Why favoring a low and steady inflation rate? -> An Introduction to Deflation

1. An Introduction to Deflation

The last few articles make inflation seem like an evil force corrupting the economy. However, the dark side is not always so dark after all. Despite all the talk about the bads of inflation, it might be surprising to you if I were to inform you that economists actually prefer a low and steady positive inflation rate. That is exactly what I am going to do. Ready?

Economists actually prefer a low and steady positive inflation rate. I said it again, and I still want to say it once more. You heard me right. However, note that, it must be at a POSITIVE but at the same time, LOW rate. In other word, we follow the rule of thumb: "too much of anything is never good, but a moderate amount is almost always perfect". This rule actually applies to many facets of life. Think about it by yourself.

Have you ever heard of "inflation target"? That is what central banks in every country do first thing in the morning. Yes, even before breakfast. Although the inflation rates between 1%-2% are normally considered acceptable and most of the time, desirable, but in reality, most inflation targets, if I'm correct, would be in the range of 1%-5% to adapt to the current settings of different nations.

All the talk, where is the explanation? Why? Why do we want a slowly growing price (or slowly deteriorating currency value)? Like the great wise man once said, you can only realize the true significance, the real value of something when you lose it. By the same token, to really understand why inflation should remain in existence, we have to imagine a world without it, or to be more precise, not just a neutral world with 0% inflation (because trust me, this is really hard to achieve, not with capitalism, not with free market), but a world with deflation (i.e. negative inflation).

Before going any further, it is best that we get to know deflation first. What is deflation? Deflation is the exact opposite of inflation. Whereas inflation is an economic phenomenon made up of rising price/falling money value, deflation is an economic nonemonehp (spell it backwards) of falling price/rising money value. However, short-term fall in price due to competitive nature of the market and improved efficiency (ex: advanced technology lowering cost ==> lowering price) can be defined as a good deflation. The bad one mostly persists in the long run for a year or more. So to sum up, you can think of it this way. Short-term deflation is generally good. It signifies efficiency and high productivity which are vital for economic growth. Long-term deflation, in contrast, almost always results in false incentive and loss. Let me elaborate it in details below.

The idea, when first introduced to people, sounds like a good plan. Who does not want cheaper clothes? Or even better, cheaper luxurious cars, houses and vacations. That is why some might think: What a horrible world we are living in! Everything seems to always become less and less affordable! If only things could fall in price, that would make life a lot easier. You think so too? If you do, I am sorry to inform you that you are about 90% wrong. 10% really wrong. Like said, short-term deflation does not spell doom for the economy, but the longer term one usually does.

Individually, you will gain in short-term simply because of the sticky wage effect. That means your hourly wage/monthly salary resists downward pressure. So if you money becomes more valuable as a result of deflation, in the short run, you will be able to buy more goods and services. Due to income effect (more income --> buy more), you will just do so. You would feel richer, and you would make more purchases, living a life of a king/queen.

How long will this fleeting bliss last? Not that long I would say. Complacency is not an option during deflation. Most governments would take action immediately to tackle this problem. Wait, why is it a problem in the first place if everyone is so happy buying more of cheaper goods? Why can we not perpetuate this happiness of ours?

You see, the greatest fear for a government is probably not inflation but persistent deflation. Deflation is an insidious disease that is, to my understanding, even harder to cure than inflation. Deflation entails a huge loss for the aggregate economy. Try thinking from a businessman point of view. Your company manufactured a car. At the beginning of the year, you purchased raw materials and other inputs on top of incurring expense on input-to-output converting process/technology at a total sum of $100. Sadly, due to deflation, the market price was put under downward pressure as currency value suddenly increased. So if the car was priced at $110 ($100 total cost + $10 profit) before, due to deflation and competitive market pressure, you were forced to reduce price to $90, or else, you would not be able to sell the car at all. Long-term deflation creates this problem for almost every industry within an economy. It becomes a real headache when firms' technologies, efficiency, and cost-cutting measures cannot keep up with this falling price. Their profit margins would shrink drastically, and most would be forced to cut production, layoff workers (since wage is sticky, it is difficult to lower wage),  and eventually, exit the market (i.e. declare bankruptcy). Now you might question yourself, if falling price occurs, then should it not be applied to both production cost and revenue? And since money gains more value, how can $90 be a loss? Could this economind's author be mistaken? Well, if you are thinking about it (at this very moment), then I must commend you for your swift economic mind. But the one thing about deflation is that prices of different goods and services do not fall uniformly. Which one falls quicker? The one on the cost side or revenue side? And that is what ultimately decides the fate of businesses.

