Is Inflation Or Deflation Bad For The Economy? Well, It Depends…

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The more I study Economics, the less I fear DEFLATION.  And let us remember, by “deflation” or “inflation” we mean, respectively, the lowering or rising of PRICES in a widespread way.  The value of the CURRENCY moves in the OPPOSITE direction.  For example, if an economy is experiencing “inflation”… it is PRICES which are “inflating.”  Necessarily and concurrently, the value of the currency will be moving in the other direction, deflating and becoming less valuable in the marketplace.  Prices and Currency-Value, are locked into a oppositional relationship.  So, to say there is Price Instability is the same as saying there is Currency Instability, and vice-versa.

I’ve come to think that, fundamentally and directly speaking, there are really only two main problems with instability in Currency and Prices.  One problem is more domestic in nature, and the other more international.

The domestic problem with an EXPECTED (or, if you will, “routine”) inflation or deflation stems from the LAG-TIME between the change in prices and the change in wages.   If there were no Lag-Time between how the different parts of the economy adjusted to the changing worth of money, then there’d be no purely domestic problem with Inflation or Deflation.  As it stands however, there is a Lag-Time and thus there are problems.

If there is price INFLATION, then people’s wages are likely to be always playing catch-up to prices… the price of items in the marketplace will rise before wages adjust.  The reason is simple… along the chain of supply of goods, price increases spread like wildfire… but one is lucky if their wages increase twice within a year.  Furthermore, if an employer is being squeezed by higher supply prices, he is going to be less– not more– likely to be generous with wage increases during a time of inflation.  Sure, he can pass on some of his additional costs to his own customers– but here again we run into the Lag-Time problem– his customers will experience PRICE-SHOCK as their own wages have also likely not risen as quickly as prices.  Thus, the seller must absorb, at least initially, some of the supply-price-increase himself, not exactly putting him in mood to raise all wages across the board.

Additionally, any middle or long-term savings or investments the wage-payer has made will be simultaneously less-returnful, further pinching his own finances.  For example… pretend the wage-payer bought a bond for 900 hundred dollars before the inflation set-in, with the expectation that at the end of the bond’s term he is to be recompensed with 1,000 dollars.  However, when he is paid-off his 1,000 dollars after the onset of inflation, those dollars will not buy as much as he has anticipated since prices have gone up.  He may even LOSE money in a REAL sense, if say, his 1,000 dollars now only buys what eight hundred dollars would have bought before the rise in prices.  Again… not a good time to ask for a raise.

[On the other hand, inflation can be good for debtors (as far as their loan balances go) for they will be paying back their loans with less valuable dollars.]

If the currency/price instability takes the form of price DEFLATION, then the situation becomes the mirror view of what I’ve just described above… and again, it’s all due to the Lag-Time problem, since the different parts of the Economy respond unevenly to the situation (I’m still assuming PREDICTABLE inflation/deflation).

The investor (bond-buyer, etc) this time (under deflation) makes out well– if prices have gone down, then his pay-off of a 1,000 bucks will actually be worth MORE than a thousand dollars on the day he bought his bond. Conversely, the debtor has to pay off his loan with dollars worth more than they were when he agreed to his terms.  This will be painful for him.  On the bright side, prices in the marketplace are falling, so his money is stretching farther.

However, wage-payers will be facing another type of dilemma here.  With INFLATION, business owners were being squeezed by higher supply prices.  With DEFLATION, they will be competing in a marketplace in which the prices which his competitors are charging are generally lowering.  He will then either need to reduce his own prices to match them, or else suffer a loss of sales.  However, if his inventory pre-dates the inflation, he may wind-up selling at a “real” loss.   His drop in revenue could mean that he will eventually need to lay off employees (theoretically, this could also mean reducing wages, but in reality wages are very “sticky,” and personally, I’ve known a lot more people who have been laid-off or who have gotten their hours cut than had their [non-bonus] wages reduced).

And we must keep in mind– an “economy” is actually a collection of economies… There are transportation economies, utility economies, food economies, and so on…  Not every industry and supply-chain will see its costs rise and fall in exactly the same proportion to the other economies.  Thus, during a time of price movement (be it inflation or deflation), not every seller will be affected equally.  The lucky ones may even find their profits rising as their competitors with more-affected supply chains suffer losses.

So much for the DOMESTIC side of price Inflation and Deflation (A.K.A., currency devaluation and up-valuation).

