Governments lie about the inflation rate and benefits from it, so, it is no surprise when they talk against deflation (for the purpose of this article, assume inflation as a general increase in prices and deflation as the opposite), which would be good for consumers and the economy, but bad for the government. (While Austrian Economists define inflation as an increase in the supply of money, the net effect of inflation is an increase in asset prices, as well as a distortion of the structure of production.)
Prices fall in a scenario where the currency is not inflated and, therefore, there are more sustainable investments and increased productivity. In an economy with little or no government intervention (at least few monetary interventions and few regulations, government spending and taxes), there are more long-term investments (capital investments, for example), which increase the economy’s productivity. In a deflationary economy, the purchasing power of money tends to increase, as there is no monetary inflation by central banks and prices tend to fall. Consumers can purchase more products and services and companies have higher profit margins.
But governments do not like deflation, they are the most indebted entities. Inflation is beneficial to borrowers, as they repay loans in a currency with lower purchasing power than when they took the loan. It is even more beneficial to the government since it can expand the money supply to pay the debt. Furthermore, inflation is good for the government because it creates an apparent economic boom, which will eventually be wiped out by a recession. But, as this can take a few years, the short-term incentive for the incumbents is to take advantage of this instrument.
Two typical arguments given by governments against deflation are as follows:
“Deflation Will Cost Entrepreneurs”
The reasoning behind this statement is that, if prices fall, entrepreneurs will sell products and services at lower prices than the cost to produce them. However, this statement does not hold if we consider the fact that, in a deflationary economy, the currency’s purchasing power tends to increase. So even if entrepreneurs get less money (nominally) than what their products cost, in real terms, they will still make a profit. In addition, the prices of the inputs used in production will also fall in a deflationary economy.
Therefore, with the use of productivity and management of expenses that every company must have, it is possible to sell the products at low prices, but with the same or even higher profit margin than in an inflationary environment. (Note: even if we disregard this gain in purchase power and lower production costs, it would be possible for the entrepreneur to protect himself through future contracts). And, precisely because prices get lower, consumers buy more products and services (without going into debt) and companies profit more due to the reduction in costs that occurs thanks to deflation. This is particularly the case in the technology sector. Computers today are cheaper and much better than they were 30 years ago. Because prices got lower (due to increased productivity), consumers began to buy more, which increased the industry’s profits, which brought more investments and higher productivity.
“Consumers Will Postpone Consumption under Deflation”
The reasoning behind this argument is that if prices are constantly falling, no one will buy the products and services because individuals will always expect prices to go down. This also does not make sense, as there are always products and services that people have to purchase (such as food and medicine). Nobody starves themselves to death or does not purchase medicines because a year later they will be cheaper. Only when the product or service is expensive do consumers postpones consumption, which is what occurs with constant inflation created by central banks. Furthermore, people tend to have a high time preference (hence, they want to satisfy their demands in the present, not in the future). If they can afford to buy what they want, they won’t hesitate.
Therefore, deflation has several benefits, not only for consumers, but also for entrepreneurs. A deflationary economy makes industries more profitable and more efficient (producing cheaper and better products and services). Also, deflation has two other benefits:
The Economy Becomes Less Indebted
In a deflationary economy, consumers would tend to buy products and services in cash rather than by going into debt. Therefore, less money would be directed towards interest payments for consumption. The incentive to save would be higher, which would lead to more investments, which would lead to greater productivity, which would lead to cheaper and better products and services, which would lead to higher profits, which would lead to more incentives for investments. It’s a beneficial cycle for the economy.
Furthermore, the current scenario of zombie companies would not occur in a deflationary economy, as the incentive would be for savings and investments in productivity, not indebtedness. The central bank (if it existed) would not inflate the currency, nor it would control interest rates and expand the money supply (hence, there would be less malinvestment and companies would be more efficient, as they would be more subjected to the profit and loss mechanism). Therefore, inefficient companies would be quickly eliminated, leaving resources to be used by potentially more efficient companies. There would be less significant waste of resources in unsustainable developments. Banking activity would also be healthier, as there would be more loans for investments (which, in general, would create value that would offset interest expenses) than for consumption.
Products and Services Would Be Cheaper, Better, and More Varied
Assuming the government would significantly decrease spending, taxes, and regulations (in addition to not expand the money supply) a deflationary economy would generate greater diversification of products and services, as competition (or potential competition) would tend to be so high that lowering prices and improving product quality would not be enough for companies to survive. They would have to invest in product diversification to give consumers more options, meeting increasingly specific demands and being able to sell to various groups of consumers (that have different desires and needs). This is already happening in the technology sector and would occur at an even greater intensity in other sectors as well in a deflationary economy.
Historical Examples of Deflation
An example of deflation occurred in the US in the nineteenth century. Between 1800 and 1900, the price index dropped by 50 percent (from 150 to 100). “Despite” this deflation, the nineteenth century was marked by great economic growth in the US (an increase in the productivity of industries and falling prices). This is precisely what happens in a deflationary economy (or, in this case, one that tends towards deflation). From 1815 to 1914, the US was in a gold standard (read pp. 89–92 of this book), which is deflationary.
There were only a few inflationary periods, such as the Civil War in the 1860s. According to Patrick Newman (p. 497), during the Civil War, Congress established the national banking system. Both state and national banks were able to pyramid credit on the same set of lawful money reserves through the use of interest paying interbank deposits. This credit expansion led to a depression in the 1870s (1873–79), as explained by the Austrian business cycle theory.
The credit expansion was still happening in the depression period (which, according to Newman, must be considered between 1873 and 1875 because the data at the time were based on nominal series and there was little access to aggregate economic information) and signs of contraction began to appear, resulting in bank runs, which led to a credit crunch. In addition, there were no fiscal or monetary stimulus during the depression. For this reason, according to Newman, the recovery was faster, as the economy was able to reallocate resources efficiently.
Singapore is also a good example. Although it is not in a gold standard, its exchange rate policy is less inflationary than the floating exchange rate policy (adopted by most central banks, including the Fed and the European Central Bank).
As of 1981, the MAS (Monetary Authority of Singapore), Singapore’s central bank, began to interfere only in the exchange rate (as mentioned by Leandro Roque at 20:11), controlling the value of the Singapore dollar (SGD) in relation to a basket composed by the currencies of the main economies of the world, increasing and reducing the monetary base through purchases and sales of assets, respectively. The goal is to have a currency that continuously appreciates against the others.
Therefore, the MAS does not act by setting a target for the interest rate, leaving it to be mostly determined by the market. Thus, investments tend to be more sustainable in the medium and long term (since they tend to be financed by savings). This contributes to sustainable economic growth, with less intense recessions. The result was that between 1982 and 2005 the SGD was the currency that lost less purchasing power in the world, surpassing even the Swiss Franc (CHF).
Hence, the inflation rate remained low (increasing significantly only in some brief periods). At some points, there was even deflation (inflation rate below 0 percent).
When it became independent from Malaysia in 1965, Singapore adopted high economic freedom, which led to the surging of private companies that were very competitive in the global market, and to a high standard of living. The government adopted a policy of low public spending and low taxation, almost nonexistent bureaucracy, and few regulations. The less inflationary policy of the MAS is one of the main (if not the main) factors that contributed to Singapore’s performance.
Deflation is only bad for the government. In a deflationary economy, it cannot tax people indirectly via inflation and it can’t use monetary policy to artificially boost the economy and get votes before there is the inevitable recession. Consumers (mainly the poorer) and entrepreneurs are the ones who benefit from deflation (due to lower prices and larger profit margins, respectively).
To learn more about deflation, watch this lecture by Philipp Bagus.