Remember, companies have assets and liabilities. Most of the time, liabilities are where deflation hit the most. Say, before deflation, the liability-to-asset ratio of your company is 30%. That means out of all the assets you own, 30% belongs to other people. You owe them. Say, that 30% = $1 million. Your business operate normally, but suddenly, deflation hits and persists for a whole year. Keep in mind that you owe other people in nominal value. That means you have to pay back $1 million (+interest). Even though price falls and currency value rises, you still have to pay exactly $1 million back in principal. What if you can only sell your products at reduced price (due to deflation effects)? How are you going to pay $1 million if, say, the expected revenue of $1.5 million turns into $0.9 million actual revenue? You would be forced to sell some of your assets. Now you see how deflation impact on businesses can turn out pretty ugly.

Falling price has a far-reaching effect. It has to do with human perception of the economy within which they reside. In the short-run, consumers in general might not notice the fall in price of goods and services. That is one of the reason, why short-run deflation is not considered harmful. However, humans are curious beings. Most put self-interest up front, and they are quick to discern any emerging opportunity favorable to their advantages. Thus, if the falling price trend lasts long enough, people would be able to notice it.

Based on historical observation, what would occur in this specific scenario is hoarding. Again, hoarding? Remember, we talked about this once before in an article: "Why is Economics important?". Yes, hoarding is once again involved. You see, people hoard for a reason. People love having lots of anything they value or is valued highly by those surrounding them. So it is a very rational decision to start hoarding money speculating high return at the end of the day. With the falling price/rising value of money trend continues, most people expect price to keep on falling even further, and with that in mind, they begin hoarding money. To put simply, if you expect your $1000 saving (that means all the expense on necessities such as food, medical care, utilities... have already been incurred) to equate to $1500 (50% return) in the next 6 months, then would you spend it now? or wait a bit longer? Most rational people would hold on to their money a bit longer. I meant 50% semi-annual return is actually a better deal compared to almost any other investments you can possibly think of, which leads to an adverse economic situation.

First, consumption falls. People spend less, and by using our "paradox of thrift" learnt from the past article (spending = earning), we know that they will also earn less as well. When taking "Multiplier" into consideration, the loss is actually bigger than the face value.

Second, people become less willing to borrow, and thus, lowering investment. It creates a scenario where wealth is redistributed from borrowers to lenders. Think about it. If the value of currency rises by 20% a year, then the $100 you received from your boyfriend A (or girlfriend of course) on valentine's, by the end of the year, would worth roughly $120. So it has come to a situation when banks find it hard to make loans. If A borrowed $100 from RipUoff Bank with 5% interest (just so he/she could give the money to you on valentine's... I meant who want a bunch of inedible roses?), A would need to pay back $105. But wait, in real term, A would actually be paying $105 + 105*20% (rise in money value due to deflation). So unless your boyfriend/girlfriend is totally insane, in a way that he/she cannot even figure out basic calculation using common sense, then he/she would not take that loan from RipUoff bank. If you did receive $100 during deflation from your boyfriend/girlfriend, then consider breaking up with him/her. Another impact of deflation. Sad. Looking from the lender side of the story, from banks' perspective, when deflation hits and people save their hard-earned cash, various assets value such as houses, lands, cars, etc., will drop, and as a result, banks would be less likely to make loans as they are aware of the expected lower value of the collateral (to back up the loan in case of default).

So when money itself becomes a safe haven for investment (with really high return), people would shift their interest towards hoarding. They would invest in cash itself, and since they also expect businesses and the whole packages of financial markets to function poorly during deflation, that creates another problem, the falling stocks/precious metals prices, and eventually, the collapse of the financial market.

All these will cause higher and higher unemployment. Now you should get the picture. People become jobless, less spending, less saving, less investment, less government revenue (less tax), less products and services offered, and the list goes on. These certainly exacerbates the impacts of deflation, taking the total worth of damages to a whole new level.

