We have been learning in macroeconomics class that deflation is an incredibly negative situation, especially from the perspective of central banks. Monetary policy becomes less effective in managing the economy once you have serious deflation. From there the basic argument goes that the economy may enter into a deflationary spiral causing lower prices to lead to lower production and therefore lower employment.
Another classmate asked the basic question: is deflation really all bad or is it just bad for our current system? There is no incentive to save now because of the artificially low-interest rates that set by the Federal Reserve. If interest rates reflected the cost of money, as we defined it at the beginning of class, then people would be rewarded for saving and as deflation started to take place interest rates would rise causing more savings and less consumption.
Now this increase in savings would cause aggregate demand to fall in the near-term. But what are savings? Saving is just setting aside money for future spending. No one saves with the intention of never spending the money, they just think they can put it to better use later.
So if interest rates were not set by the Fed but instead allowed to reflect the natural price of money, more people would save and be rewarded for their savings. At some point even if interest rates were 0% forever, debt taken on by individuals still means that future consumption is merely being pushed forward for present spending. That does not change the basic definition of debt as something that has to be paid back. The debt still must be paid back there is just less future consumption.
Back more to the original question now, if deflation starts and people leading up to this have been rewarded for saving, then wouldn’t people eventually buy things as prices fell even if they thought the price might fall a little bit more? Or put another way, there has to be some threshold where people would see an opportunity to invest even if prices could fall further? I’m thinking of Warren Buffett investing billions into Bank of America recently when few people wanted anything to do with the banks.
One of the counter arguments seems to go that: lower-income people will never have a large enough savings cushion to weather a true deflationary spiral with high unemployment. My question now though is, are people really better off with the current system? It looks like we have at least another year or two of slow to low growth. That hurts everyone but especially the people who cannot find jobs to get back into the economy.
If you see something I am missing here, please comment. This is a genuine question that I am trying to learn more about and answer.
No related posts.
Here’s two interesting blog posts that talk about Irving Fisher’s debt-deflation theory.
http://blogs.wsj.com/economics/2008/11/20/whats-so-bad-about-deflation-remembering-irving-fisher/
http://www.urbandigs.com/2008/10/fishers_debtdeflation_theory.html