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The INTERNATIONAL problem with price INFLATION is two-fold, involving both money supply and product demand.  On the money supply side, foreign investors will not want to buy into countries possessing a currency which may plummet and reduce the value of any returns.  On the product-demand side, foreign buyers will buy fewer products from a country whose prices have gone up.

Furthermore, in reality, during inflationary times, a home government does not simply stand aside as everyone runs out of money… governments will cause to be made available MORE money.  Ironically, the pumping of MORE money into the inflationary economy will speed-up the decline in the value of the currency and increase prices even more.  If the fundamentals of the economy which caused the original price inflation do not correct, than the increase in the money supply will exacerbate all the domestic and international problems presented by rising prices… prices which by this time, will include higher (nominal dollar) wages for American laborers, as enough time elapses and even wages begin to adjust to the increase in money supply and prices in the economy.

I find a completely different scenario when it comes to analyzing DEFLATION from the international perspective…  Unless the currency is being erratic– meaning it could go down OR up– I don’t think straight domestic price deflation would be DIRECTLY discouraging to foreign investors at all.  Here’s my reasoning…

If there is a general tendency toward deflation, then the foreign investor may find that his investment paid back in dollars worth more to him than he anticipated before the deflation–  especially if the home government REDUCED the amount of currency in circulation in an effort to halt price deflation, thus further increasing the real value of the currency.  Furthermore, prices and wages in the “deflating” country would go down– making their products more sale-able in the world market.

The only problem I see with Deflation in international markets is indirect…  If the deflation occurs in such a way that domestic economy shrinks, then foreign monies may be lured to other places on the globe with “hotter” economies– economies with greater chance of higher returns upon their investments.

Deflation actually may not be a cause but a SYMPTOM of an economy in trouble.  Under this scenario, there are goods at market which cannot be sold due to an economy that is ALREADY bad, and so sellers begin lowering their prices. In this situation, foreign investors may feel less confident that businesses in the deflating economy will actually make a profit.  This should not affect investment in domestic GOVERNMENT securities– unless the economy was so catastrophically encumbered that the entire government could tumble.

But then… perhaps both price Inflation and price Deflation are to ALWAYS be treated as effects and not causes of the state of the economy.  If Deflation is a sign of a bad economy, in the sense that nobody can afford to buy things until the prices drop, then Inflation might mean that the converse is true–  the economy is a good one in which everyone is all-too-capable of buying things at current prices, and so sellers find themselves able to RAISE prices.

But then, where does this leave the foreign investor?  If he is hesitant to invest in a faltering economy (of which deflation is a sign), shouldn’t deflation’s opposite– inflation– spur him to invest in the country of rising prices in spite of the risk of begin returned less-valuable currency at the end of his investment-term?

The view that emerges — at least for me– is that…

1)  foreigners WILL invest in a deflationary economy — as long as the overall economic fundamentals are decent and they have faith in the particular company or security in which they are investing, and…

2)  foreigners WILL invest in an inflationary economy– as long as the economy is booming– so that returns outpace losses due to currency devaluation on the world market.

Basically, and frustratingly, this means there are no absolute outcomes when it comes to inflation and deflation.  It all… depends.  No two occasions of price/money/wage instability are the same– just as no two sunny, or no two rainy, days are exactly the same… there are far too many factors in play to ever make either environmental or financial prognostication one hundred percent accurate.

This unpredictability of economic results in times inflation/deflation is the most convincing argument in favor of maintaining a generally stable price and currency level… The temporary gains which a country may experience by finagling with prices and money supply are not worth the long-term risks and unintended consequences.  And on the individual level, both domestic residents and potential international buyers, sellers, and investors can make reasonably secure assumptions about the future and evaluate their financial risks more truly and confidently– which in turn will reduce the number and severity of international shocks to global trade.

I think most economists today, especially those with any real power over things like interest rates, believe in trying to maintain an economy of slowly but steadily inflating prices.  But as far as I can tell, there is no sound reasoning behind favoring a low-inflation world over a low-deflation world or a world with a steady price level.  PREDICTABILITY is the key, the important thing here.  Whether prices go up or down or stay the same is not so important– for the domestic economy– as that the changes are predictable.  Remember my earlier contention… domestically speaking, it is only the LAG-TIME in full across-the-board adjustment to predicatable price/money changes that actually causes disturbances in the domestic economy

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