The Closet Moderate: Why deflation sucks

Thursday, November 20, 2008

Why deflation sucks

Having been prodded by my co-bloggards, I will now explain to the blog-reading public at large why deflation sucks.

I will first note that if you google "why is deflation bad", you'll probably get better explanations than the one I'm about to lay on you. But if you truly value getting taught economics by a someone with a nom de plume from The Muppet Show, this may your best resource.

There are a number of stories that can be told about this, depending on how you think the economy works. I'm going to go with a simple story, called "sticky wages".

What "sticky wages" mean is that, in many circumstances, nominal wages (that is, the number of dollars that get deposited in your bank account on a biweekly basis) do not adjust very nimbly. For instance, if GM sells fewer cars one month than it expected, it doesn't suddenly reduce the wages of all its workers: for one thing, those union workers are under contract, and their contract doesn't allow management to suddenly cut wages.

So, ignoring the causes of deflation for the moment, imagine prices of all goods dropped by 90%, so GM's cars now get sold for 10% less. Suddenly, GM is making a lot less profit per car. In a world with perfectly non-sticky wages, GM (and every other company) would cut nominal wages by 90% across the board, and the world would gone on as if nothing had happened, just moving the decimal places on all their checks one over. But if wages are sticky and don't shift, suddenly GM is losing a lot of money on each car it makes, and it has to cut production and lay off workers until its profitable again, which is a big blow to what economists like to call the "real economy", which deals directly with objects built rather than with money earned, because we've got a lot less cars being built now. And, of course, those workers who just got laid off are also the guys buying stuff, and they're not inclined to spend when they're unemployed, which means that companies need to lower prices in order to sell things, and because of sticky wages, that means they need to lay off more workers, until everyone in the country is unemployed.

So, when Bloomberg tells you deflation is coming, that is one reason to know cold, cold fear in your heart. Enjoy!

3 comments:

Silent Cal said...

The way I've been evaluating it is that I bought a house in 2008 dollars, and I have to pay that money back. If my non-union wages do go down, I'll be boned. Debtors love inflation, but we fear the deflation.

This is good to recall next time you read about the industrialists of the late 19th century always reducing their factory workers' wages; that period in world history was almost entirely a deflationary period. Until big gold strikes inflated the money supply at the turn of the century, a guy with a fixed income was getting ahead.

Waldorf said...

There are several channels through which deflation can bone the economy. The sticky wages model is one; another is the sticky debts you're describing.

I will quibble with your characterization that you bought your house in "2008 dollars" and that now you need to pay it back, because I think that's exactly the opposite of what you mean. Your mortgage is NOT in 2008 dollars, rather its in dollars. "2008 dollars" are a real measure: how much stuff a dollar could've bought you in 2008 (say, a can of soda from a machine). A dollar, on the other hand, is worth one machine-soda in 2008 and 2 machine-sodas in 1990. Your mortgage is denominated in dollars, so when dollars increase in real value, the cost of your mortgage increases the same amount.

On an economy-wide scale, this ends up benefiting creditors and screwing debtors, and since poor debtors tend to have a higher propensity to spend than rich creditors (and also rich creditors might be a bit nervous about a higher risk of debtor default), that means less money gets spent over all, which ties back in to the deflationary cycle I described earlier.

Herodotus said...

Deflation = awesome!

http://www.cnn.com/2008/US/11/23/us.gas.prices.lundberg/index.html?eref=rss_topstories

Suck it sticky wages!