Pulling off the plaster

On my blogpost "There's no more money" I stated that one reason for the Bank of England's QE programme was to stave off deflation. There has been one comment in response:

                                                "Why is deflation bad?"

It's an amazing question.

My immediate reaction was "well, obviously it is".  And then I thought, "well, actually it's not obvious at all, and I don't know the answer".  So I did some research to find out what economists say about whether deflation is a good or bad thing.  I found Krugman's article on this, and several others as well. As I expected, Krugman's article was accurate in description but uniformly negative in opinion about deflation. But the others were more balanced. And one, ElliotWave, pointed out that deflation was not bad unless you were unprepared for it.

Now, according to ElliotWave's description, the UK is pretty unprepared for a period of deflation.  Households, businesses and government are all carrying exceptionally high levels of debt. Government debt is heading for 70% of GDP. Individual debt is over 100% of GDP. And corporate debt is higher still.  But deflation seems to be what everyone wants.  The Government is putting in place measures designed to reduce the rate at which government debt is growing, which generally reduce the amount of money available, to households in particular.  Banks are not lending anything like the amounts they were prior to the financial crisis. And individuals and businesses are choosing to pay down debt rather than spend money. All of this adds up to a severe and rapid contraction. Deflation is not just a risk, it is inevitable.

But my questioner wants to know whether deflation is a bad thing. And after reading all those articles and papers, I don't know any more than I did before, except that this is another subject on which economists don't agree. But of one thing I am certain. Whether deflation is a bad thing depends on the circumstances. And in the present economic circumstances I don't think it is a bad thing at all.  I think it is essential.  The only debate should be over how fast the economy should deflate.

Let me explain my thinking. 

The prosperity of the ten years to the financial crash in 2008 was built upon a credit bubble, not on real economic growth. There was no sound economic foundation to this prosperity.  In effect, the UK was living beyond its means. As a consequence of this, many businesses and individuals are carrying historically unprecedented and unsustainable levels of debt. This debt is now much more expensive than it was a few years back, and tighter lending conditions mean refinancing it is no longer an option for most people and businesses. The only other option is to reduce it, and that is what people and businesses are doing.

Debt reduction causes shrinkage in the money supply, which increases the value of monetary units and therefore tends to reduce prices. This is deflation. Under normal circumstances this shrinkage would be offset by expansion in the money supply due to new bank lending.  But at present the banks aren't lending at anything like the levels required to offset private sector debt repayment. Nor should they be. After all, the private sector wants to reduce its debt, not take on more.  So deflation is necessary if the private sector debt burden is to be reduced - unless, of course, the reduction in private sector debt is offset by increases in public debt.

Officially, we don't have deflation as such at the moment - we have inflation, mainly due to a VAT increase coupled with rising world prices for fuel and food prices.  But the pattern of behaviour in the domestic economy is definitely deflationary. House prices, which have been inflated due to the credit bubble, are falling, and the retail sector is turning in awful results.  People and businesses are reducing their spending across the board, and rising prices in some sectors are simply encouraging people to make even deeper cuts. Were this not the case, external factors would mean that inflation might well be quite a bit higher than it is at present.

Government policy so far has ignored the drive to deleveraging in the private sector and concentrated on controlling public sector spending while stimulating the economy in various ways to promote growth. These measures include a failed attempt at demand stimulus through  quantitative easing; corporate tax reduction; measures to improve lending to businesses, both through the banks and directly from government; light-touch regulation of tax avoidance measures such as offshoring. All of these are bound to be ineffective if the private sector prefers to pay its debts and sit on its cash, which is what is happening. Near-zero economic growth is here to stay while the private sector isn't spending.

The question is, do we really need to push for economic growth at the moment? Or should we accept that the UK economy is rebalancing itself, deflating the unsustainable credit bubble and returning to a more stable, if smaller, base? If we interfere with this so as to slow down the rate of contraction or delay its effects - for example by encouraging more bank lending to businesses, or increasing debt-financed public spending - do we make the necessary adjustment easier to bear, or do we simply turn an excruciating but mercifully short adjustment into a long-drawn-out agony?