Wasting. Wasting is bad. There was an article solely dedicated to "food waste" in this blog, so do look it up. Anyway, wasting is a result of inefficient consumption/production. Deflation can cause wasting because initially, as goods and services become cheaper, everyone feels richer and they start spending more, sometimes on something they do not even need. If those things turn of to be perishable goods, then they will be wasted. Sadly, this spending surge at the start of deflation most likely does not create enough inflationary pressure to offset deflation simply because the price does not fall steeply in a single day. Imagine this scenario. If price of a microwave drops from $100 to $50 in a single day, then there would probably be lots of people who would buy microwaves pushing up the microwave price almost immediately. Sadly, that is unlikely the case. The whole falling price process might take months, but the change normally is noticeable. That is why people hoard, and that is why there usually is not enough inflationary pressure to save the day.

Deflation, like I said, is bad, but natural deflation is mostly harmless. Deflation resulted from the movement of free market under market force (natural deflation, I made this term up) can actually be desirable. An example can be seen in computer industry where prices fall significantly, but everyone is happy. You can buy cheaper computer, they can sell more for more money. It is a win-win situation. That is the magic of knowledge and technological advancement, and efficiency improvement. The harmful one is usually man-made, a consequence of bad economic policy, especially monetary policy, either expansionary (increasing money supply) or contractionary monetary policy (decreasing money supply). Deflation can result from both. What most people would think is that deflation results from contractionary monetary policy because with decreased money supply, there would be less money in circulation, and as a result, money value goes up. For instance, the deflation in Japan that lasts for 2 decades (and is probably about to end, or not) was believed to be probably caused and/or perpetuated by its policy failure. However, deflation can also be caused by excessive expansionary monetary policy. True story (I will not explain unless you ask).

Do note that the effects of deflation witnessed in this article have been stretched to the extreme. The actual effects might fall somewhere in between with lower severity. That is why economics is sometimes called a dismal science because of its gloomy nature. Though that is actually not true and not supported by this blog!

Entertain your economic brain with the below video about how the Japanese economy was afflicted with DEFLATION (which takes you on a more realistic journey on deflationary route):

Why can't a country just print more money to be rich? (PART 2)

Previously, we have discussed about how any attempt to raise a nation's wealth by printing money (or in fancy term, Quantitative Easing) would be futile without prior growth in production, both goods and services. The demand-pull inflation, the depreciation of currency value due to the delusion people hold (they feel richer) when having more money printed out of thin air, renders this approach ineffective. Is that all though? Nope. The repercussion does not stop here. I dare say that any reckless decision based on personal whim, rather than on well-studied reasons or systems, can incapacitate the whole economy, or at least, some sectors within it.

First, you must know that though an economy heavily depends on production of goods and services, the role of money as a medium of exchange is indispensable. We work to earn money. We then use it to purchase various goods and services as needed and desired. So what will happen if the $100 bill we hold suddenly depreciates in value? You know it, I know it, She knows it, Everyone knows it. When our money depreciates, we can purchase less goods and services just as mentioned in Part 1 of this article. In other words, inflation erodes our purchasing power. If our wage is not pegged to the CPI (Consumer Price Index, a metric measuring inflation about which I will probably explain more in my later article ), then we are in big trouble. Wage that is adjusted following the change in inflation rate can, to a certain degree, cushion the adverse effect of inflation. However, those living with fixed wage, ex: retirees depending on pension, will surely suffer as the real value of the pension paid to them is becoming lower and lower. This, in a way, is a means of stealing people's money by the central bank or the government. By printing more money, making you feel richer, they are making your hard-earned cash worth less, turning you into a poorer being in real term.

That is not all. When inflation increases, the real interest rate you obtain from whatever amount of the loan you made will fall. Think of it this way. I will make it simple. Imagine you lend me $1000 with 10% interest. So with no inflation at all, the money you would get back is exactly $1100 in real term, a $100 profit. What if there is 50% inflation? Simply put, that means you are still getting $1100, but its real value is 50% less (because price of goods rise by 50%). So the actual amount you get from making this loan is actually ($1000+$100)*0.5 = $550. Well, you are losing $450 of the initial principal, the original sum lent of $1000.

