Christopher Pang
Does deflation really create a endless spiral?
Deflation is commonly defined as a decrease in price levels by the mainstream economists and financial news commentators. It is a terrible thing so they said. They alleged that a fall in prices generate expectations for a further decline in prices, and induces consumers to postpone their purchases to future because they expect to buy these goods at lower prices. This weakens overall economic activity and pushes prices even lower, resulting in a downward spiral of economic activity.
Let us understand what are the causes of deflation. There are 3 main causes of deflation:
1. Reduction of money supply is the Austrians’ definition of deflation and is one of the reasons for decreasing price levels. If the money supply decreases, each money unit in the money supply becomes more valuable based on the Law of Marginal Utility. Marginal value of money has increased as compared to the supply of production.
2. Increase in demand for money. Demand for money refers to the money people want to hold in their pockets and bank accounts. There are two ways to accumulate more money – sell more assets, or spend less money. This would lead to an increase in the supply of goods/assets in the markets. This would lead to all relevant asset/goods prices decreasing as demand for money increases.
3. Economic growth at constant monetary conditions. If neither demand nor supply of money changes, this means we neither hoard nor dishoard money. The total spending does not change. Growth deflation is possible when overall volume of production is increasing at a constant level aggregate of spending and constant monetary conditions.
Mainstream economists disagree with point 3 and allege that increasing production of goods and services must correspond with an increase in money supply. They alleged that if money supply do not increase, goods and services would not be able to get enough demand because there is not enough money. Any amount of money can support an economy as prices will increase or decrease with the changes in demand or supply of goods. It is the responsibility of the entrepreneur to anticipate falling or rising prices and make adjustments according to his/her anticipation. A business will make profits if the anticipation is correct and losses if the anticipation is wrong. Prices are packets of information and signal to entrepreneurs how to adjust resources in their production to minimize wastage. Prices are also formed by every consumer in their buying decision. As capital is a scarce resource, a consumer has to prioritize his purchase based on his/her subjective preference/valuation. Money supply manipulations will only result in miscalculations and creates an illusion of profits which entrepreneurs continue to consume their capital.
Since the Great Depression, deflation has been one of the great scarecrows of present day economic policy and monetary policy in particular. This experience has led to many theories concluding that deflation leads to depression. Policy makers had been fearful of deflation and have been “inflation targeting” in order to prevent a sequel to the Great Depression. However in a study “Deflation and Depression: Is There an Empirical Link?” done in 2004 by Andrew Atkeson and Patrick Kehoe, they found no evidence of a link between deflation and depression for 16 countries from 1800s to 2000, except for the Great Depression.
The claim that wages are “sticky”, suggesting it is hard to adjust wages as fast as prices decline is fallacious. If prices can fall, so can wages and costs. Wages are the price of labour. As prices fall, workers can reduce their demand for money as the costs of living have already been adjusted downwards. Existing workers have to compete with the unemployed workers or new workers by reducing their wage rate. This would aid businesses in adjusting their overheads. If workers are unwilling to reduce their wages, businesses will then find ways to reduce their costs by either improving the productivity of the workers with capital investment into technology or machinery. Supposed an entrepreneur anticipated that prices in future would be falling as compared to his factors of production, he would bid down prices of his raw materials and labour such that a positive spread between price and cost can be achieved, otherwise known as profits. If labour costs as suggested is sticky, this particular entrepreneur will shut his business down as it is no longer profitable to continue operations. If his anticipation was right, prices would eventually fall to the level as he anticipated and workers would then have empirical evidence that such a lower cost of living is required to maintain his/her previous lifestyle and adjust accordingly. The only reason creating unemployment is a minimum wage that prevents workers/businesses from contracting at a lower wage.
As profit is the difference between the price and the average cost required to produce a good, it can be generated even in a deflationary environment. Lower prices help to increase demand by making the goods more affordable to consumers. A black and white TV was a luxury item back in the 1970s, only affordable by the wealthy. Today a flat screen HD TV is a fraction of most people’s monthly income. The first mobile phone cost USD 3,995 in 1983 dollars. An Iphone today cost about 1,000 SGD. Mass production leading to affordability is why more and more people upgrade their mobile phones and computers every couple of years.
