The Case For Deflation

After having been previously been obsessed with bashing Germany, Krugman has now started to bash Sweden, saying it has fallen into a “deflationary trap”.

But why should we really worry about deflation? When we go the store we get happy when we get lower prices and sometimes we substute to other goods because they’re lower prices. There is of course a good reason for this as lower prices raises our purchasing power.

At this point, some pro-inflationist might object that lower prices will lower nominal income too, and so not really raise our real income.

That is sometimes correct, but not always. Higher productivity could lower prices without lowering wages or profits. And lower prices can in fact cause that higher productivity by increasing volumes and so reducing fixed cost per unit. Furthermore, if lower consumer prices is caused by lower import prices, national nominal income won’t be lowered.

And in any case, if lower nominal income is the supposed problem, focus should be directly on that, not on the positive of a lower cost of living.

And contrary to a common misconception, deflation isn’t as bad for borrowers as is commonly believed because it reduces their costs as well as their income. If nominal income is reduced by $100 per month while rent is reduced by $50 per month and the cost of other purchases is reduced by $60 per month, it will be easier, not more difficult to pay debt payments. Only if income is lowered by more than the cost of living will it make things tougher for borrowers.

Another argument against deflation is that it could make consumers postpone purchases waiting for lower prices. But first of all, if nominal interest rates fall then this won’t affect this incentive.’

Second, this is exaggerated, as prices of electronics have long fallen, yet people have kept buying it as they want the stuff right now.

And thirdly, better incentives for saving, and against borrowing isn’t really all bad.

Indeed, the main problem with Sweden’s (likely short-lived) deflation is that it will provoke the Riksbank to follow Krugman’s advice and lower interest rates and so encourage excessive borrowing. But that is obviously not an argument for fighting deflation using Krugman’s means.

[This is a translated and slightly reformulated version of a post I wrote in Swedish earlier today]

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2 Comments

  1. The idea of inflation is that cash should lose value compared with every other asset, so people won’t hoard cash but exchange their cash into other assets, such as stock, right?

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