What is Worse: Inflation or Deflation?

Amidst all this talk about inflation lately, one could be forgiven for forgetting the existence of the yin to inflation’s yang, deflation.

Joe of Heresy Financial on YouTube recently brought up an interesting point on the matter, and essentially his point was that the Fed cares way more about deflation than it does about inflation.

And it is true that back during the Great Recession, then-Fed Chair Ben Bernanke was primarily concerned with avoiding deflation, and that all the actions he took back then were in an effort to stave off a deflationary spiral and collapse.

Bernanke had spent many years of his life studying the Great Depression and its causes. It was Bernanke’s belief that the reason the Great Depression of the 1930s was so bad was because the economy went into a deflationary spiral, where falling prices caused consumers to withhold spending, which led to decreased business profits and eventually unemployment as businesses had to tighten their belts. This increasing unemployment, of course, would then lead to less and less spending, further exacerbating the deflationary spiral.

Paul Krugman of the New York Times explains the deflationary spiral as akin to an economic black hole:

… the economy crosses the black hole’s event horizon: the point of no return, beyond which deflation feeds on itself. Prices fall in the face of excess capacity; businesses and individuals become reluctant to borrow, because falling prices raise the real burden of [loan] repayment; with spending sluggish, the economy becomes increasingly depressed, and prices fall all the faster.

The fundamental idea behind the deflationary spiral is that consumers will wait to make purchases because they expect lower prices in the future. I can give an example of this from my own personal experience; for the past couple of years I’ve wanted to buy a new TV, but I also know that TV prices are lower and lower every year. You can buy a larger TV for less money with each passing year. So why would I buy a new TV now, then, when I know it’ll be cheaper in the future?

Now this makes sense in theory, but what about other purchases–smaller, more regular purchases, as opposed to larger, one-off purchases? What about things like food and gasoline? People always have to buy food and gasoline no matter the price, this is why businesses that sell essential goods (and services) typically have very strong pricing power, meaning they can charge whatever they want and people are more or less forced to pay the price.

And what about this assumption that when consumers see lower or falling prices, they hold off on making purchases because they expect those prices to continue falling? Is this true?

Maybe for some consumers, it is. A segment of the population will see falling prices and conclude prices will keep falling. But not everyone. Others may see reduced prices as a limited-time opportunity that they must take advantage of now, as prices may go up in the future. Many consumers are conditioned to view suddenly lower prices as an opportunity to take advantage of, and they don’t assume prices will continue falling indefinitely.

Additionally, wouldn’t there be a certain point at which prices have fallen so far that consumers decide it’s a great time to buy, regardless of whether or not prices may keep falling? If, for example, I want to buy a new TV and it was originally $750, but then after a few months I see the TV now costs $675, and then a few months after that it costs $580, I might just go ahead and buy the TV because of how much cheaper it is now. Why would I take for granted that the price of the TV is going to keep falling? I’ll think to myself, “What if it goes back up to $750? Then I’ll feel like an idiot.”

At the very least, some consumers will pounce on the lower prices. In my view, it’s foolish to assume that all or at least most consumers will cease spending in the face of falling prices. At a certain point, low prices will spur an increase in demand that will eventually lead to higher prices.

There is also the matter of how much prices have fallen by. If it’s 5-10% per year, that’s one thing, but if it’s 0.5% a year, is that really going to have much of an effect on consumer spending? If the price of an item goes down by 0.5% in a year, is that really going to convince me to hold off on purchasing that item because I expect its price to be 0.5% another year from now? I’d say no.

And what of the role that wages play in all this? Businesses facing declining revenues due to falling prices will have to cut costs to stay afloat, and this means either wage cuts or mass layoffs. If my wages are cut due to falling prices, then my purchasing power goes down as well. If prices across the board have fallen by, say, 5%, but my wages have also fallen by 5%, then nothing has really changed for me.