I don't know the answer to this. But I know how I prefer to take off sticking plaster.


  1. Yesterday an oil supplier phoned me to ask if I needed any heating oil. It was charging 56.5p a litre for 500 litres. This is about 5p less than Boilerjuice was saying was the lowest quote from a selection of suppliers in my area. Is this a natural result of supply and demand? Companies are growing uneasy about cash flow and becoming proactive in touting for business and lowering prices, potentially reducing profit margins? Bring it on! I want lower prices, then I will buy more. Is that a bad thing?

  2. From the point of view of the consumer, reducing prices is clearly a good thing. From the point of view of business it is generally not a good thing, especially if their supply prices are high - as they are for oil at the moment. And the reduction in demand and squeeze on profit margins can result in unemployment. Deflation is therefore painful for businesses who have high fixed costs or have to pay world prices, and painful for people who lose their jobs. But I think it is necessary. As you say, bring it on!

  3. I'm no expert either, but it sounds like a lot of the economists are just as clueless. I'd always understood that, if you are in debt, inflation is good because it erodes the real value of your debt. Deflation is, therefore, bad because it increases the real value of your debt.

    Given that most of us and our governments are in debt, won't the only people who gain from deflation be creditors?

  4. Good point, Rick. My opinions on economists are sadly not printable....

    Krugman and others are indeed arguing that higher inflation would be a good thing because it would erode debt. But that's different from deleveraging, which is what is going on in the private sector. People and businesses paying down debt instead of spending money cause deflation - as do people hoarding money instead of spending it, which I think is the underlying cause of the long-term deflation in Japan. You can argue that spending money so that inflation increases and erodes debt is just as effective as paying it down. But it's not what people and businesses are doing, and government has no means whatsoever of forcing anyone in the private sector to spend money if they don't want to.

    The point of the blog is that the economy has to adjust to a lower credit base before real economic growth can recommence. Otherwise we are simply reinflating the bubble. Deflation is therefore essential. There will be both gainers and losers from the process, and it will be painful. But I don't think there is any point in trying to stop it, and slowing it down or mitigating its effects will simply prolong stagnation.

  5. Inflation may erode debt but it also erodes savings, pensions, investments, incomes, and the value of almost everything. It also reduces demand as prices increase. So why is the BoE not doing something about it? Is the Monetary Policy Committee just a bunch of economists?

  6. Ah, OK, I see what you're getting at.

    So, even if the government pumps more money in, evidence suggests that people and firms will still just sit on a lot of it. Better, then, to get the deflation over with.

    But even if that happened, wouldn't rise in food, raw material and energy prices still push inflation up?

  7. Lots of Austrianism in here, can't say I approve!


    The only things inflation erodes are wealth, debt and fixed incomes. If you think it reduces incomes & demand you are confusing its meaning.


    I don't know how you couldn't get why deflation is bad from that Krugman article. Deflation *does not* move an economy towards some sort of previous equilibrium; it just causes stagnation. We've seen this throughout history - The Great Depression & Japan more recently, for example.

    I'm not sure if you've read these Krugman articles - maybe you have - but here they are if you haven't:

    Babysitting recession: http://www.slate.com/id/1937/

    Hangover theory: http://www.slate.com/id/9593/

    If you want to argue that we need to get rid of debts; absolutely, many need writing off. But a fall in the general price level would accomplish very little.

  8. TMMBlog, I'm not arguing that deflation isn't painful. It is - very. But I can't see how the unprecedented levels of private debt in the economy can be reduced without deflation.

    Deflation because people are paying off debt is very different from deflation because people are hoarding. Paying down debt ACTUALLY reduces the money supply. Saving doesn't. We haven't had this situation before and no-one really knows what to do. Japan is not similar - the levels of personal debt were much lower and people have been saving, not paying debt.

    I am not suggesting that anyone engineers a fall in the general price level. I am suggesting that deflation is a necessary counter to the overexpansion of credit and the asset price hyperinflation we have experienced in the last 15 years. The only possible counter to this would be vastly increased Government debt. Some economists think that would be a good idea, but politically it's out of court.