It is an increase in production capacity that leads to lower prices that result in an increase in demand and not an increase in demand that helped increase production capacity. By misunderstanding the cause and effect, the focal point of most economists has been on increasing aggregate demand, measured by GDP. On the recent devastating earthquake in Japan, Larry Summers told CNBC, “It may lead to some temporary increments, ironically, to GDP, as a process of rebuilding takes place.” This is a broken window fallacy which I have explained in a previous article when Singapore were hit with flash floods and Ryan Young’s rebuttal to Larry Summers’ misguided economic thinking.
Supposed an entrepreneur who has financed his business by equity has spent 100 units of money to produce his products and deflation occurs during this period, resulting in the entrepreneur being able to sell his finished products for only 60 units of money after completion. He would not be bankrupt as he had financed his entire business through equity. All he had done was just made a bad investment and sunk money into the ground. Would this entrepreneur then continue to buy his factors of production (labour and raw materials) for 100? Obviously he would not. He would turn to his suppliers and employees, renegotiate a new contract, asking them to provide these factors of production for half of what is before. By producing at 50 units of money and selling at 60, profits will ensure the continuity of the business. The most important consequence is that no one else would offer 100 units for these factors of production as competitors have faced similar deflationary pressures which means workers would not be able to find such a wage rate and suppliers would not be able to find a higher price for their raw materials. If an entrepreneur has anticipated a future revenue of 60 units of money, he would not even spend the 100 units in the first place. This entrepreneur will shut the business and wait for prices to fall to the level which he believed his future revenue will be able to generate a profit margin after his present costs of production.
On the contrary if an entrepreneur has financed his business through debt, this entrepreneur will be unable to repay the amount which he have borrowed because the revenue he generated after deflation would be insufficient to repay the debt owed. There are a few solutions to which this situation can be resolved.
1. Renegotiation of the debt. This is similar to many countries in Europe which have refinanced their debt, e.g. Greece, Portugal and Spain.
2. Default. This occurs when creditor insists on payment, debtor is unable to pay and the business goes into liquidation. The end result is either a takeover by creditors or the creditors would sell the assets of this business at a price level which other entrepreneurs expects to be profitable to generate a return. The bankruptcy of a company only results in a change of ownership but does not destroy any of the existing physical assets or human capital. If there is a global meltdown, this only means there is a massive change in property owners. The previous owners(debtors) will now be employees to the new owners(creditors) who would take over the companies or assets. This is at most a temporal effect until the property ownership changes hands fully.
Irving Fisher alleged that if there is bankruptcy of a bank, this would necessarily exercise some deflationary pressure on price levels. The reduction in circulating money would lead to less money being spent. The victims of lower expenditure would be the companies with low profit margins and these companies would then be unable to repay their debts. The result is more bank failures and more companies would go bankrupt and the spiral goes on. This is a snowballing effect and the economy sinks into a bottomless pit according to Fisher.
Austrians can largely agree with most of Fisher’s theory except for deflation being an endless spiral. There is an end. The ending is a massive brutal bankruptcy for indebted firms that are no longer able to generate enough positive cashflow and the money supply that is created artificially by banks through fractional reserve banking would be destroyed. However as long as there is any positive level of spending, investors can and will keep the economy going as long as there is a positive spread between revenue and cost. Deflation is at most a temporal effect if the free markets were allowed to work their magic. Government intervention through bailouts, monetary expansion, fiscal deficit spending and setting artificial interest rates will hinder this self correcting process. The end result is a more severe depression in time to come. To the politicians and central bankers, that is another problem for another politician or central banker for another day.
Prices are sticky because you have these things called contracts in which nominal prices persist for many months as a result of legal agreements. Wholesalers, producers, workers, etc do not adjust their prices instantly. Menu costs become significant when you have to adjust prices all the time.
You are also not drawing the distinction between expected and unexpected inflation when discussing the consequences of inflation.
If so, the consequence would just be the party suffering the effects of deflation would calculate the cost of legal compensation versus the cost of losses and decide the appropriate action to take. If the legal compensation is lower than the estimated cost of losses, he would terminate his contract immediately and pay off his damages instead of waiting out for even higher potential losses in the future. This would also eventually lead to contracts being drawn with shorter term and prices would be more flexible and adjust faster than it would be under a longer term contractual obligation.
