Dealing with Deflation

The prices of houses and other fixed assets are declining. The prices of commodities are falling. This is deflation. It hasn't made its way to the supermarket shelves yet, so official CPI figures are still registering inflation. That's a good reason why governments need to change their way of identifying inflation.

The combination of economic decline with deflation is disastrous for many reasons. With total output declining, wages need to go down in real terms. Deflation means that wages are rising in real terms, and this can be very hard to renegotiate. The result is rapidly rising unemployment and companies going broke. Another problem is that companies are unwilling to sell assets preferring to leave them on the balance sheet at an inflated price, thus concealing the loss.

When we have a forced economic decline, and we need to get used to that, then we would like to have that run smoothly, with everyone getting poorer together. Deflation prevents that, causing the economy to seize up. Deflation is actually easy to fix, but the important thing is to do it in a way that addresses the underlying problems rather than the symptoms. More on that later.

Decline leads to Deflation

Deflation occurs when there is less money chasing the available goods and services. Since the available goods and services are going down, it is not obvious why an economic decline leads to deflation. The reason is that money is not just the stuff the central bank prints. For practical purposes it includes credit.

In an expanding economy it is relatively easy to use borrowed money to do things which will bring in more money, or for the consumer to buy now expecting to earn money in the future to repay. In a declining economy, and particularly when switching from expanding to declining, we see that loans go bad, wiping out credit, and then lenders are unwilling to lend and borrowers are often unable to roll over their debt.

There's a chicken and egg problem here. To a large extent it is the deflation itself that stops lending, which in turn leads to more deflation. Only the first few percent of the current decline was caused by the contracting oil supply.

Why does deflation stop lending? I remember when I had a young family I bought a house on borrowed money. Then, after a bout of inflation, I was lucky to be able to repay it with much less valuable money. Deflation has the reverse effect. If you borrow money then you have to repay a larger amount in real terms. If you are trying to run an enterprise and you borrow money to buy the inputs, by the time you have a finished product to sell its price has gone down. Inflation hits those lucky enough to have money in the bank, but deflation hits the most vulnerable and the most productive.

Inflation makes real interest lower than nominal interest rates. Deflation has the reverse effect, making real interest rates higher than nominal.  This is a problem for central banks, which try to stimulate the economy by reducing nominal interest rates, and they can't reduce nominal rates below zero.

Printing money

Deflation is easy to deal with. Just print enough money. It is hard to do this without distorting the economy. Even when you do want to distort the economy in a particular direction, it is a mistake to go too far, and most of the created money needs to be distributed in a way that does minimal distortion. More on that in the next section.

The next problem with printing money is that the extra money will tend to cause inflation as soon as the economy bottoms out and credit starts to rise again. So money needs to be put into the economy in a way that is substantially reversible. However it would be a good idea, particularly in our expected peak oil economic decline, to not allow the huge credit expansions of the past. This is what many advocates of sound money desire, but they want to get there by allowing deflation to run its course, and that would be a catastrophic and unnecessary mistake.

When governments print money they do it as a loan from a magic account, which then goes negative, to the spending agency. Repayments to the magic account represent money being "burnt", the reverse of "printed". It is important to understand that this is not a real loan in any sense. It is not "this generation spending money that furure generations will have to repay" or anything like that. Printing money is all about the here and now, and not about the future. It is a tax on people holding money and on lenders. It is the easiest tax to collect, which is why it is so popular in war time.

An alternative way for governments to raise money is to really borrow money, by selling bonds. This doesn't normally counteract deflation. However when people are just holding on to money, then that is deflationary and government can counteract that by selling ultra-safe bonds to soak up that money, then spending it. America particularly needs to do this because they buy a lot of oil and other stuff without sending equivalent amounts of goods and services in return. They should try to stop doing that, but until then they need to provide somewhere for all those dollars to go. Since the oil exporters and other savers have lost confidence in commercial opportunities it is necessary for the US Treasury to borrow that money so that it has somewhere to go, so that the wheels of commerce don't grind to a halt.  The $700 billion expansion of US borrowing won't be enough. Now borrowing money like that really is a debt that future Americans will repay. However Americans worry unduly about this since they can obviously print money to repay the loan if necessary. This is not an option for most countries whose loans are denominated in a foreign currency, normally US dollars. Argentina might go broke and default, but the USA never needs to.

How to spend printed money

As with inflation, preventing deflation needs to be a central bank job, not a government job. Since the solution is to print money and spend it, the politicians would spend it on vote buying and that would distort and destroy the economy.

It is also wrong to do what we are seeing worldwide: Giving money to banks and encouraging them to lend it. This is an unjustified gift to bank shareholders and bondholders, and success would be just another credit bubble.

Deflation happens when people are sensibly battening down the hatches and preparing for the future. The government has to respond to this by shifting economic activity to things that will be useful in the expected difficult economic future. The matter needs to be given careful consideration and modelling. However to me the likely best answer seems obvious:

The central bank should counter deflation by printing money and spending that money to buy and store durable commodities. This has multiple positive effects:

• It puts money into the economy to counteract the shortage of money caused by the collapse of credit;
• It keeps up the price of those commodities and hence the products that are derived from them, counteracting the decline of prices;
• It can be done in a fairly automatic way, with purchases being done to preserve normal relative levels of production uniformly across all durable commodities;
• When the economy turns and there is a need to soak up that extra money put into the economy before it causes inflation, then all that needs to be done is to sell the commodities. This is doubly anti-inflationary since it soaks up the money and reduces the price of the commodity.
• Stockpiling useful commodities really is a good way to prepare for various future difficulties such as wars and natural disasters interfering with supply.

Critics won't mind this when the commodity is produced locally. However it is important to cover the range of commodities evenly so that the central bank can do it in a very automatic way, just like setting the interest rate. In may ways it is even more important to stockpile essential stuff that can't be sourced locally.

When the central bank prints money and buys commodities that are sourced overseas then the local currency has to be converted into the sellers currency. This takes place in the currency market. The effect is to reduce the value of the local currency relative to others. This makes exports more competitive and imports more expensive. The import of the purchased commodities has to be matched by higher net exports (and/or higher foreign investment). Either way the money that seems to be spent on foreign stuff actually finances an equivalent amount of local activity.

Summary

Central banks need to have the job of fighting deflation as well as inflation. To do this they need to print money and pump it into the economy in a reversible way so that it can be removed when inflation reappears. A simple an automatic possibility will be to use printed money to buy and stockpile (and later sell) durable commodities in their normal ratio of use.