Why Not Deflation?

This week for Ask an Economist, I have a question from Wilson. Wilson rightly notes the Federal Reserve targets an inflation rate of 2% and wants to know why. Why target increasing prices?

Wilson says,

If the FED shoots for annual inflation at 2%; why is inflation positive? Why not shoot for 2% deflation? Is deflation always bad? Can it not be positive?

(I just bought a new color TV for $120.00. Years ago I bought a black & white TV for very much more money when considering inflation. Is that deflation? Is that bad?)

Why 2%?

Interestingly, I’ve already had one person ask why 2% inflation is the target (see my response here). To be transparent, it’s at least somewhat arbitrary. But in that response I provided three of the commonly given reasons.

1. Keeping inflation at a low rate of 2% minimizes the need for individuals to spend resources to mitigate inflation. When inflation is high, individuals have to run to the bank and convert their currency into stable assets. This process costs real assets. When inflation is low, this sort of cost is minimized.
2. Second, a positive rate of inflation is argued to help employers because it allows them to make real cuts to wages without offering a lower nominal salary. If inflation is 2% and an employer offers a 1% raise, the value of an employee’s salary is falling. Some economists argue that the ability to do this is good because workers tend to be unwilling to accept decreases to their salary number. If that’s the case, then the only way to lower salary expenditures is to fire employees. Positive inflation provides an alternative method.
3. Lastly, money, like all other goods, has variable demand. In a world of private money, like gold, an increase in demand for money would lead market forces to increase the quantity of gold money supplied. In other words, there would be more mining of gold if people’s demand for gold-as-money increased. A 2% inflation target often means a steadily increasing money supply. This means that the supply of money could increase to match an increase in money demand, as would theoretically be the case with commodity money.

There are other reasons given beyond what I gave in that article.

Reason four is, some economists who support activist monetary policies argue that a positive inflation target drives up the price of lending and borrowing (the nominal interest rate).

If the nominal interest rate is higher, the central bank has more room to use monetary policy to lower rates and stimulate economic growth. Personally, I’m opposed to an activist monetary policy and am not convinced by this reason, but it is one of the major justifications. In fact, this is one of the primary arguments in favor of raising the nominal interest rate to 3% as my colleague Bryan Cutsinger pointed out to me.

Reason five says that if it’s the case that CPI underestimates inflation (perhaps due to quality improvements being underestimated) then a 2% inflation (based on some government inflation quantification) target may actually be a policy which maintains price stability—a goal prized by some macroeconomists. I owe this insight to Bryan as well.

These reasons are commonly given for the 2% target. It should be noted that even though 2% vaguely seems to match these concerns, it’s not obvious why 1%, 3%, or 4% couldn’t be the pick (except in the case of the last reason).

In fact, zero or negative inflation (deflation) addresses reason one. I tend to be less concerned about reasons two and four as they tend to be more Keynesian concerns, but reason three provides interesting insight into Wilson’s other question—is deflation bad?

Is Deflation Bad?

Economist George Selgin has done significant work which he summarizes here on whether deflation is a bad thing. His short answer is that deflation can be good or bad.

In Selgin’s work, he pinpoints two types of deflation. The first type of deflation is caused by a shortage of money. If, for whatever reason, people do not have access to the amount of cash they’d like to keep on hand, they will tend to hold onto or (using Selgin’s language) hoard money.

This hoarding of money comes with a side-effect. If for whatever reason the quantity of money supplied cannot grow to match the increase in demand, people may choose to hold more cash than they otherwise would. In this case, spending will decrease and resource unemployment (including labor unemployment) will be relatively higher. Because of this the price of goods and services will fall relative to money (in other words—deflation).

Eventually price adjustments will alleviate this shortage, but in the short run there could be painful unemployment which may occur.

In a system where private currencies are allowed, these currencies could (and would) increase in quantity to match the increased demand and alleviate the issue more quickly. If a central bank prohibits this increase in supply, they prolong the money shortage.

Selgin argues that in this sense deflation can be bad, because the money shortage exacerbates resource unemployment as people hold on to money they would otherwise spend, since the supply is prohibited from increasing.

It should be noted that deflation here isn’t really the root cause of the issue—it is a symptom of a shortage of money which goes unalleviated, and the symptom can exacerbate things.

However, as he points out, this is not the only sort of deflation. Some deflation occurs not as a result of an increased demand to hold money but because improved technology makes production of most goods and services relatively less costly. If the supply of all goods and services increases, we would expect the relative price in dollars to fall. In other words, there would be deflation.

This productivity increase is certainly at the root of the lower price of Wilson’s TV, but it’s important to note that a decrease in the price of a single good doesn’t constitute deflation. Deflation as a concept is about the price of all goods and services relative to the price of money. For some goods productivity increases have outpaced the growth in money supply, but overall most quantifications of changes in price find inflation is still generally up. That is, prices are generally higher than they used to be.

Selgin argues no major issues accompany this form of deflation and therefore this deflation is not inherently bad.

Freedom and Deflation

Some argue that even the former case of deflation is not so bad compared to the alternative. These economists argue that money creation even for the purpose of matching increased demand will distort the cost of lending and borrowing such that businesses take on longer term projects than they otherwise would have.

These projects, because they were based on rates distorted by the changing quantity of money, are doomed to fail. This is a very short version of what is frequently referred to as Austrian Business Cycle Theory (ABCT).

Addressing the debate between Selgin and the varying portrayals of ABCT is beyond the scope of Wilson’s question, but there’s a reason I bring it up. Some argue that deflation, even in the case of excess demand for money, is acceptable because the pain from the prices adjusting down will be less than the pain caused by printing money.

In other words, sound economics says that deflation is not always bad, and some argue even more strongly that it is not bad at all when it occurs due to market forces.  

I’ll leave you to research and adjudicate between those views if you’d like, but I’ll first highlight that one easy way to tell which view is right would be if these sorts of systems were allowed to compete. In a world of free competition between banks, these banks would have the ability to issue money to meet excess demand or not.

Ultimately, these companies that issue money would be able to weigh the various costs and benefits associated with increasing the money supply. Some systems, like fiat money, might respond to changes in supply quickly whereas commodity money would adjust more slowly, and a currency similar to Bitcoin may have a hard cap which allows for little adjustment past some point.

Which sort of currency would “win”? I’m not sure. I imagine there would be a bit of a mix.

In any case, the benefit of economic freedom is we place people in a system which arms them with the knowledge and incentives to engage in all sorts of innovation—including monetary and financial.

So is deflation bad? Not at all. A 2% inflation target may sometimes help avoid the money shortages Selgin fears, but it’s certainly excessive when the source of deflation is improvements in productivity.

Courtesy of FEE.org

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