Deflation

Discussion

Why deflation is a bad thing

Yanis Varoufakis:

"In a recent debate, I was confronted with the argument that deflation is a godsend. “Poorer people crave lower prices”, I was told, “and they cannot understand why ‘elitists’, like yourself, oppose them”. Of course people, especially those who struggle to make ends meet, prefer lower to higher prices other things being equal. But under the heavy shadow of deflation other things are not equal . Deflation is indiscriminatory. Once it sets it, all prices subside, including the price for labour. In fact, wages tend to fall faster than prices of other goods during deflationary times, leaving the weak poorer. Worse still, deflation reduces investment which, in turn, raises unemployment.

Some readers find it hard to see why wages must fall faster than prices and why jobs are jeopardised as prices fall. To see why this is invariably so, compare the degree of power over price that a corporation has (e.g. Walmart or Mercedes Benz) to the degree of power over the wage of a blue collar worker. As customers are no longer prepared to pay the same prices as before, the corporation can limit the decline in the price of its wares by restricting output. Its price will still fall, but not by as much as it would have done had the corporation not had a capacity to influence price through restricting supply. In sharp contrast, the blue collar worker has no comparable power to restrict her labour supply in order to arrest the fall in her wages. The result is twofold: As corporations restrict output (to reduce the rate at which prices fall) their demand for labour falls, the result being even greater wage reductions accompanied by layoffs which, in a never-ending recessionary circle, reduce further the demand for goods.

Moreover, as prices fall, manufacturers face a timing problem. Assuming there is a time lag between ordering raw materials and shipping the final product to market, deflation means that firms buy their inputs when average prices were higher compared to their level at the time of shipping the final product. Thus the greater the rate of deflation the lower the profit rate and the larger the number of companies that are forced either to lay off workers or to close down completely.

Lastly, as prices fall consumers with some savings have every reason to delay the purchase of durables (e.g. white goods or cars) since they know that their saved dollars or euros will buy them a lot more (or a better model) of these goods the longer they wait. But this is terrible for the manufacturers as well as for their workers and suppliers.

On this last point, a reader challenged me that falling prices are a fact of life and they do not seem to be a problem: “I can think of many goods and situations”, he wrote “in any economy right now where if you delay a purchase, you’ll get ‘more’ for your dollar.” Of course. But these falling prices are not a problem when it is not all prices that are falling at once. The benefit from patience in the US today comes from actively searching for a better deal in a market where information is imperfect. Deflation, on the other hand, rewards the patient just for being patient, rather than being a reward to costly searching activity. Under deflation everyone benefits from waiting and aggregate demand thus collapses (penalising us all).

If, under such deflationary circumstances, monetary policy cannot be loosened up to stop the decline of average prices, wholesale disaster is guaranteed. This was the terrible flaw of the Gold Standard, in the mid-war period. It is the Achilles Heel of Bitcoin today and, indeed, remains a design fault of the Eurozone too." (http://yanisvaroufakis.eu/2014/02/15/bitcoin-a-flawed-currency-blueprint-with-a-potentially-useful-application-for-the-eurozone/)