Why Deflation is a greater threat than Inflation

The United States and Canada are tremendously wealthy countries. Geographically, we have assets that China would do anything to obtain: vast amount of high quality land suitable for growing way more food than we need, plenty of water, lots of natural resources and commodities, and plenty of space to spread out. Politically, we are also extremely lucky: we have governments that are rock-solid-stable, honest law enforcement, strong private property laws, and low levels of corruption. The social dynamic in our countries is great, too. People here generally do not try to screw over their neighbors to get ahead; instead of trying to bring others down, we work hard and emulate them in order to achieve success.

We also have extremely productive economies. Since we have plenty of food to eat and it hardly takes anybody to grow it, what’s everyone else supposed to do with themselves? To fill this void we have a dynamic economy that creates an endless amount of goods and services we can buy.

 

Why do we consume so much and save so little?

The reason we consume so many services and so much stuff, is because we are optimistic about the future: it is ingrained in our national culture to be consumers: work hard, make money, and have babies. Also, we have confidence that things will be even better tomorrow than they are today. Instead of saving 10% of my income, I’m going to take an expensive vacation and buy the iPhone because I will have a better job and make more money next year.

We have good reason to feel this way: since WWII, the United States has experienced phenomenal economic success. We have enjoyed booming asset markets, huge job creation, strong foreign appetite for our debt, and a strong dollar. What if something happened that caused a shift in this optimism? The result might be higher savings rates and necessarily a reduction in aggregate demand.

 

The FED is afraid of a Japan-Esque-Deflationary-Slump

Japan went through a tremendous boom in the 1980’s. The economy, along with asset prices expanded at an amazing pace. Turns out, a lot of this growth was a bubble and when it crashed in the late 80’s, the hangover that followed was severe. After people lost so much money in real estate and the stock market, their national appetite to consume decreased and their national savings rate went up.

Japan is similar to the US in that they are a very productive society: plenty of food, water, health care, and shelter for all. So when everybody decided to save instead of spend, the economy stagnated for ten years. Prices for goods and services stayed the same or even declined over this period. Despite massive injections of liquidity, negative real interest rates, and tons and tons of freshly printed money, people just didn’t feel like consuming. On top of this, Japan has a rapidly aging population and low birth rates.

All things being equal, one could argue that a deflationary period is a good thing. But a deflationary/stagnant economy is hardly consistent with the United States’ role as an economic and military empire. Deflation is also a worst-case-scenario for a debt-laden society at both the consumer and government level. Deflation increases the real size of our liabilities because the liabilities grow in size relative to incomes and the general price level.

And here’s the real reason why we should be scared to death of deflation: the demographic time bomb the US faces sometime between the years 2015 and 2040. We face massive — and totally unfunded — future liabilities in the form of Social Security and Medicare. The only way we have a hope of paying for these is if economic growth is robust in order to keep tax revenues flowing to the government.

If something were to happen, such as a housing crash, which caused people to change their positive expectations for the future, people might choose to save instead of spend. Faced with high taxes (to pay for “entitlements”: interest on the national debt, Social Security & Medicare), people might stop working so hard and the economy would slump.

Thoughts?

 

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2 Responses to Why Deflation is a greater threat than Inflation

  1. Destry says:

    I am a saver, I always have been. I don’t trust the future, I never have. I don’t expect to get any social security, so I stock away money in my 401k, stocks, and money market accounts. Seeing the intrest I make makes me giggle in delight.

    My company is going through a period of lay offs and people are freaking out…the people that lived above their means. Did they need the super expensive flashy car or the giant house….well I don’t think so. To me it seemed silly and foolish. I don’t latch on to every penny…I spend for pleasure too, but I am far less extravagant than a lot of people out there. If I should get laid off it wouldn’t matter…I have plenty of money saved, and I’ll just get a new job.

  2. Will says:

    Hi Destry — congrats on being so frugal!

    I’m worried this post was too doom and gloom and that my readers are becoming depressed. Keep your chin up and keep saving and investing, I’m sure you’ll be rich someday.

    In the meantime, it sounds like you might want to consider the Roth 401k instead of the regular after-tax 401k. Check out this post for some details.

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