    Government is backed into a corner and would be well advised in my view to accept that private sector deleveraging and deflation is a fact, and put in place strategies to support those who will be hurt by this - and yes, this might involve increasing public debt, but at least it would be debt used directly to benefit people. That would be much better than trying to hold back the sea.

  9. But even if people are paying off debt why should there be price falls? The Central Bank can (and should) just use extremely expansionary policies to prevent it, because deflation creates uncertainty but doesn't actually fix anything.

    Write off bad loans, let house prices fall - yes, but there's no reason why there should be *general* deflation in the economy because of this.

  10. I was always taught (at an admittedly basic level!) that deflation 'impacts' otherwise perfectly viable businesses because 'why buy something today when it'll be cheaper next month?'

    If we're talking about allowing the economy to shrink (e.g. because of the house price bubble) is that always commensurate with deflation?

  11. I do wonder how things will pan out. All very interesting. I've spent a lot of time trying to understand how economies and the markets functioned.

    I saw amazing complexity and as I understood more I saw lots of dodgy goings on -
    high frequency trading,
    market makers front running deals,
    debts hidden,
    dark pool trades,
    governments forced into asking the traders that had invented 'products' how best to regulate them,
    governments bowing to the lobbying of financiers,
    strings of shell companies cloaking dodgy deals,
    revolving door between government, regulators, central banks and investment banks.

    I see other problems -
    Growing inequality between rich and poor,
    Ever increasing social and environmental damage as markets fail to address these externalised costs (and look set to continue to do so)
    The demand for constant growth at all costs.

    I wonder why.
    Economics and the way we organise our economy is treated as a science, as 'the way it is' yet its all something us humans have invented in the last couple of hundred years and given the power to destroy lives, communities and ecosystems.

    Is this the price we have to pay for progress/growth?

    Cant we do better than this? I hope this is not the pinnacle of human economic organisation.

    I hope that the ever growing ease of international communications allows people with keen minds and some imagination to come up with better ways to do things.

  12. TMMBlog: I am using the classical definition of deflation which is shrinkage of the money supply, increasing the value of money and therefore tending to depress prices. In addition there is a domestic demand slump because households are paying off debt or cutting spending because of pressure on real incomes. Price falls are therefore inevitable, and are already happening in sectors where external factors are not keeping prices high.

    There is little that a central bank can do to counteract the deflationary effect of individuals and businesses reducing debt levels. QE does not work, and interest rates are already up against the lower bound. Banks are not lending to businesses, and even if they were there is no real evidence that the demand is there to support business expansion (pace the neoliberals who think that demand will always respond to supply expansion - not at the moment it won't!). Maybe you had some other expansionary policies in mind that the central bank (not the Govt) could try? These are all I can think of, and none of them will work.

    The Government could, as I said, massively increase public spending financed by new debt issues. That's about the only strategy that has any chance of working, but internationally there is a heavy price to pay for that.

    It's analogous to bank bailouts, really. We prevented bankrupt organisations from failing rather than allowing them to fail while protecting the people affected. Same here. The unsustainable level of private debt in the economy has to be reduced. That is deflation, whether it is done by means of paydown or by writeoff. And overvalued asset prices have to fall. I don't want to see artifical attempts to prevent price falls and expand an economy that wants to contract. I would rather see the government focus public resources on protecting the individuals who will be affected.

  13. For example-


  14. Demand must fall if prices are rising. All other things being equal.

  15. And of course if demand falls - as it is doing - prices should fall, all other things being equal. However, world commodity prices recently have been very high, so prices for essential items - food and fuel - have been rising. Those prices are the ones that feed the inflation figures. Demand does not fall so quickly on these: people tend to cut back in other areas in order to be able to maintain spending on essential items. Hence awful retail results, high street "fire sales" and a swathe of bankruptcies - including the discounter TJ Hughes, hardly a "high end" retail outlet. Much more to come I think.


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