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Deflation and Waiting Consumers

Monday, 23 August 2010 08:11

The NYT had an article this morning warning of the dangers of Japanese-style deflation. While Japan has suffered from weak growth since the collapse of its stock and housing bubble, deflation has not been a serious factor in this weakness. Consumer prices in Japan fell in 6 of the 19 years from 1991 to 2008. The largest decline in this period was a 0.9 percent decline in 2002. (Japan's CPI fell by 1.4 percent in 2009 and is projected to do the same this year.)

The consequences of relatively low rates of deflation are minor. While the article asserts that deflation causes consumers to delay purchases this is implausible on its face. A 1.0 percent rate of deflation would mean that if a person delayed buying a $500 television set for 6 months, they would save $2.50. The gains from delaying smaller purchases would be proportionately less.

The problem facing Japan (and now the United States) is that it would be desirable to have a lower real interest rate. Since nominal rates cannot fall below zero, an inflation rate that is negative makes matters worse by raising the real interest rate. However, the fact that prices are actually falling is not important. The drop in the rate of inflation from 0.5 percent to -0.5 is no different in its impact on the economy than the drop in the inflation rate by 1.5 percent to 0.5 percent. Both are hurtful because they raise the real interest rate by 1.0 percentage point.

The article also wrongly asserts at one point that Japan is prevented from doing more stimulus because its debt is twice the size of the Japanese economy. This is not a constraint at present. The Japanese central banks hold close to half of the debt, so it does not impose a substantial interest burden on the country. Furthermore, markets are willing to buy government debt at extremely low interest rates, so there is little fear about default or inflation.

It is also worth noting that the Japanese central bank could adopt a policy of targeting a higher inflation rate, such as 3-4 percent. This course of action has been advocated by Paul Krugman, Ben Bernanke, and Olivier Blanchard, the chief economist at the IMF. An article that is ostensibly examining the options available to Japan's policymakers should have noted included this one.


Comments (13)Add Comment
Why stop there Dean?, Low-rated comment [Show]
written by izzatzo, August 23, 2010 10:17
The trade off to which Baker refers lies between lenders holding sunk cost of debt incurred for future collection, compared to not-yet incurred marginal costs by private investors more likely to spend on opportunities for which a higher rate of inflation would increase their real rate of return.

For whatever reasons politically in the US, creditors have much more lobbying power to beat down such reform, in order to collect higher real future returns from debtors at lower rates of inflation, or deflation.

In effect, lenders and holders of long term debt are shielded from risks of inflation or more broadly, from risk of government undertaking a policy designed to increase employment during a deep recession.

It's critical to keep the appropriate priorities in mind. Upper class members of the financial community are not expected to take risk, which is trickled down to others, to face risks on their behalf.

Without this policy, all lending and credit would dry up and we would all die quickly in a take-it-or-leave spot market based solely on hyperinflated cash. It's better to be unemployed and homeless than dead. Read Econ 101.

Stupid liberals.
Deflation would help consumers
written by al, August 23, 2010 10:44
Some economists keep telling us that deflation, even a little bit, is REALLY BAD. They tell us our policies in Washington should be seriously changed so that we can to avoid deflation.

But, this article makes me think that the consumer would benefit from a long period of flat or falling prices.

I mean, hey, the US is a consumer-centric economy with a puny (if any) health care safety net for the average person, and skyrocketing college tuition costs.

US consumers could really benefit from deflation. If in Japan, a little bit of deflation was not a bad thing -- and they have universal health care and much lower education fees -- than a little deflation should be somewhat more helpful to US consumers.

I fear deflation a lot less after reading this article.
Why Wait?
written by Hugh Sansom, August 23, 2010 11:09
Just as a matter of plausibility, there are two obvious reasons why consumers would either stop spending or put off spending. One is an expectations that prices will soon be sufficiently lower to justify waiting. The second, and more important, is that people just don't feel they can afford it.

