Deflation – Good, Bad or Confusing?

As commodities tumble, people look for the silver lining.

Deflation is widely misunderstood. The pedantic (and true) definition is that deflation refers to the contraction of money and credit in an economy. The popular definition is that deflation refers to decreasing prices in an economy. Whilst the contraction of money and credit often leads to falling prices, it doesn’t have to. The prices of goods and services in an economy rise and fall for many different reasons and specific sectors can diverge widely (e.g., computer prices have been falling for decades). Since genuine deflation is relatively rare, most people’s frame of reference is limited to the crushing deflation that accompanied the 1930s Great Depression, which was generally a bad experience. But consider this recent headline in USA Today.

“Lower gas, oil prices could boost spending, economy.

US consumers should have more holiday cash.”

This references the crash in crude oil prices since October. The article states, “Falling oil and gasoline prices should deliver an early Christmas present to holiday shoppers and the economy in coming weeks, lifting consumption by a few billion dollars a month, economists say.”

You see, many economists think that falling oil prices act like a tax cut for the economy, giving people extra money with which to consume other products. Following that logic, therefore, falling prices (what people think of as deflation) is actually good for the economy!

“In Defense of Deflation” is a book by Philipp Bagus. He argues that, in contrast to the widespread belief that deflation is harmful to the economy as a whole, free market deflation is both liberating and beneficial. He also takes the view that the idea of deflation being bad serves to justify ongoing expansionary monetary policy.

It’s interesting that asset and commodity prices are falling as the Federal Reserve continues its policy of Quantitative Tightening (i.e., reducing the pace of money creation in the economy). But it is the glacial forces of social mood that ultimately drive the economy and we think that the negative trend in social mood has only just begun.