There are so many different aspects to deflation that it might be impossible to cover the whole subject exhaustively here. For instance, what is causing the falling consumer prices in the first place? Is it a drop in producer prices, i.e. commodity prices? Virtually all the goods we buy start out as commodities: for instance, clothing prices are heavily dependent on the price of cotton. If cotton prices go up, clothing prices will likely go up. Bread prices are driven by the price of wheat. Bacon prices are driven by the price of lean hogs, etc.

A decline in commodity prices leads to a decline in consumer prices, and vice versa.

But commodity prices are usually cyclical in nature, meaning they go up and down over time, which undermines the idea of the potential for some sort of secular deflationary spiral occurring. In other words, if commodity prices drop sharply, sure, prices may be lower for a time, but eventually commodity prices will go back up, which will lead to an increase in prices down the road.

There are also secular, long-term deflationary forces like productivity that drive prices of certain things lower over the long term. Take TVs, for example: TVs have come down in price significantly over the years, and it’s because TV manufacturers have figured out how to produce them more efficiently. But this hasn’t caused widespread deflation across the board.

Essentially what we have, in the broadest terms, is a longstanding debate among economists about whether inflation or deflation is the greater threat to the economy. The two main sides are Keynesian economists and Austrian economists. The Keynesians fear deflation the most, the Austrians fear inflation.

The Keynesians point to the Great Depression, which they consider to have been exacerbated by deflation, as proof that deflation is the greater threat, while the Austrians point to both the stagflation era of the late 1970s/early 1980s, as well as the Weimar Germany hyperinflation of the early 1920s, as proof that inflation is scarier.

Joe, in the video above, argues that despite the hawkish tone posed by St. Louis Fed President Jim Bullard regarding inflation, the Fed won’t actually fully commit to fighting inflation because the Fed fears deflation a lot more:

“The Federal Reserve will not attack inflation as aggressively as they need to in order to actually stop it, this is because they fear deflation far more than they fear inflation. So while they want to stop inflation from being up at 7-7.5%, they do not want it to go under 2%.”

“They need inflation. When you have a system built on debt, if you don’t continually have a degrading of the purchasing power of the units of currency, the debt gets more expensive, harder to pay back over time, not easier. When you have inflation, it benefits the borrowers at the expense of the lenders.”

He’s right about this. And debt is the one aspect of deflation we haven’t mentioned yet, but it may be the single greatest influencing factor on why policymakers are so terrified of deflation.

We currently have the highest level of US government debt on record, the highest level of corporate debt on record, and the highest level of household debt (including mortgage debt) on record.

Deflation would make this debt more expensive.

Think of it this way: we know that inflation make debt cheaper. This is because debt incurred in the past is a fixed amount and not chained to inflation. If you took out a mortgage for $300,000 in 2000, that mortgage has gotten significantly cheaper over time. $300,000 in 2022 dollars is only equal to about $180,000 in 2000 dollars according to the BLS inflation calculator. Meaning having $300,000 today is like having $180,000 back in 2000.

$300,000 in 2000 bought you a lot more than $300,000 in 2022. That’s due to inflation. Today, you’d need $500,000 to buy what $300,000 would’ve gotten you back in 2000.

With inflation, we repay our loans with devalued money. See how from the figures above the dollar has lost over 40% of its value since 2000? That means your debt also got about 40% cheaper since 2000.

The main beneficiary of the effect of inflation on debt is of course the federal government, and it wants an inflation rate of about 2% a year because that means its debt is steadily be eroded over time purely by the forces of inflation.

The government, because it has a way longer timeline than you or I, just pays the interest on its debt and then lets inflation take care of the rest. In 1945 at the end of World War II, America’s public debt was the highest it had ever been in history, $259 billion. That was over 130% of GDP at the time.

But $259 billion is nothing to the federal government today. They pay more than that in interest alone every single year.

And so you can see how debt gets cheaper over time. The government racks up $259 billion of debt in 1945, and yeah, it was a lot at the time, but all they had to do was make the interest payments on that debt and inflation would take care of the principal over the course of several decades. The principal would just be repaid in devalued dollars.

