Friday, December 10, 2010

Why We Fear Deflation

Mr. Einhorn’s Question



On CNBC’s Squwakbox show one day this week, guest host and Hedge Fund manager David Einhorn questioned, successively, former Fed Governor Larry Meyer and Nobel laureate Joe Stiglitz, on why economists feared deflation? Mr. Einhorn posed a compelling example of Apple Computer improving its product without raising its price (or perhaps even lowering price). Why, he asked, is that deflationary act considered to be bad for the economy? Neither luminary provided Mr. Einhorn with an answer. In this post, I endeavor to give the answer.

A Short Answer

On its face, Mr. Einhorn is correct; an improvement in product quality or capability that does not raise the price -even more so if it lowers price - is an unmitigated societal good. It increases wealth. If all products underwent this type of transformation simultaneously, real GDP would tick up – because expenditure of the same dollars would procure more value – to the benefit of some and the determent of none. So, why should we fear deflation?

The short answer is that it depends on what has caused the deflation. Economists fear a decline in nominal GDP-which means there are fewer dollars (to use a US example) being spent on goods. If this occurs, not as the result of the spontaneous decline in the cost of producing goods at prevailing input prices, as described in Mr. Einhorn’s example, but as a result of a decline in the money in circulation, and if goods and labor prices do not immediately adjust downward in proportion to the decline in the money supply, then the volume of goods transactions in the economy supportable by the money supply must fall. Wealth and employment must decline.

It is the lags in adjustment of prices behind the reduction in the money supply that creates the problem. Moreover, if debt contracts are written in nominal terms –I owe $X dollars on such and such a date – then a fall in nominal GDP will, in aggregate, cause debt payments to increase as a proportion of spendable income, and this will trigger an increased in loan defaults –payment defaults and collateral value covenants – that will cause disruption in actively and a decline in wealth and employment, via a downward spiral of ever increasing haircuts begetting forced asset liquidations begetting yet more haircuts, like what spread through the economy after the collapse of Bear Stearns in March 2008.

The Monetary Collapse of 2008

The effective money supply is something like MZM, which includes the assets people and businesses treat as a medium of exchange, or immediately exchangeable thereto – like hard cash (high powered money), bank checking accounts, money market funds etc…It is impossible to produce a definitive demarcation-in fact the shifting boundary between assets considered illiquid and liquid depends on market conditions –but we can be clear about the concept.

In the aftermath of the financial meltdown in the autumn of 2008, there was a panicked ‘flight to liquidity’, in which individuals and corporations sharply increased their desired money balances and lenders essentially ceased lending. Increased demand for cash balances and deleveraging caused a sharp contraction in the velocity of circulation of high powered money (M1), which would have triggered a sharp contraction in the money supply, had not the Fed engaged in open market operations -purchases of securities- to massively increase high powered money – currency and Fed deposits in banks.

The inverse of Velocity is the Money Multiplier, the ratio of MZM/M1. As is shown below, it collapsed in the autumn of 2008.



In response to the collapse of the Money Multiplier, the Fed embarked on an unprecedented and massive program of purchasing assets (see below)



with newly created M1,in order to stave off a sharp monetary contraction, such as triggered the Great Depression in the early 1930’s. The Fed’s efforts succeeded in stabilizing MZM (see below).



If the Fed had not increased M1, then the money supply would have tanked and with it nominal GDP. With slowly adjusting prices and nominal debt contracts, the US economy might have lurched toward a ‘debt deflation’ spiral like occurred in the Great Depression.

A Formal Exposition

We briefly review the Cambridge Cash Balance equation representing the monetary economy, favored by Monetarists like Milton Friedman. The Cambridge equation is:


Md = k*P*Y

Assuming that the economy is at equilibrium (Md = M), Y is exogenous, and k is fixed in the short run, the Cambridge equation is equivalent to the equation of exchange with velocity equal to the inverse of k:



M*1/k = P*Y

M is aggregate base money (M1).
M*1/k is money demand (MZM)
K is the money multiplier (inverse of velocity).
P is an index of the aggregate price level.
Y is real GDP.
PY is nominal GDP.

Mr. Einhorn’s Question Again


Mr. Einhorn asked, in effect, what would happen if Y was exogenously increased (by product improvements), or, alternatively, if P were reduced. What happens depends on the reaction of the other variables to the change in question. But if we assume a relatively stable demand for money (M*1/k), a price fall will accompany an increase in real GDP –no bad thing – and real GDP will increase in response to a price decline (no bad thing either). In fact, either event would result in an improvement regardless of its impact on the demand for money.


So, Mr. Einhorn has identified an instance where deflation is compatible with –may even be caused by – an increase in real GDP.


Why We Fear Deflation More than Inflation


Now suppose there is a collapse of the Money Multiplier (k). In this instance, without an offsetting increase in base money (M), there will be a contraction in nominal GDP and this contraction will be split between a decline in prices (P) and real GDP (Y). If prices are not infinitely flexible, or if debt contracts are written in nominal dollars, a portion of the burden of adjustment will fall on a decline in real GDP (Y). That is the problem with deflation.


Central banks have often been unsuccessful in stemming a deflation caused by monetary contraction. Think about the US in the Great Depression and the Japan over the past two decades. It seems that once set in motion, the forces of money hoarding –the value of money is rising – and debt deflation dynamics overpower the central bank’s ability to counteract the contraction with increases in base money. A deflation, once in motion, can trigger an ever increasing demand for money, deferment of expenditures –since prices will be lower tomorrow- and contraction in credit. While Milton Friedman and Ben Bernanke have maintained that a ‘helicopter drop’ of unlimited quantities of money should be able to reverse trend, it may be that the economic disruptions caused by the collapse of financial intermediation –induced by debt defaults- disrupt the monetary transmission mechanism (by destroying credit creation) and reduce potential real GDP.


On the other hand, experience has taught that inflation can be tamed by curtailment of base money (M1) growth. A curtailment of money growth will reduce both base money and velocity, as the negative return on money holdings is reduced. Policies reversing inflation by monetary contraction have been successfully implemented by central banks all over the world in the past 50 years.


So, there is an asymmetric risk in monetary policy right now. The massive injection of base money raises the tail risk of high inflation down the road –which we know how to tame- but monetary abstinence presents the tail risk of a deflationary spiral, which central bankers do not know how to reliably reverse.


In answer to Mr. Einhorn’s question, deflation caused by monetary contraction can be a very bad thing indeed.

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