Friday, November 21, 2008

Sense and nonsense about Deflation

Deflation, like inflation, is a confusing word that conflates price changes due to a change in money supply, with price changes due to a change in some underlying supply/demand dynamic in the good itself. For example, if the Government prints a lot of money (increases money supply) but new manufacturing technology in China makes TVs cheaper to produce, the net impact on the price you pay for your new flat screen may be positive or negative depending on which effect was bigger. Our past 100 years as seen a massive increase in money supply that has swamped the also dramatic increases in productivity. A bottle of coke that cost 10 cents in 1908 should cost 1 cent in 2008, not $1.50.

When Nouriel Roubini talks about deflation, like most commentators he's referring to the net effect of money supply and underlying supply/demand dynamics on price. If prices are going down, then we're in"deflation". But he brings out the standard canard about why this is bad:
Second, when there is deflation there is no incentive to consume/spend today as prices will be lower tomorrow: buying goods today is like catching a falling knife and there is an incentive to postpone spending (consumption and investment spending) until the future: why to buy a home or a car today if its price will fall another 15% and purchasing today would imply having one’s equity in a home or a car fully wiped out in a matter of months? Better to postpone spending. But this postponing of spending exacerbates the vicious cycle of falling demand and supply/employment/income and prices.
Does this make any sense to you? Does it match your own spending habits over the past 10 or 20 years?

Computers are a product category that experience dramatic deflation. Your $1000 Dell today is worth $500 next year, and $100 the year after that. And while computers continue to become dramatically more powerful and cheaper, and people consider holding off so they can buy that new model, there are still plenty of consumer sales.

Cars are another product category with dramatic deflation. A $25K Subaru WRX today will outperform a $70K Ferrari built in the 1970s. The cars of tomorrow will be even better, and cheaper. But there are plenty of car sales.

Look at other goods categories that have experience dramatic price deflation due to cheap labor in China: clothes, toys, consumer electronics. All of them have become much cheaper through the 90s, and yet people still buy plenty of them.

One area where falling prices might give people pause is housing, but housing remains overpriced in almost all areas in the US (based on equivalent rents) and it should give one pause. The real "problem" with deflation is that it makes the real cost of debt higher. But haven't we been hearing that the US, as a whole, needs to be less indebted?

People aren't buying cars now because cars are a big ticket item that it's easy to postpone for 6-12 months. People aren't buying houses now because houses are still too expensive compared to rents, and without price appreciation to gamble on, it makes no economic sense. This "people won't spend if prices fall" does not fit with empirical observations.

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