is quite clear and rather different:

“it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged. That the price level is controllable is not only claimed by monetary theorists but has recently been evidenced by two great events: (1) Sweden has now for nearly two years maintained a stable price level, practically always within 2 per cent of the chosen par and usually within 1 per cent. (2) The fact that immediate reversal of deflation is easily achieved by the use, or even the prospect of use, of appropriate instrumentalities has just been demonstrated by President Roosevelt.”

In other words, it is quite possible to avoid deflation and this can be done despite the savings and investment intentions of private institutions and individuals.

It is true that this is unlikely to provide a particularly encouraging environment to holders of credit, but in our over-indebted and asset-inflated state there may be more pressing concerns.

In general, it might not be a bad thing if unserviceable debts and over-priced assets were to fall in value, even if this would turn out to be of no benefit and not a little pain to anyone hoping for a return on their investments.

So, deflation is not inevitable. On the contrary, it is avoidable. And instead inflation is quite possible and may even be seen in some quarters as desirable if it can cause the real value of debts to fall.

The greater danger in the US and the UK—and it seems to me to be a very real danger—is that the central bankers may over-estimate (as they usually do) their abilities to control the supply of money. Even if they can prevent deflation, stable prices may be beyond their powers. A period of rather-higher-than-expected inflation seems to me not unlikely.

On the other hand, in Europe there may be a different problem. According to Fisher again:

“the infectiousness of depressions internationally is chiefly due to a common gold (or other) monetary standard and there should be found little tendency for a depression to pass from a deflating to an inflating, or stabilizing, country.”

It is not at all clear that the European Central Bank shares the inflationary tendencies of either the Federal Reserve or the Bank of England, and the “other monetary standard” that is the Euro may provide a medium through which deflationary infections might move quite quickly within the Euro zone.

It is possible, although by no means inevitable, that the US and the UK might—despite all the many vulnerabilities of their respective economic positions—find a path through our current difficulties more quickly than either the Europeans, who appear to perceive the risks only dimly, or the Asians who—as creditors to their major export markets—are likely in short succession to lose both their investments—inflated away in a currency which they do not control—and their markets—unless they are foolish enough to recommence the credit recycling that got us all into this trouble in the first place.

d. sofer