Wednesday, February 18, 2009
A debauched King
Apparently, Unswervin' Mervyn has written to the Chancellor of the Exchequer asking for permission to start making up new money to stave off deflation. After all, if you have dropped rates as low as they can reasonably go, the next stage in making money cheap is to print the stuff with gay abandon. The economic logic is certainly sound, but I do wonder about the theory underpinning the policy prescription. We keep getting told, as though repetition makes it true, that deflation is bad. But surely deflation is just negative inflation? I can see the argument for the existence of a deflationary spiral, which the Great Depression is said to have been; but from exactly the same era the Weimar Republic proves the existence of an inflationary spiral. In fact, inflationary spirals have been more common than deflationary ones: the Roman Empire fell prey to them. Both kinds of spiral are dangerous, so why are we so scared of a little deflation, but not scared of a little inflation? Is there good econometric evidence to suggest that deflationary spirals start earlier than inflationary ones?As far as I can tell, people insist that the Great Depression was a deflationary spiral, but ignore the fact that deflation theory only really applies in modern economies with fiat currencies. At the time of the Great Depression, everyone was on the gold standard. On the other hand, Austrians and other gold-bugs tell us that deflation is no worry at all, but their evidence is also from the gold standard era. So again I ask, is there any evidence, under a fiat currency, that deflationary spirals occur earlier than inflationary ones?The only reasoning I can really see is for someone to take the view that economic policy should serve the interests of net debtors. Given that a good economic policy would neither favour nor disfavour anyone, I see that thesis as profoundly immoral and politically corrupt. There surely ought to be a better reason than that for printing money.Debauching the currency is a serious measure and not one to be taken lightly. If it were to turn out that, in fact, the effects of inflation and deflation are equal in magnitude and opposite in effect, then the Bank of England's current inflation target and consequent plans for "quantitative easing" would look extremely dodgy.
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Deflation applies to all currencies I think, whether fiat or not - it's simply the rise in the value of money or else the fall in the prices of goods and services in the economy. This can happen even on the Gold Standard.
I don't think it's anything about spirals occurring earlier than the other, but rather the consequences of each. (Besides, the BoE merely sets policy to pre-empt future inflation/deflation as it takes about 18 months for monetary policy to work).
As we've already reached incredibly low interest rates, it's now impossible to lower them much more - That's why deflation is scary - it's because we'll no longer be able to use interest rates to control the economy. Instead, quantitative and qualitative easing needs to be used (which is either buying ok assets and printing more money to do so, or else just buying lots of riskier assets - they either "debauch" the currency, or it means we take on risky assets).
We're simply out of other options.
You'll probably say "What about fiscal policy?" but there's a trade-off with this as well: As you know, we can't take on more debt, reducing services is unpopular, and yet we still need to either decrease taxes or increase spending!
Apart from that, deflation really is pretty darn bad:
The real value of debt increases - OUCH!
(Think of the implications both for Guv, for those in debt, and especially for banks with their assets going 'bad' because it's harder for people to repay them!)
Aggregate demand and thus economic growth decreases as consumers delay purchases, firms have their profit margins squeezed, people on credit put off purchases, firms using credit (lots of them) put off investment.
On the other hand, there isn't a 'crunch point' for controlling inflation, as interest rates can always be increased to lower it, and a small amount is good as it boosts demand in the economy as people buy now rather than later and the real value of debt decreases.
Yes, deflation does occur under all currency systems, but the consequences may well differ, hence my concern about the historical evidence. If the gold standard era is valid evidence, then it suggests that a little bit of deflation is not a bad thing. If it is not, then we can stop all this fretting about deflationary spirals right now, because we appear to have no *evidence* that they happen in a modern economy. So far, all we've got is a plausible story about people putting off spending, but here is an equally plausible story:
Spending slows down and consequently investment (savings, so mostly credit investment) speeds up; therefore, goods prices fall and credit-asset prices rise. These combine to reduce credit-investment returns. As returns fall, consumer spending becomes more attractive and it picks up. Then goods prices rise, asset prices fall, returns rise and just like Old Man River, the business cycle keeps on rolling, keeps on rolling along.
Of course, if the central bank insists on mucking about with interest rates, money supply and asset prices, then one has to question the deleterious effects this may have on investment. We could be in for a very random walk on Threadneedle Street.
Is deflation bad? Ask an estate agent.
Or ask me, a few months ago during the downside of the spike in petrol prices, as I drove around on a near-empty tank of petrol waiting for prices to drop below a pound. It struck me at the time that if you extend that behaviour to the entire economy then you're going to have problems.
I'm no economist, but as I see it the situation is this: yes, inflation can be a terrible thing. But the point is that inflation only becomes a serious problem when it becomes high or "hyper". By contrast, even a little bit of deflation can be a serious problem.
Perhaps - and again, this is pure layperson speculation - the point is that if there is any symmetry between inflation and deflation (and Anton's observations would suggest not), then why would we assume that the axis of symmetry lay at zero? Could there be a "natural", "healthy" level of inflation - say 2 or 3 per cent - so that then 6 or 7 per cent inflation and -1 or -2 per cent deflation are roughly equivalent in the problems they pose? (One point about 2 or 3 per cent inflation is that it encourages spending without discouraging saving, assuming interest rates aren't at an all-time historic low, of course. Erm...)
Although again that assumes the effect of each is linear - it may be that you need to push inflation higher above the "axis of symmetry" in order to produce the same effect as deflation.
Consumer electronics is in permanent deflation: has that industry become moribund? Do people permanently hold off buying a computer just because it could get cheaper? No!
