Does Anybody Understand This Stuff?, Part One: Deflationwebdev
Read Part Two Here
This is one of several blogs in a series called Does Anybody Understand this stuff?, concerning economics and our future. There is no way to honor the blogging rule of 600 word posts when we are talking about the economy, so I will try to keep them short but no promises. I am not an economist, but as a serious student of cycles and history, I spend a lot of time trying to figure this all out. Below is a interesting discussion on deflation and Austrian Economics.
By the way, I think Austrian Economics are the only real answer even if this author doesn’t. Governments are notorious for expanding, prolonging and deepening economic problems either by trying to stretch their economic resources to engaging in more spending or by trying to diminish short term effects of natural economic cycling.
I WANT TO POINT OUT VERY STRONGLY HERE THAT THE ARTICLE BELOW IS BASED ON THE CONCEPT THAT A DEBT ECONOMY IS A GOOD THING. HE NEVER ADDRESSES WHAT WOULD HAPPEN IF THE GOVERNMENT STAYED OUT OF THE WAY, OR IF THE FEDERAL RESERVE WAS NOT IN CHARGE OF THE MONETARY SYSTEM, OR IF FAMILIES WERE MORE SELF-RELIANT. IT ALL DEPENDS ON WHETHER YOU ARE TRYING TO MAKE A CURRENT UNSUSTAINABLE SYSTEM WORK OR IF YOU ARE CONSIDERING ALTERNATIVES.
The only reason I have begun this series with this article is to give you a sense of the level of complication that has been brought to the economy as a means of convincing you to not even try to understand it. When you reach that level of frustration, just move on to Part Two.
I borrowed this discussion entirely from Furry Brown Dog
Austrian economics and the fallacy of deflation
According to the Austrians, deflation is not necessarily a bad thing. Deflation is defined as a fall in the overall level of prices in the economy, generally a fall in the price of a consumer basket of goods/services tracked. Intuitively it may be a good thing because it helps to lower prices and wages until they become affordable again. This runs counter to what is normally understood in everyday conversational economics and introductory courses. Personally I am of the opinion that in general, falling prices across the board are a bad sign, but this statement requires some clarification and qualification.
To understand why deflation is normally thought of as being undesirable, here’s the standard explanation by Nobel Prize winning liberal economist Paul Krugman:
So first of all: when people expect falling prices, they become less willing to spend, and in particular less willing to borrow. After all, when prices are falling, just sitting on cash becomes an investment with a positive real yield – Japanese bank deposits are a really good deal compared with those in America — and anyone considering borrowing, even for a productive investment, has to take account of the fact that the loan will have to repaid in dollars that are worth more than the dollars you borrowed.
A second effect: even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts. Now, you might think this is a zero-sum affair, since creditors experience a corresponding gain. But as Irving Fisher pointed out long ago (pdf), debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount.
Finally, in a deflationary economy, wages as well as prices often have to fall – and it’s a fact of life that it’s very hard to cut nominal wages — there’s downward nominal wage rigidity. What this means is that in general economies don’t manage to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept those wage declines. See Estonia and Latvia, cases of.
Sounds persuasive right? But here’s what the Austrians say. They claim it isn’t bad when prices fall, because falling prices are observed in the computer and technology industry. While the personal computer used to costabout $3,000 in the US back in 1982, today’s Windows-compatible PC prices are typically much cheaper, at about $600 for the cheapest basic ones. The computer industry has gone from strength to strength and has experienced nothing of the kind of economic disaster so often warned about when prices decline.
Secondly, to quote from a Austrian rebuttal the world has seen falling prices, most notably during the Second Industrial Revolution during a period of economic prosperity:
For example, both the U.S. and Germany enjoyed very solid growth rates at the end of the 19th century, when the price level fell in both countries during more than two decades. In that period, money wage rates remained by and large stable, but incomes effectively increased in real terms because the same amount of money could buy ever more consumers’ goods. So beneficial was this deflationary period for the broad masses that it came to the first great crisis of socialist theory, which had predicted the exact opposite outcome of unbridled capitalism. Eduard Bernstein and other revisionists appeared and made the case for a modified socialism. Today we are in dire need of some revisionism too – deflation revisionism that is.
Is this really true? A commentator pointed out that prior to 1913 there was no CPI data for the US, so the claim can’t quite be verified using official statistics. Secondly what matters is that the fall in prices are prices tracked by the basket of consumer goods, rather than other goods which may not be purchased by consumers. But more importantly, the fatal flaw in the Austrian argument that deflation may be a positive thing lies in a failure to distinguish between different factors behind falling prices. While deflation is more commonly understood as falling prices it’s important to understand that two distinct economic causes can have the same effect. Economist Nouriel Roubini, one of the few economists to have accurately forecast the economic crisiselaborates why in a video here.