Who in this country feels they can spend right now? The rich, certainly. The huge and pretty public (though not entirely public) transfer of wealth from average American to wealthy must have, in some measure, the side-effect of reminding the robbed that we are now poorer so the rich can be richer.

In some arenas, there is a kind of product inflation that might parallel price deflation. Computer, smart phones, digital devices get so much better so quickly that, with even a slight economic downturn, there is a significant incentive to postpone purchases. Likewise software. Manufacturers like Adobe make a big show of releasing supposedly major upgrades every year, for which they charge huge sums. If the software really is getting so much better so quickly, why not wait another year and save some money now?

Save now, because tomorrow Government and Corporate America will be trying to rob you of still more of what little you have.
written by Lord, August 23, 2010 11:17
Low levels of deflation are not generally a problem beyond real interest rates that are too high, but this is not the case for higher levels of deflation which encounter price and wage rigidities and can lead to a downward spiral in the economy. Any deflation can increase the probability of this occurring.
written by Queen of Sheba, August 23, 2010 11:37
One thing is absolutely certain regarding a time of deflation: the debt a person holds does not "deflate." The price for most everything else might go down, but the price of the things you've already bought with borrowed money doesn't. Lower prices on everything else might make it easier to pay off existing debt, but only for a while, e.g., until you lose your job (or your company loses its customers) because customers are no longer will to pay the cost of the company's products or services.
written by Clifton, August 23, 2010 11:51
Dr. Baker,

Speaking of interest rates and consumer behavior, what did you make of Gretchen Morgenson's column on Sunday, "Debt's Deadly Grip"? I often agree with her, but she seemed off the mark on that one. Would much appreciate your thoughts. I'm a big fan.

written by bailey, August 23, 2010 3:08
Since our economy was inflated some 40% by leveraged gambling isn't it reasonable to EXPECT it to return to long term growth rates FROM where it was before the gambling wnent nuts? Am I the only one to notice how much prices increased in Home Depot, for example, over the last six years?
What is deflation or inflation anyhow?
written by Ron Alley, August 23, 2010 9:11

You ain't the only one. The prices of most things I buy - whether at Home Depot, Lowes or Menards and just about any other retail outlet - have increased. And what about the cost of medical, dental and other services?

Why are the economists (including Dean Baker) so insensitive to the changes we actually observe?

My thought is that if any of those economists would speak candidly, they would admit that the CPI and perhaps other measures of price change systematically understate inflation. However, the inflation measures the economists use have the advantage of being consistent and widely accepted. The economists (unlike consumers) gladly trade consistency and acceptance for accuracy.
written by deanx, August 24, 2010 4:53
In my community, far from the beltway, I am seeing alot of signs of wage deflation. Entry level jobs are being offered at 30-40% less wages, and with no benefits. Refilling more senior positions are be downgraded by one or two labor grades. It will not be long before this effects people in existing positions.

I suggest this is a canary in a coal mine of future deflation which will eventually 'trickle up'. While these employers presently proudly announce the impact of this on the bottom line, it strikes me this how the Great Depression began.
written by zinc, August 24, 2010 6:11
As long as the US maintains the policy of wealth redistribution to the top, deflation, stagnation, and import penetration will continue, as they have since Ron Reagan.

Money in the hands of the less fortunate 95 % leads to strong consumption, job growth, capital expansion, inflationary pressure, and a slight emphasis non-price competition, and positive interest rates. The loss of jobs is not the only distortion caused by wealth and income polarization. The low interest rates have caused the fixed income people to curtail spending also.

O'Bama's plan to eleiminate the tax cuts on the wealthiest is a good start. However, seeing the repeal of the 15% tax rate on wall street hedge fund managers go down in defeat is not a good omen.
written by bailey, August 24, 2010 11:43
Ron Alley, There are many of us that understand this. Surprisingly, the answer is simple, demand anyone who talks about "inflation" to tie their measurement to a population sampling - ANY population sampling for starters!
Economists, Dean Baker and a small minority excluded, have disgraced themselves & their profession over the last 15 years.
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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.