The preposterous deflation scare Part IV – Who should be scared of deflation?

There is no sound empirical evidence and no convincing theoretical justification for why deflation is such a danger to the economy. Although deflation can be the result of an economic crisis, it can also be caused by cost reductions due to falling raw material prices or technological progress. Historically, not only crises, but also periods of lasting economic success — e.g., the rise of Great Britain in the 19th Century — have both been linked to deflation.

Deflation is always the outcome of a (positive or negative) economic development and can in very unrealistic circumstances become the cause of a negative development such as a deflation spiral. There is also very little evidence that low or moderate inflation exerts a particular influence on economic growth. Could it be that it does not matter whether there is inflation or deflation — as long as inflation does not spiral out of control?

It does, however, matter for long-term investors, creditors and debtors, whose debts and liabilities are measured in nominal values. Inflation or deflation brings about a redistribution of the real value of assets between these groups.

The debtors are chiefly in favour of inflation because it leads to a real devaluation of their nominal liabilities. The creditors, on the other hand, are interested in deflation or genuine price stability because it ensures that their debts maintain their real value.

The greatest debtor of all has been and remains the state. It is therefore no coincidence that even periods of low inflation have largely been characterised by considerable state budget deficits. All state expenditure that is financed by debts is expansionary and, as a result, inflationary. This may be desirable in times of crisis; however, normally it only results in the crowding out of private activity.

From the point of view of investors and consumers, an inflation rate of 0% p.a. would be ideal, because the purchasing power of their money is maintained. In the long term, in particular, even a low rate of inflation results in a considerable decline in value. However, there is currently little prospect of improvement due to the widespread financial difficulties of almost all major states, as a certain level of inflation and low interest rates considerably facilitate their financing.

The central banks’ inflation goal of 2% p.a., which is currently packaged as “monetary stability”, should therefore be seen as a political orientation. It is a pragmatic compromise between the necessity of providing a concrete inflation goal, of meeting the interests of investors by ensuring that  the value of money does not to decay too fast as well as those of a state apparatus, which is chronically in debt.

Unfortunately this is never communicated honestly. Instead we have to live with the myth that there is an optimum rate of inflation and, on top of that, we are told that this is price stability. This facilitates argumentation for the politicians and central bankers, but is infuriating for investors and consumers. It is unfortunate that they, as opposed to the debtors, have virtually no lobby.

Deflation is only really dangerous for debtors, in particular those with high liabilities, as it makes it difficult for them to service and repay their debts. One should always keep this in mind when the press or economists evoke “the dangers of deflation”. Evil to him who evil thinks.