On Wednesday, at a speech before the Economic Club of New York, Janet Yellen joined the growing number in the global financial elite to sound the alarm that we should all be afraid of the scary deflation monster. According to the transcript of her speech, Yellen said, “The FOMC strives to avoid inflation slipping too far below its 2 percent objective because, at very low inflation rates, adverse economic developments could more easily push the economy into deflation. The limited historical experience with deflation shows that, once it starts, deflation can become entrenched and associated with prolonged periods of very weak economic performance.” Janet Yellen, European Central Bank President Mario Draghi, and IMF Director Christine Lagarde have all recently warned of the dangers of deflation in recent months.
Why, exactly, is deflation so scary? Some Keynesian followers seem to try to convince people that the problem with periods of deflation is that people end up postponing purchases indefinitely, waiting for prices to drop. I find this argument strange, however, as it seems to go against one of the most basic tenets of economics: that as prices drop, demand increases.
They tell us that deflation is caused because aggregate demand is too low…and that by keeping interest rates low, it should increase aggregate demand. But why is aggregate demand so low in the first place? Is it not at least partially because, for many average Americans, prices are too high? If prices were to drop, shouldn’t, theoretically, demand increase?
But that leaves at least one other danger associated with deflation that is also occasionally mentioned: deflation’s toll on debtors. Deflation, falling prices, makes paying back debt more difficult and effectively more expensive. Inflation, however, makes paying back debt easier…because you’re paying it back with devalued dollars. Inflation, however, is essentially a hidden tax on the poor. If you have money, then inflation doesn’t hurt you (so much). But if you’re already barely making it, then inflation kills you.
You will hear governments, especially in Europe but also in the U.S., talk about deflation with nearly mortal fear. Why? It’s because Europe (and America and Japan) are indebted up to their eyeballs and they’d be much better off if they can manage to inflate away their debts. Central banks know that if there’s deflation, however, then there will likely eventually be defaults…perhaps even a chain reaction of defaults. And in a highly leveraged financial system, with record levels of government debt, corporate debt, and margin debt, deflation and defaults would be potentially devastating. (Who, by the way, are these debtors? Well, ultimately, much of America and the Western world. The federal government has over $17 trillion in debt. U.S. households have over $13 trillion of debt. There is also a record amount of corporate debt. For these debtors, inflation is good).
But inflation is also good for asset holders. As prices are inflated, so often is the value of assets. Furthermore, people usually forget that the debt on one person’s balance sheet is an asset on somebody else’s. Should deflation occur, and defaults inevitably rise, the debtors could find relief through restructuring, while the (rich people) who expected the debt to repaid would have to recognize losses on their (often massive) balance sheets. This extend-and-pretend game keeps asset prices up, helping both debtors and asset holders. Who does it not help? The poorest among us as well as the middle class, who have little in the way of either assets or debt.
We shouldn’t completely ignore the positives that the world was able to experience faster than we otherwise would have partially because of fiat currencies, credit expansion, and slow but steady inflation. The explosion of credit growth has expedited all kinds of scientific advancements that probably wouldn’t have been possible so quickly if there had been a more limited credit supply or no inflation. But, we’ve reached a point where debt is literally maxed out. And so central banks can’t afford to let deflation happen or there will be massive defaults. And that is why they are really so afraid of deflation and why they continue to warn of the scary deflation monster. On one side of the global financial system there is the deep and deadly pit of deflation. And on the other is the perilous and destructive road which is rampant inflation. We all must pray that the Federal Reserve and global central banks are able to walk the tightrope. Otherwise, we all fall off together. Our lives are in their hands, and so we just hope that they really know what they’re doing and that their grand monetary experiment works.