*Chuckle*. So, in that case, why do banks offer 20-year mortgages? Why do we have any multi-year legal agreements in commerce at all?
Long contracts are not without their disadvantages. Normally, under normal conditions, they allow you to lock in and forecast your cost more easily. If not, menu costs go up for you. For example, a half-yearly renewal of space lease makes more sense than monthly renewals for large firms because you can predict your costs more easily and plan for your business. Of course, when office rental is in a freefall as in a recession, it’s bad for you because you’re paying more than others. But running a business where you renew your office lease on a weekly basis is a bad idea normally. As a business owner, you don’t want to spend all your time renegotiating your office rental when you can be more productive concentrating on running your business. As the landlord, you don’t want to spend all your time finding tenants every month. The menu costs are simply larger when you have to renegotiate contracts all the time.
“If an entrepreneur has anticipated a future revenue of 60 units of money, he would not even spend the 100 units in the first place. This entrepreneur will shut the business and wait for prices to fall to the level which he believed his future revenue will be able to generate a profit margin after his present costs of production. “
And you don’t see that there is a problem with that? You realize that when businesses shut down, unemployment goes up. When unemployment goes up, the price at which this entrepreneur can sell his stuff goes down. Then he hold out some more. And then more workers get laid off, more land become unused, more minerals stay in the ground. Strangely enough, getting to your economic utopia involves a tremendous amount of the idle resources in the economy for a long time. Of course, in the long run, the economy will get back on its feet but as a great man once said, in the long run, we’re all dead.
They offer 20 year mortgages because the price of houses have reached a price no longer affordable by the average person based on his average income.
Menu cost can happen for both situations, whether deflation or inflation. In an inflationary environment, restaurants have to update their menus often, which is also why it is called menu cost in the first place. Landlords who locked in rental rates at a previous lower rates would then also be suffering the effects of inflation as the income generated no longer sustain their previous living standards as purchasing power of their money has been reduced. What I am suggesting is that prices are not as sticky as it seems, and not that longer term contracts are no good. A longer term contract can also be renegotiated during the middle of the period.
Supposed a bank which has lent 50m to a company to buy a piece of land when the company anticipate rental yield of 5%. Now after deflation the land is only worth 25m. However, all other prices have fallen correspondingly. The consequence is either the company default and the bank take over the piece of land or the loan is renegotiated with a smaller outstanding loan amount. As the market price of this land is 25m, a 5% yield would only generate 1.25m yearly. How is it different from the land being at 50m and generating 2.5m yearly? The yield is still 5% and the living standards have not changed given that corresponding price levels have moved in correlation. In fact, generating less revenue/profits would reduce tax obligations in a progressive tax system and increase real wealth further.
And you don’t see that there is a problem with that? You realize that when businesses shut down, unemployment goes up. When unemployment goes up, the price at which this entrepreneur can sell his stuff goes down. Then he hold out some more. And then more workers get laid off, more land become unused, more minerals stay in the ground. Strangely enough, getting to your economic utopia involves a tremendous amount of the idle resources in the economy for a long time. Of course, in the long run, the economy will get back on its feet but as a great man once said, in the long run, we’re all dead.
I have said time and time again. You do not want to be employing people just so that they can be employed. The same argument goes for the part for fixing Japan’s economy because of the earthquake. If employment is a key indicator of an economy’s health. We should hire all of our 2.5m people in Singapore to dig trenches and another 2.5m to cover the trenches. What do we get at the end of the day? Just mud.. If entrepreneurs are unable to generate profits why should they continue the business so that their workers can be employed. If their workers do not take a lower pay so that the business can remain profitable, why would an entrepreneur carry on this charity organization to feed his overpaid workers? This applies similarly with suppliers for the other factors of production. When prices have adjusted to a low which people find it acceptable to make their purchase, they will. Prices form signals whether in an actual or expected deflationary/inflationary environment for entrepreneurs to make their decisions. If an anticipatory deflation does really happened in the end, it is also because of the majority of the people who bid down the prices more than the bullish people who believe in an inflationary environment. That is still the dynamics of a free market based economy. The job of a central bank is not to ensure profits for businesses but to maintain the value of the currency. This said, central banks worldwide have done a terrible job.