Deflation more than just falling prices
I don’t have a transcript but the point Roubini was making was that if falling prices are a consequence of technological advancement and increased productivity (as was the case during the 2nd Industrial Revolution), they are a good thing, but if they are due to the fact that consumers are holding off purchases because of declining wage levels or lost jobs (eg. Great Depression, Japan’s lost decade, America 2008-?), we have a negative situation. Why is this distinction important despite the fact that in both cases, falling prices are the consequence?
To understand this in introductory economics under the assumption of perfect competition, falling prices due to technological advancement and productivity corresponds to a right-ward shift of the supply curve of the goods market, whereas if deflation is the result of withheld consumer spending, this means that the demand curve shifts to the left, which also results in lower prices. Why should the former be beneficial to the economy while the latter be disastrous? I would argue the difference that matters is because in the former case, though prices are lower the cost of producing goods are lower as well. Unlike in the latter case where decreased consumer spending is depressing prices, there’s still an increase in output. By comparison, in the latter destructive case of falling prices, output falls unreservedly.
To take the widely cited example of the computer industry, even though computer prices have fallen drastically since thirty years ago, the total annual number of computers manufactured and sold have not fallen. Similarly, though I have not actually searched for data on this, it is likely that despite the fall in average unit prices of steel, industrial engines and other industrial produce have all increased in output. Contrast this with the great contraction in output as tracked by GDP during the Great Depression, and much of the Western world today and you’ll see that falling prices are typically not accompanied by huge increase in output whether measured in real or nominal terms. Instead, falling prices are seen together with rising unemployment, cuts in wages and declining GDP.
Hence we see from the above explanation that the Austrian rebuttal fails to take into account the broader economic picture. Falling prices are harmful if they also imply falling wages, which leads to decreased consumer spending, causing prices to fall again in a destructive spiral. See here also for a much better written article on the difference between the two and why deflation is bad.
Does this mean that the Austrians do not understand the difference between the two? I was about to conclude that way, but happen to chance upon an article by a popular Austrian website where the difference is clearly explained:
What needs to be realized is that there are two distinct causes of generally falling prices. One is the increase in production and supply, which should never, never be confused with deflation, depression, or poverty. The other is a decrease in the quantity of money and or volume of spending in the economic system. Falling prices is the only effect that they have in common. They differ profoundly with respect to their other effects.
For example, if falling prices result from the fact that while the quantity of money and volume of spending in the economic system are rising at a two percent annual rate, production and supply are rising at a three percent annual rate, the average seller in the economic system is in the position of having three percent more goods to sell at prices that are only one percent lower. His sales revenues will be two percent higher, and that is what counts for his nominal profits and his ability to repay debts. His profits will be higher and his ability to repay debt will be greater. There are lower prices here, but absolutely no deflation.
What wipes out profits and makes debt repayment more difficult is not falling prices but monetary contraction, i.e., the reduction in the quantity of money and or volume of spending in the economic system. This is what serves to reduce sales revenues, and, in the face of costs determined on the basis of prior outlays of money, causes a corresponding reduction in profits. It is also what makes debt payment more difficult, in that there is simply less money available to be earned and thus available to be used for the repayment of debts. It is monetary contraction, and monetary contraction alone, which should be called deflation.
The case is different when the need for the fall in prices is caused by monetary contraction. In this case, the failure of prices to fall, in the face of the anticipation that they will fall, to the extent necessary to clear the market of unsold supplies of goods and labor, leads to a speculative postponement of purchases, which increases the pressure on prices to fall.
Deflation, which, it cannot be repeated too often, means monetary contraction, not falling prices, is at best in the category of a pain to be endured only in order to avoid greater pain later on. It should never be, and virtually never is, regarded as any kind of positive in its own right.
A few things to note. Unlike the quick and misleading rebuttal, the author acknowledges some key points about deflation in general. Namely, that falling price levels due to decreased spending will make debt much more difficult to repay (resulting in bankruptcies), that a deflationary spiral may result from it, that it’s traditionally accompanied by massive unemployment or cuts in working hours and pay. In other words, deflation should never be seen as a good thing but at best a necessary pain to be endured sooner so as to avoid even worse future economic suffering. In the end however, while there is much to commend the Austrian economics professor for acknowledging these crucial facts the economist also seems to think there should be some magical level prices would have to fall to before the economy can pick up again. As pointed out in a reply to Christopher, this is wishful thinking:
You are arguing from the perspective of an economy which is already at potential output. This is not the case for the US or much of Europe now. In the US, there are five unemployed persons to every job vacancy, which means that if every job vacancy is somehow miraculously filled 80% of the unemployment problem would still be there. The entire argument about crowding out works only when you have limited resources and when there is demand for it but right now there’s only slack. I hope you recognise that deflation is self-reinforcing, falling prices only make consumers hold back purchases in anticipation of further price declines; there isn’t any magical level prices would have to fall back to before firms and businesses suddenly decide to invest and hire. Inflation on the other hand, is what makes it unprofitable to sit on cash. Expectations of future inflation would make businesses and consumers do something with idle cash instead of just sitting on them. This is something Greg Mankiw pointed out in an op-ed last year. Raising inflation expectations sharply might be a way of jolting the moribund economy.