I don't buy the idea that a deflationary spiral is necessarily indefinite. People do hold off on spending, I agree; but they spend eventually, either when they think the prices are worthwhile (for discretionary purchases) or when they run out (for essential supplies). You might have driven around on an empty tank for a few days, but eventually you'd have had to have bought some. Oil companies, supermarkets and the like are described as "defensive" (in contrast to "cyclical") for a reason!
Or take the housing market. Just because the bottom appears, currently, to have fallen out, that does not mean that demand for housing has dissipated. As prices move down to an appropriate level, investors will move back into the market for housing, and it will begin to re-inflate.
The only sector of the consumer economy left to survey is discretionary spending. Like, um, electronics…
Phil:
The problem is however that what you've described is in the long-run. Although it's likely to happen eventually, in the words of JM Keynes, "we're all dead in the long run".
There is however another problem, and it addresses John's point about the axis of symmetry.
Although there's likely to be an axis at 2-3% under normal conditions, what we're seeing right now is by no means ordinary.
For example, a bit more inflation, or a bit of deflation during a boom is not so bad.
However, what we're seeing right now, similar to back in the 30s, and which prevents the long-run effects from occurring, is a freeze-up of credit.
Essentially, although under normal conditions savings = investment, right now the banks are deleveraging, so they're more likely to stockpile savings in order to pay off their debt as opposed to lending and investing to the real economy. Therefore, as savings increase, the rate of investment doesn't increase by as much.
This means that the long-run effects are now likely to happen in the even farther future. That's why deflation is particularly scary right now.
As for "evidence", I'm afraid we're thinking more about theory here and the application of sound economic models. This is the same for all situations in economics, as no two circumstances are the same.
Phil: You posted your last point while I was still writing.
Yes, the main problem with deflation is not putting off purchases - that's why I listed it last - the main problem is the effect it has on debt and the fact that it is less controllable than inflation.
Well, when economists say "long-run" I just remember that a week is a long time in politics. My long-run is, I think, a lot longer than many others'. And anyway, we all rather hope that our children (or nieces, nephews, etc.) may still be alive in the long-run. Admittedly, the amount of debt they are being lumbered with makes me wonder what kind of life it will be and whether they will thank us for it.
So I think I can see the point about savings not being invested, but rather held back as banks do not want to lend. But does that necessarily persist? Even though I < S, is not 0 < I? In other words, does investment not continue, albeit at a lower rate? And therefore, why will things not pick up again even if left alone?
As for the positivist/evidentialist debate, how do we know a model is sound apart from the evidence? Once we have a model which accounts for the evidence, then we can apply it to the current situation. But my objection to the models I currently see propounded is that they fail to account for all the evidence.
By long-run, economists generally mean when all factors are variable - e.g. where production can change - what you've described is of course a long-run process. That can be a very long time indeed.
The point about our children however, is that the measures we take now are geared at the restoration of economic "normality" (e.g. without speculative bubbles - these require models of their own, that were neglected possibly for political expediency). For example, averting the threat of deflation, and even replacing it with inflation, will benefit our children as the debts will be worth less.
Yes, you're right, it won't be indefinite because eventually the banks will deleverage fully and lending will resume. They will pick up again if left alone, but we can't afford for that to happen, as we need much more short-term solutions - why should we allow millions of people to suffer right now, when we are able to both alleviate that suffering and to prevent the economic suffering or future generations?
As for the positivist debate, I understand what you mean, but it's impossible to do - you may as well just look at the real economy.
Models are necessary because you can never account for all the variables. However, models look at what happens in isolation (ceteris paribus - all other things being equal) - we can still use a lot of models to predict what will happen, just as we've been able to show what will happen in the long-run with deflation - I've merely pointed out another model that changes its ramifications, or rather, delays them. The failings are not in the models themselves, which account for all the factors they impact upon, but in the economists stringing together those models in order to see the full effects on the economy as a whole.
Seems to me if we didn't have the debts in the first place, we'd not be messing around with the currency in this apparent attempt to have our cake and eat it too. Is a structurally high-debt high-inflation economy really a good legacy to leave our kids? Are we really helping future generations, or are we just helping ourselves and kidding ourselves about the future?
I'm not unsympathetic to the argument that we should help people who will suffer as a result of the recession. But I question whether stoking spending and inflation is really the way to do it. Is it not investment which will beat a recession, and can we not use fiscal policy to help people at the margins in the meantime?
I agree with you completely Phil.
There was indeed (and to a certain extent still is) a better way of doing it.
I wasn't arguing for the use of QE (although it may well work), but for the case that deflation is indeed a lot worse in our current situation than moderate inflation.
The SLP (I recommend that you join - but then again I would) came up with a whole load of solutions that would not have involved such huge debt, and if used, could render future government interventions of such a huge scale unnecessary.
Here are a few links on Debt-for-Equity Swaps if you're interested: (and before you ask, yes, I wrote them)
http://soc-liberal-party.blogspot.com/2009/02/solving-banking-crisis.html
http://soc-liberal-party.blogspot.com/2009/01/mystery-that-is-debt-for-equity-swaps.html
http://www.adamsmith.org/blog/economics/debt%11for%11equity-swap-200902162938/
As for the fiscal measures you suggested, the best thing to do is to reduce Employers' National Insurance Contributions, the minimum wage, etc. Here's another link just to bore you as to my reasons why!
http://www.adamsmith.org/blog/regulation-and-industry/deregulate-the-labour-market-200902182965/
Oh, scrap the minimum wage. I used to think it's a good idea, but it's actually a really bad idea, dressed up as an affordable folly in good years. I agree fully with freeing up any and every market (read some of my stuff on development or education), although I am also willing to allow that some sort of payment for people while they look for work (what to call it: a jobseeker's allowance?) is a reasonable thing to do.
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