Inflation can also affects people's perception of the economy. When there is high inflation, people tend to save less (because the value of their money, if saved, will just get lower and lower) unless the bank offers high interest rate, at least, as much as the inflation rate. That means if the money is losing 20% of its value annually, the bank must be willing to offer 20% return (interest) of the amount deposited in order to attract customers. Plus, if the interest rate is fixed by the central bank, rising inflation will increase demand for loan accompanying with much lower supply of it. The problem is, just as in the previous example, people know for sure that if they borrow $1000 now and spend it, they can just pay back much less in real term in the future because inflation eats away the value of the $1000 and the interest they are obliged to return. However, people with surplus of money (saving) are not stupid. They know they will get less if they lend their money out to those opportunists. So the most rational decision is to spend the money now, buying as much goods as they can, investing in assets and commodities, which in turn, will worsen the effect of inflation, and shake the very foundation of the market. You might end up seeing precious metals price such as gold price jumping through the roof, but at the same time, there might be much less saving, thus less investment, a vital component of a country's GDP.

While saving (which constitutes the supply of loan for new investments) shrinks, Inflation greatly discourages investors (the demand side of investment) as the expected return from their investment in existing or start-up business becomes less and less. For instance, if the expected return of the investment is 40%, but the current inflation rate is 50%, that means you will lose 10% if you decide to invest. So high inflation rates can significantly lower the propensity to invest within a country.

If we look at the foreign trade sector, we will know for sure that inflation is bad. Inflation will pose 2 major challenges for the global competitiveness of a country. First, inflation increases the price of goods and services within a country, and that means, at the start, domestically produced goods and services cost higher than the imported ones. People, consumers in general, will normally choose lower price products, so local businesses now have a hard time competing with those of the foreign ones who are not suffering from the inflation pressure (to raise price). This holds true to both the local and the global markets. Thus, domestic producers will be susceptible to bankruptcy, threatening higher unemployment rate and many other problems within that particular economy. When the demand for foreign goods increases and the demand for domestic goods decreases, what will happen is the depreciation of the domestic currency (i.e. the domestic money declines in value). Why? Think about the demand and supply. More demand for foreign products is equivalent to more demand in exchanging domestic currency to foreign currency to purchase those foreign goods. You know where this is going, right? More demand for foreign currency and less demand for domestic currency will eventually increase the value of foreign currency and lower the value of domestic currency. As the domestic currency depreciates, foreign investors will face a huge loss. It is almost as if they are getting ripped off. For example, you are a US investor. You invest in the Japanese market, and you earn 1,000,000 yens. At that time, 1 yen = $1 (of course, it is just an example). Since Yen has depreciated, now 1 yen = $0.5 (yes, just an example). So before the inflation took off, you can convert your return of 1,000,000 yens to dollars, and you would get exactly $1,000,000. Not bad. But now, since 1 yen = $0.5, your 1,000,000 JPY is reduced to only $500,000. You know what? You have just lost half of your return. As a result, it will certainly discourage you or any other investors to consider Japan as a potential target. Worst case scenario, Japan will be labelled as a country with high risk lower return for investment.

High inflation effect can be seen everywhere. Just for the fun of it, I will give you another example of how inflation might affect your business. If you own a restaurant, with high inflation, you must change your prices often to keep up with the rising prices in the economy. This is costly because you need to spend your time and energy doing it, and not to forget, you also need to probably print new menus!

Well, inflation seems to hurt, but economics is not a straight-forward social science. Economics confuses a lot of people because they tend to think of it from only a corner of view. Inflation, though seems hazardous, also have its positives. However, when we are talking about inflation, note in mind that there are different levels of inflation. Economists tend to favor a low and steady rate of inflation because they (and I) think that it is good for the health of an economy. In the next article, we will look beyond our pessimism, and explore the positive space of inflation.

Because when a cup is half empty, it is also half full.

Why can't a country just print more money to be rich? (PART 1)

Back in the old day, when I was about 8 or 9 years old, I was curious about one thing, among many others, in particular, money. Why do people work so hard for it? Why don't we use leaves as money? Why cannot the government just print more money if it is so valuable and "printable"? After all, this would solve the world economic crisis which happened every now and then. I thought I had made a major breakthrough in modern economic thinking. Well, I was not very thrilled when reality struck. That, to be honest, was the inception of my unwavering love for economics, way before I even realized what it really is. 

