U.S. Experience With Deflation

Letter to St. Louis Federal Reserve employee                                   10/03/2010

 Dear Mr. ——,

 I just read your cover article regarding the “U.S. Historical Experience with Deflation” (National Economic Trends, October 2010). As you will readily ascertain I am not a credentialed economist just a street level economic person. As I read your article I was struck by several points. First, the Mark Twain story about the cat that slept on the stove came to mind. You may recall that story. A cat routinely slept on top of what was normally an unlit pot bellied stove. One day the cat jumped up on the stove and found it had been lit and was very hot. The cat learned not to sleep on the stove. The cat should have instead learned to check if the stove was lit.

Is the U.S. experience with deflation analogous? Have we simply learned to avoid deflation at all costs rather than to manage an economy to avoid both excessive inflation and deflation? Is it not possible that our economy would be better overall if we accepted limited deflation as well as limited inflation? If not, why not? Has it been any easier to rein in excessive inflation than to correct excessive deflation?

It is not clear to me why the rationale of reduced economic growth as a result of deflation is accurate. If deflation is a symptom of reduced growth rather than a cause the linkage is even more tenuous is it not? As a street level economic person I would not hold cash per se during deflation but would invest it so as to earn a return. Clearly a 2% deflation makes cash more “valuable” in real terms but cash invested at 3% (or 2% or 1%) provides even more value. Nor would I hold off buying items just because they might be cheaper in a year. This is of course the common argument against deflation.

Indeed, if I need a car why would I wait a year? If I needed (or wanted) a new house why would I wait? Yes, it might be cheaper but 2% or 5% even? Is the “cost” of waiting a year worth some modest percentage of the value? Presumably I would receive at least that much value from the new asset else why buy it? The short answer is yes, I would buy it even if it would be cheaper a year from now.

Consider please every single electronic device created over the past 30 years or more. Every single one has gone down in price year after year but people continue to buy today rather than wait a year or two or three. Where is the practice of sitting on ones cash evident? Would a business not invest today if they believed it would be profitable? As a small business owner I can assure you I would even if I knew that a new building, new equipment, new vehicles – new computers? – would be cheaper in a year. I might lose 5% or 10% of additional profits by waiting for 2% cheaper prices. That would be stupid and while I might not succeed I try real hard not to be stupid.

But there’s the rub isn’t it? Business would invest if they thought it would be profitable but because they don’t think it will be profitable they don’t invest. From my perspective way down at street level the issue isn’t deflation but demand that has been pulled (yanked, jerked, dragged) forward through every imaginable type of macro-economic policy government can conceive. Now that the U.S. has reached the end of that economic gaming the worry is deflation. Yet just as I lag behind the inflation curve so too I would lag (my income that is) behind the deflation curve. Allowing prices to decline may incur some pain (possibly severe) but it would certainly clear the surplus assets faster and permit a more measured and sustainable growth to resume. The big losers will be those who benefitted from the unsustainable, inflationary economic policies. And I care about them as much as they care about me. Seriously though I understand such a policy would present a severe economic disruption but I also believe our nation and economic system is strong enough to survive. Most forests benefit, in the long term, from a forest fire. We need the economic version of a forest fire which is deflation.

Second, why is a 2% inflation rate considered “price stability”? I certainly don’t consider the annual loss of 2% of my dollar value as stable. It means that every 25 years my dollar buys half what it used to buy and that assumes (wrongly I believe) that the published inflation rates are in fact accurate. It also means I must run twice as fast just to keep up with those “stable prices”. Worse, inflation rises ahead of and typically faster than my income. Consequently I am always behind that inflation curve. Government is not of course and the suspicion is that that is the actual intent. Is this the best that our Federal Reserve can do?

Why wouldn’t a true zero inflation/deflation rate be better for the average worker? Would we not gain economic value through productivity gains and technological advances? Why is it necessary to devalue our currency to achieve economic growth? Mind I am not suggesting stable money supply. I recognize that as population grows the money supply must grow to accommodate that increased population. What I don’t recognize is why it must grow faster than the population.

 Thanks for your article. Clearly I found it quite interesting if also frustrating. I’ve not read a review of the economic history presented in this way and I appreciate the perspective.

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