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BASTIAT REVIVAL BLOG VOL. 2, ART. NO. 1 (2011) DEFLATION IN A DEBTOR NATION BRAD DeVOS* Deflation is an economic principle that most people do not understand, let alone worry about on a daily basis. So, when Jeannine Aversa, economics writer for the Associated Press, writes on the subject, most readers probably take her at her word. In her September 22nd article, “Unusual worry for economy: Is inflation too low?”, Aversa (2010) claims that deflation will cause falling prices, consumer fear, unemployment, and bankruptcies which will lead to an overall economic disaster. However, there is much more to deflation, and depicting it as an outright economic bad is very shortsighted. Making matters worse, Aversa (ibid.) does little to support the claims she makes within the article. A typical reader may not know much about deflation, and this article does very little to educate them on the subject. What it does accomplish is making the reader feel that deflation may be the worst thing that could ever happen to the economy, and that intervention by the Federal Reserve is the only way to avoid it. While Aversa (ibid.) lists several reasons why deflation is bad, I will address two of her major points. First, Aversa’s (ibid.) overall point is that economic growth simply cannot occur during periods of deflation. The article states, “Once deflation takes hold, it can wreck an economy. Workers suffer pay cuts. Corporate profits shrivel. Stock values fall. People, businesses and the government find it costlier to 1 2 BASTIAT REVIVAL BLOG 2, 1 (2011) pare debt. Foreclosures and bankruptcies rise” (ibid.). While the author would have you believe this to be an absolute fact—it is not. From 1800 to 1913 (the year the Federal Reserve was created), prices fell by a staggering 21.4%1. This was the height of the Industrial Revolution, and often seen as the most prosperous time in Western history. In comparison, the deflation rate during the Great Depression was 15.8%2. If deflation “wrecks” the economy, how could the US have deflation during an economic revolution and an economic depression? The truth, I believe, is much more complex than Aversa (ibid.) and the Federal Reserve would like us to believe. The fact is, periods of inflation and deflation were commonplace before 1953, and economic growth occurred despite this. In the 1920s, deflation and inflation were both viewed as a negative. Economists argued that deflation hurt the entrepreneur, while inflation harmed the worker (Delong and Sims 1999, 230). Since then the U.S. has had varying rates of inflation, and until 2009, it had always remained positive3. It may be because inflation has been the norm for so long, that deflation is now worrisome. It is simply unknown territory to most consumers. To make matters worse, we have begun to rely on inflation to fuel our debtculture. Up until the 1970s, the average American household had a 66% debt-to-income ratio. This ratio climbed to a staggering 113% between 1981 and 2003 (Iacoviello 2008, 930). Americans are conditioned into thinking that some debt is “good” and some debt is “bad.” Good debt (homes, land, education, etc) is good to have because, as prices and wages rise, the burden of 1 Historical consumer price data: 1913 =.099, 1800 =.126 ((.099 - .126)/.126)x100)=-21.42 (Sahr 2008). 2 Historical consumer price data: 1937 =.144, 1929 =.171 ((.144 - .171)/.171)x100)=-15.79 (Sahr 2008). 3 Between 1953 and 2009, the inflation rate has ranged from 0% to 15.8% (Trading Economics 2010). DEFLATION IN A DEBTOR NATION 3 debt lessens over time. Paying $250,000 for a home today seems normal, and since ‘home prices and wages always go up’ borrowers and lenders risk very little when they sign a mortgage agreement. With predictable and reliable inflation, a homeowner can always sell their home and pay off the entire balance of the mortgage. However, when home values do decline, being a quarter-million dollars in debt becomes a real issue—and all debt suddenly becomes “bad” debt. Our standard of living now almost requires the average American to take on debt. With little risk of deflation, lenders drastically reduced the demands they place on borrowers. Before the Great Depression, a 50% down payment was commonplace and mortgage terms were much shorter (normally 5-10 years) (Green and Wachter 2005, 94). At that time, borrowers and lenders protected themselves from price reductions. With such a large down payment, even if prices fell by 50%, mortgagors could withstand substantial price decreases without having to foreclose or go into bankruptcy if they had to sell. As a result, even during the peak of the Great Depression, only 10% of American homes were in foreclosure. Today, or at least before 2007, 30-year 100% loan-to-value (LTV) mortgages are commonplace. With absolutely no down payment, households are entirely reliant on inflation to remain financially secure. The result is, those financing their home with a sub-prime mortgage (the riskiest of all