It turns out money is just a medium of exchange, and that, the whole economy is anchored on products and services it produces. So to explain this economic phenomenon, let's just forget about money. The wealth of a nation is not the amount of money it has, but the amount of total outputs it generates and accumulates. After all, you would not survive with a million bucks if you were in the middle of Sahara desert. True, don't you think? Because the amount of goods and services Sahara desert has to offer is virtually ZERO. Thus, I guess (and I am pretty sure) that you would be willing to pay a truckload of cash (Benjamins), let alone a million dollars, for just a bottle of water. How can it be so expensive? Because it is so scarce, so rare to be found, in Sahara that a bottle of water is worth any amount of money you can possibly imagine. This means that its price is merely a signal of the scarcity and the demand for water. If you think of it this way, I guess it will help you to better grasp the concept of economics, especially money. 

If a nation prints 10 millions more of $100 bill, it does not necessarily mean that its people are now any better off than how they used to be. Look at it this way, if a poor country suddenly prints more money, but it still produces the same amount of outputs with no increase in employment or natural resources, that country, technically, is still poor in real economic sense. So what are the outcomes of having more money but same level of goods and services within an economy?

Imagine living in a small village with no apple tree, no apple import (i.e. a closed economy). While walking, you kick a genie, woke him up, and the genie now grants you 1 wish. Where are the other 2 wishes? Well, I wouldn't grant you 3 wishes, let alone 1, if you kicked me. He is just too kind. Anyway, now you ask him to bestow upon you, 2 apples (who needs a billion bucks, or even better a huge mansion with unlimited wealth inside, when you can have free apples?). You now have become the only person in the entire village to own 2 apples. Now everyone, especially the rich, would be willing to pay you high price, say $1000 just for a bite. I meant they have never tasted apple before. Until, someone else kicks the genie again, and ask for a billion apples (That is why maths is important because by studying maths, you can count more than 2). All of a sudden, your 2 apples are now worthless because the village now has tons of apples on its hand that it does not even know what to do with them.

This specific scenario, as described above, should be quite similar in nature, and thus, comparable to reality. Money and apple are two different things, but the law of supply and demand are applicable to both items. When apple supply spikes, its value depreciates/declines. When money supply increases (while the output produced remains unchanged), its value will simply fall. In other words, as people get more money in hands, they feel richer, and as a result, they start to demand and consume (buy) more. The demand for goods and services rise, but since the quantity of output is the same as before (remember, we only print more money, NOT produce more), then high demand will turn into a competition, thus bid up the price of each good and service. Simply put, people, who are now richer as a result of having more money within circulation, are not afraid to spend. They compete to get what they want, and in doing so, they either directly or indirectly raise price in the economy. The golden rule is when something is strongly desired by everyone, its value appreciates/rises. 

I will give you another example just for fun. You bake a pie, and you hand out 2 tickets to people, each worth half a pie. Now suppose, instead of handing out 2 tickets, you hand out a thousand tickets. Each ticket is now almost worthless because each can only be exchanged for a really really thin slice of pie (1/1000 pie). This is what printing more money does to you when your production has not been improved first (i.e. same amount of goods and services in the economy).

This is what we call "inflation". It is the deterioration of money value while goods and services become less and less affordable due to rising price. Let's assume you have $10. Before, you can purchase 10 pens, but inflation arrives, and now, you might be able to purchase only 5 pens with your $10. So before, $1 = 1 pen, but now, inflation strikes, and $1 = 0.5 pen. So the real economic value of your money is decreasing by half. ouch!

So printing more money can lead to inflation, a "demand-pull inflation" to be precise. That means the higher price is caused by the rapid increase in demand within an economy (while the supply level does not change).

In short, you cannot eat and drink money, but it is, without doubt, one of the foundations of a strong and vibrant modern economy. Its importance is undeniable. However, printing more money is not going to make you any richer in real term because like I said, money is just a medium of exchange. If you are crossing a river, having more boats is not going to speed things up for you, is it? But it will, it will if and only if you have lots of friends and stuffs to be transported.

I will provide further explanation including the negative impacts of printing money within an economy in PART 2.