I have a question concerning a deflationary spiral, as many demand-siders fear it.
The thing is that I have thought about this theory over and over, but I still didn’t find any error in it.
If there’s a deflation of, let’s say, 10% a year and most market participants expext this deflation to continue, isn’t there a huge incentive to postpone one’s purchases, since everything will be even cheaper next week/month/year? And will that increase of cash holdings not increase the deflation (decline of price level) even more? And suppose that there is an investment that pays a return of 5% a year, while the annualy deflation is 10%. If I invested $1000 in it, after 5 years I would get back my initial investment (now “only” $620.92) plus $189.53, in sum $810.45. If I just hoarded my $1000 I would get back, well, $1000, so I don’t have any incentive to invest my money (only for a really high return).
So, where are the mechanisms that prevent a deflation from becoming an evermore self reinforcing deflationary spiral?
First, deflation is unrelated to pricefalls except it is one of several possible causes; second, people will bite the bullet and buy(just look at the computer industry).
Take the computer industry for example. Prices continually drop year after year but people buy them every single day. Why wouldn’t someone wait until tomorrow, next month, next year or even 10 from now to purchase a new computer?
The mistake that many people make is to think that the money would be sitting idle during this period and that it would not be spent in the future. When societies time preference is low i.e. there is a high savings rate businesses are able to devote freed resources to expansion knowing that people will spend their money in the future.
A deflationary process is something all growing economies should expect to see as production runs increase over a fixed sum of money. As the value of the monetary unit increases, so will the savings rate and consumption rate, ceterus paribus (if this was not the case, and consumption increased higher relative to savings, than it wouldn’t be deflation, as prices would increase, or what mainstream economists would call an increase in “V”). As savings increases, the rate of interest falls, thus allowing for increased capital investment and a lengthening of the structure of production (making it more capital intensive and efficient). Greater efficiency means lower unit costs; basically, costs fall faster then prices. The rate of profit is based on time preferences, and deflation, that is, falling prices, doesn’t affect time preferences. Lower time preferences mean more savings and a higher degree of capital accumulation, which increases long term profits, always. You’re going to invest becuase the price of investment has fallen (the interest rate), and like all things, investment is price sensitive.
The price of Oil has dropped from $140 to $40 in less then a year. It is now back to $70. According to the deflationary spiral, it should have hit $0?
You are always bidding against others. As a price of a commodity you want to purchase drops, you know that there will be more and more potential buyers as the price drops so drop will be halted and perhaps reversed. At some point you will buy!
You assumed the deflation was expected. Therefore, wages would fall by the same amount and there would be no incentive to postpone purchase. Also, the deflation would be incorporated into the interest rate so there is no problem there either. The problem is specifically an unexpected deflation not written into contracts.
Okay, thanks for your answers. The examples of computer and oil are convincing. Maybe I shouldn’t think of market participants as simple stimulus-response models but as highly complex, competing units.
But I still have a problem with the investor. In a period of high inflation, one has an incentive to invest in goods with a very low rate of return, to save one’s money. Sometimes one even invests in gold, which doesn’t pay any return, to save one’s assets from inflation.
A deflation, vice versa, bears a huge disincentive to invest one’s money since it’s gaining purchasing power by just lying around and the price of your investment good falls together with the income that you derive from it. For example, if I buy an apartment building for $ 10.000.000 to get rental revenues of $500.000 a year, through deflation, not only the price of the building will collapse, but also my yearly income will steadily fall. Wouldn’t that hurt the economy?
It’s worth expanding on Jake’s point, if there is deflation in the face of fixed nominal wages you’re likely to see something the Keynesians described in which people aren’t buying because their purchasing power has been curtailed. Once wages have been pushed above market clearing levels, you’re likely to see an increase in unemployment. However, the problem is that this causes shortages of demand due to loss of purchasing power which is likely to spread across the economy and lead to idle resources.
Why exactly would fixed wage contracts disappear in a free society? Will cultural norms that discourage wage decreases disappear? Will people become omniscient and create contracts that account for every conceivable situation? I have to say, I just don’t understand these kinds of claims at all.
In a free society workers will either take their nominal wage cuts or be fired; that’s why. Wage contracts simply won’t exist because they’re too dangerous for companies, and may not be beneficial for workers. Rather, wages will go up when savings increases, and go down when consumption increases.
That’s part of it. Making new contracts is costly, so companies may prefer long-term contracts with a fairly inflexible wage. Just as important, is that people are risk-averse. Many prefer an average wage to a fluctuating one. This would not change in a free society. Lastly, there are the cultural norms I mentioned that deem wage decreases to be taboo and cause them to demoralize workers.
Yes, inflation tends to encourage investing. A large percentage of investing is done with borrowed (created) money, so the increased investments create an increased cash supply which increases inflation. Similarly, deflation discourages investing, tending to reduce borrowing, reducing the cash supply. The Keynesian theory that lower nominal rates would increase borrowing is very short sighted, because the borrower does not care about the nominal rate, but about the real rate that always moves inversely to the nominal rate. The entire current crises is rooted in the invalid notion that lowering interest rates will increase money distribution. Doesn’t work. Isn’t working. Never will work
The worst thing about potential falling wages is that it will always show in consumer spending (sales). The entire economy rests on the consumer dollar. Falling wages would mean collapse for everything. If wages were normally indexed to the Dow, we would really be in the crapper.
You misunderstand. Central bank injections of money can produce a drop in real rates which persists until prices adjust. That is why it is called forced saving.
A falling wage rate implies a greater demand for labor. Besides, if deflation (or inflation) is expected (written into contracts) then wages and prices will fall at basically the same rate. I don’t see what you are getting at.