Wednesday, February 22, 2012

Deflationary Universe

Suppose you live in a country with deflating prices – a country where prices keep going down. This might seem like a good idea, but as with much in economics, there is a downside. Suppose you have some savings. In a deflationary regime, banks tend not to pay much, or maybe any, interest, but if you just hang on to that cash, or maybe even just stick it under your mattress, it has the prospect of buying more tomorrow than it can today. This creates an incentive to save, which conversely, is an incentive not to spend. If nobody is spending, demand evaporates, businesses start closing their doors, and the result is recession or depression. This is the regime Europe has imposed on Greece, and Japan has imposed on itself. In Greece, add the threat of default and exit from the Euro zone, and Greeks have a huge incentive to take their money out of Greek banks and put it almost anywhere else, in a German bank or under the mattress.

If you are a creditor, like Germany, deflation has a big upside. The money people owe you becomes worth more and more – if they can manage to pay. For the debtor, it’s the other way around. Many economists – I would have said most before I decided that many economists are idiots - think that the downside of deflation is severe enough that it should be avoided like the plague.

Inflation is opposite in its effects. Creditors are penalized and borrowers are rewarded. Saving is also penalized, since the money one saves will later be worth less. Consequently, everybody has an incentive to spend whatever money they have, either on consumption or durable investments. This is economically stimulatory. High inflation is extremely destructive though, since it strongly penalizes saving and consequently, investment. It also undermines planning of every sort. Navigating between the Scylla of inflation and the Charybdis of deflation, most economic theory advocates a slight bias toward inflation as defense against being sucked into the depths by deflation.

What to do if you are already caught in the outer spirals of the whirlpool? Some prominent students of deflationary events – notably Paul Krugman and Ben Bernanke in his professorial mode – have advocated a moderate dose of inflation as a specific, say 4 or 5%, for a few years. The Bank of Japan, after decades of deflationary engineering, and with Japan increasing laboring under a larger debt to GDP than Greece, has taken a very modest step in that direction, saying they will target a 1% inflation rate.

Can we say too little and too late? Probably so, but maybe it will inspire Bernanke to put his money where his mouth was back in his academic days. The incorrigible Germans are unlikely to be content until Europe is crushed.