mortgages) end up in foreclosure 18% of the time—and this was before the sub-prime crisis hit (Gerardi, Shapiro, and Willen 2007, 2). Foreclosures and bankruptcies may indeed rise if we experience deflation as Aversa (2010) suggests. However, deflation merely exposes an underlying problem—it is not the cause of it. The second point I will address is Aversa’s (2010) conclusion that the inflation rate should be used as an economic growth indicator. The author claims that inflation is a sign that 4 BASTIAT REVIVAL BLOG 2, 1 (2011) “shoppers are confident enough to spend and businesses confident enough in customer demand to raise prices.” Furthermore, “Companies can’t raise prices because high unemployment and scant pay gains are making shoppers cautious. Companies must resort to discounts and promotions to entice them.” (Aversa, 2010) Both of these statements are misguided. Aversa (2010) would have you believe that companies must arbitrarily raise prices from time to time in order to remain successful. If they cannot, they will fail. It appears that Aversa (2010), like most consumers today, assumes that inflation is the norm and has adjusted her thinking in response. If we remove the assumption that inflation is a sign of normality, we can look at deflation more objectively. It is true that during times of inflation, firms must constantly increase prices to remain profitable. However, this is only in response to increased input prices. During deflationary periods, firms see lower input prices and can lower prices to stay competitive and profitable at the same time. There is simply no reason for firms to raise prices when input prices fall. What is more is that, when prices fall, real wages increase and employees have less reason to ask for raises. In fact, in a deflationary economy, new workers begin to expect future prices to be lower and are satisfied with lower wages. These lower wages correct for the lower prices, and real wages begin to fall back to its original level. Nominal pay gains are not needed during deflationary periods, plus real pay gains are made through lower prices. Therefore, Aversa (2010) is correct in saying that pay gains are “scant,” but this is only natural when prices are falling and should not be used as an economic indicator. It is possible that since our inflationary period has been so long, Aversa (2010) assumes any future deflationary period will be just as long. Long-term deflation can lead our economy into the liquidity trap, whereby consumers demand less and investors are reluctant to borrow (despite ultra-low interest rates) because DEFLATION IN A DEBTOR NATION 5 they expect prices to be lower in the future. However, cyclical inflation (short periods of inflation followed by short periods of deflation) should not be cause for concern. The problem is that we have become reliant on inflation, and are so far in debt as a nation, that most Americans live in constant economic peril. The result is that any deflation (short or long term) is a recipe for an economic disaster. This, not deflation, is the root problem. Aversa (2010) lists what could happen if the liquidity trap occurred, but she unfairly blames deflation itself for the resulting economic mess. Any economic issues arising from short-term deflation are merely symptoms of much larger cultural problems. Furthermore, simply promoting deflation as an outright economic evil could result in a self-fulfilling prophecy. If consumers believe that deflation is a sign of bad things to come, then they will naturally get nervous at the first signs of deflation. This nervousness may in turn lead to the dreaded liquidity trap she alludes to, turning a short-term price adjustment into a long-term deflationary crisis. Works Cited Aversa, Jeannine. 2010. Unusual worry for economy: Is inflation too low? Associated Press. September 22. http://finance.yahoo.com/news/Unusual-worry-foreconomy-Is-apf-1253519994.html?x=0. Delong, Bradford J., and Christopher A. Sims. 1999. Should We Fear Deflation? Brookings Papers on Economic Activity 1, no. 1: 225-252. Gerardi, Kristopher, Adam Hale Shapiro, and Paul S. Willen. 2007. Subprime Outcomes: Risky Mortgages, Homeownership. Working Papers - Federal Reserve Bank of Boston. No. 07-15 (December 3). http://www.bos.frb.org/economic/wp/wp2007/wp0715.pdf. 6 BASTIAT REVIVAL BLOG 2, 1 (2011) Green, Richard K., and Susan M. Wachter. 2005. The American Mortgage in Historical and International Context. Journal of Economic Perspectives 19, no. 4 (September 21): 93-114. Iacoviello, Matteo. 2008. Household Debt and Income Inequality, 1963–2003. Journal of Money, Credit and Banking 40, no. 5 (8): 929-965. doi:10.1111/j.1538-4616.2008.00142.x. Sahr, Robert C. 2008. Inflation Conversion Factors for Years 1774 to estimated 2018. Oregon State University. http://oregonstate.edu/cla/polisci/download-conversionfactors. Trading Economics. 2010. Inflation. Trading Economics. http://www.tradingeconomics.com/. BRAD DeVOS is managing director of The Bastiat Society. E-mail: [email protected]. *