In other words, while Austrians assert that while prices have to fall, they have not told us explicitly how much prices have to decline before the economy picks up again. For example, prices in Japan today are actually lower than they are in 1989 (a somewhat amazing fact once you consider that every other part of the world has only seen higher prices), and in return Austrians have claimed that the reason why Japan hasn’t boomed is because prices haven’t fallen enough yet. At the moment, Christopher has yet to address most of the rebuttals made to his replies. It’s somewhat regrettable to see that New Asia Republic host articles such as Christopher Pang’s economic myths which themselves are really nothing more than unsubstantiated and debunked economic fallacies. At the same time they’re a good thing because it forces laypersons such as us to clarify and nail down exactly what is meant and implied when we use certain terms such as inflation/deflation.
Update: To be fair to Christopher, I realise that it’s more accurate to say that he hasn’t addressed the arguments yet rather than because he doesn’t bother to. My apologies to Christopher for sounding extremely rude and discourteous.
Do the Austrians offer any lessons?
Now despite what I’ve written above many will continue to point to the fact that the Austrians have a good explanation of recession busts and economic booms, the Austrian business cycle theory. These same folks are fond of pointing out that the monetarists and (Neo/Post/New)-Keynesians on the other hand can’t explain why booms and busts occur. While I agree that contemporary economics (though be warned that as a layperson I might be completely mistaken) can’t explain why both booms and busts occur, the idea behind a credit surge and bust coupled with speculation and market irrationality isn’t unique to Austrian economics. As Professor Krugman explains in a new Voxeu.org paper, non-Austrian economist Hyman Minsky spent much of his professional life developing theories of speculative bubbles, credit models linked with financial instability; which sounds much like what we’ve seen the past few years:
The current preoccupation with debt harks back to a long tradition in economic analysis, from Fisher’s (1933) theory of debt deflation to Minsky’s (1986) back-in-vogue work on financial instability to Koo’s (2008) concept of balance-sheet recessions. Yet despite the prominence of debt in popular discussion of our current economic difficulties and the long tradition of invoking debt as a key factor in major economic contractions, there is a surprising lack of models – especially models of monetary and fiscal policy – of economic policy that correspond at all closely to the concerns about debt that dominate practical discourse.
We envision an economy very much along the lines of standard New Keynesian models – but instead of thinking in terms of a representative agent, we imagine that there are two kinds of people, “patient” and “impatient”; the impatient borrow from the patient. There is, however, a limit on any individual’s debt, implicitly set by views about how much leverage is safe.
We can then model a crisis like the one we now face as the result of a “deleveraging shock.” For whatever reason, there is a sudden downward revision of acceptable debt levels – a “Minsky moment.” This forces debtors to sharply reduce their spending. If the economy is to avoid a slump, other agents must be induced to spend more, say by a fall in interest rates. But if the deleveraging shock is severe enough, even a zero interest rate may not be low enough. So a large deleveraging shock can easily push the economy into a liquidity trap.
Krugman wasn’t alone in noticing that Minsky’s work of the 1960s and 1970s offered a promising non-Austrian theoretical framework from which more rigorous and prescriptive economic theories and policies may be formulated. Both Tyler Cowen and Rajiv Sethi have acknowledged this as well. In addition Krugman has an additional post on that here.
In addition I argue that although it is admissible that current prevailing economic orthodoxy does not offer good theoretical and model explanations of the causes of the economic crisis as well as recommendations, Austrian economics does not appear to be the way forward. At the heart of Austrian theory lies the assumption that the free markets must be allowed to work their magic, outside of any form of government interference whether it be the open market operations of the central bank or any fiscal policy apart from cutting taxes. Minsky’s theories on the other hand, centre around an explicit distrust of the efficiency of the free markets which he characterises as the “financial instability hypothesis”, arguing that left unchecked, financial institutions are no more rational than gambling dens driven by Keynesian “animal spirits”, in stark contrast with the efficient market hypothesis:
Minsky’s model of the credit system, which he dubbed the “financial instability hypothesis” (FIH),incorporated many ideas already circulated by John Stuart Mill, Alfred Marshall, Knut WicksellandIrving Fisher. “A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”
Disagreeing with many mainstream economists of the day, he argued that these swings, and the booms and busts that can accompany them, are inevitable in a so-called free market economy – unless government steps in to control them, through regulation, central bank action and other tools. Such mechanisms did in fact come into existence in response to crises such as the Panic of 1907and the Great Depression. Minsky opposed the deregulation that characterized the 1980s.
Personally I would say ignore the Austrians. Once upon a time it could be said the Austrians were ahead of everyone else in economics when they came up with their business cycle theories in the 1920s, but that was then. They have not progressed in any way since then. On this point John Quiggin has an excellent post on an overview of Austrian theory and why it shouldn’t be taken seriously here.
Read Part Two Here