This is an extreme example, but it illustrates the point: Imagine if you had a crystal ball and could peer into the future, and you saw massive hyperinflation on the horizon. You take out a loan for a home for $500,000. Then, the next month, hyperinflation hits and suddenly it costs $500,000 for a loaf of bread. Well, your home loan has not gone up with inflation. It is still $500,000. But now thanks to hyperinflation, $500,000 is basically pocket change. So you walk down to the bank, hand them $500,000, and your mortgage is paid off just like that.

That’s why debtors like inflation. I know it’s an extreme example but you get the picture.

Deflation, on the other hand, makes debt more expensive.

Because remember, your debt is not chained to the rate of inflation or deflation. In a deflationary spiral situation, prices and wages are falling, meaning your wages are falling and your debt level is staying the same. Your debt burden grows and grows with deflation. If you have $300k worth of debt but your wages fall from $80k a year to $65k a year, your debt-to-income ratio has increased significantly.

Here’s a decent explanation of why deflation makes debt more burdensome for everyone:

Deflation creates the opposite phenomenon: Debt gets more expensive over time, because consumer spending power declines. When prices and corporate revenue fall for a sustained period of time, wages inevitably go down, too. That makes fixed-rate debt more expensive, because you have less money instead of more to make the same regular payments. The mismatch affects companies and even governments the same way it does consumers, causing cash-flow shortages, liquidity problems and bankruptcy. Each of these ugly outcomes reinforces the others, making a deflationary spiral very hard to pull out of.

On top of that, deflation makes people wary of taking out debt in the first place. Too much debt is a problem in itself, but prudent lending is an essential element of capitalism. Without it, investment shrivels and wealth is more likely to disappear than accrue.

Deflation is bad for debtors. And while household and corporations in America today have record levels of debt, the biggest debtor of all is the government. And they cannot have deflation. It would be devastating for them.

So this is why Joe says the Fed is way more afraid of deflation than it is of inflation. Certainly the Fed has a mandate to get inflation under control, and it will take steps to do so, but it will not go as far as it needs to because doing so will cause deflation.

The Fed is always and everywhere attempted a balancing act. It wants stable inflation at around 2% a year, every year. Anything lower than that and it will try to boost the inflation rate up to 2%. Anything higher than that and it will try to bring inflation down to 2%.

There are risks in both direction. Deflation is a bad scenario, but inflation is also a bad scenario if it gets too high. Not only because it could lead to hyperinflation, but because it means consumers no longer have enough money to spend on anything other than the bare essentials. Discretionary spending collapses due to inflation, which leads to recession.

So I guess the answer to the question posed at the start of this article is that there is no correct answer: both inflation and deflation have serious drawbacks, and this is why we see the Fed attempt to talk a fine line between both. The Fed believes that 2% inflation is the perfect target, as it’s not an excessive amount of inflation that will decimate consumers, but it is also a decent buffer against falling into deflation.

In light of this, perhaps I am being too harsh in my prediction that the Fed will hike rates into a slowing economy because the Fed is determined above all else to get inflation under control. That has been my operating assumption for a while now, and I based it off the Fed’s actions during the stagflation era when it hiked rates into a recession because it felt getting inflation under control was more important.

I figured the Fed’s commitment to getting inflation under control would surprise everyone who has grown used to the Fed always bailing out the market at any sign of trouble. My prediction was that people would be in for a rude awakening as they find out the Fed is no longer their friend in the face of soaring inflation.

A key difference between then and now, though, is that there was far less debt overall–less government debt, less corporate debt and less household debt. And so it was not nearly as risky to hike rates, even to sky-high levels. Deflation never materialized back then; inflation only came down steadily as the economy ground to a halt.

The Fed simply does not have anywhere near as much leeway to hike rates today as it did in the early 1980s–not unless it wants to cause a massive debt crisis.

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