Deflation is a a nominal phenomenon and is determined by the quantity of money available in the economy relative to the demand for money. Deflation will result if:
- Strong productivity growth is not matched by a likewise increase in the money supply.
- Declining money supply due to restrictive monetary policy or a collapsing money multiplier.
The chart lists annual inflation in the U.S. spanning back to the Great Depression. This 43-month recession saw deflation up to -10.74% and a severe contraction in economic activity; the average annual growth rate spanning 1930-1933 was -9.3%.
This is a perfect example to illustrate how deflation can be a serious problem. Driven by severely restrictive monetary policy (the central bank was not increasing the monetary base quickly enough), saving was wiped out and the availability of goods and services fell substantially.
The classic economic costs of deflation are:
- With debt obligations being set in advance and deflation occurring unexpectedly – think of a fixed mortgage rate –all nominal variables fall (labor income), except for those tied to preset debt obligations. The resulting economic impact is a transfer of wealth from the debtor to the creditor. The deflation gives easy money to those who made the fixed loans, and causes difficulty in making payments for those who took out the loans. Debtor spending falls (must consume less to make the mortgage payments) and saving falls, but this is unlikely matched by an increase in spending and saving on the part of the creditors. The aggregate effect can be disastrous: spending contracts, saving is wiped out and default rates skyrocket.
- Production and consumption decisions based on price expectations change. Consumers and firms do not know what to expect going forward, resulting in less demand and less production. If deflation becomes embedded in consumer expectations, consumers spending falls and economic growth suffers further.
Deflation is not an axiom of recessions. Prices fell during the 2001 recession and afterward because of the weak labor market. The rising unemployment rate put downward pressure on wages that dragged down price pressures, resulting in sharp disinflation (deflation on a monthly basis). Furthermore, prices fell in the 1981-1982 recession because Paul Volcker restricted the money supply with the exact intent of driving down inflation. However, during the 1980 recession, inflation hit 14.73% during the quarter that saw a -7.8% contraction.
Some say that the Fed is pushing on a piece of string: flooding the banking system with massive amounts of liquidity and seeing no stark improvement in the macro-economy. However, what the Fed is doing is maintaining positive money supply growth positive. As long as Bernanke keeps the liquidity hose on and the money multiplier doesn’t fall to zero, the money supply will not contract.
The money supply is growing and sharply reducing the probability that deflation – especially levels seen in the Great Depression – disrupts the macro-economy.
To be sure, the Fed is worried about deflationary pressures, as illustrated by its shift toward quantitative easing. However, the Fed is doing its job by keeping the money supply afloat. It’s Congress’ turn to step up with its $500 billion stimulus package to rescue the macro-economy.