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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
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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
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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.
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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].
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