Because the two words, inflation and deflation, look alike, they invite the conclusion that there’s a single phenomenon– -flation–that has two varieties, de- and in-.  As a practical matter, despite the similar names, inflation and deflation are actually quite different in how they affect an economy.   In the US at present, knowledgeable politicians (an oxymoron?) and economists have their fingers crossed that inflation somehow resurfaces and that deflation will not become an issue.

inflation

An economy with inflation is one where the price of things in general is rising.  It isn’t enough that some prices are rising–even very visible prices like gasoline or movie tickets.  In an inflationary economy, overall prices have to be rising, so that the cost of living steadily goes up. (I wrote about inflation more extensively in a post from May 25, 2009.)

In a developed economy like the US, the only price that really counts for inflation is the price of labor.

If inflation had a tendency to stay well-behaved, at a constant, low rate, it wouldn’t be much of a problem.  But it usually doesn’t do either.  One way to think about what happens is this:

in an inflationary environment, some people underestimate inflation.  They think prices will rise by, say, 3% in the coming year.  They ask for and get a 3% wage increase.  But inflation turns out to be 4%, so in real (i.e., adjusted for price-level changes) terms they are making less than they used to.  So the following year, they ask for a 6% raise.   Others ask for and receive a 5% raise, so they’re better off in real terms than before.  So they try to do the same thing the following year.  As a result, the rate at which prices are rising tends to increase.

At some point, expectations change. Companies start to raise the prices of their output and individual wage earners up their wage demands in anticipation of, and as protection against, future inflation increases.  In doing so, they create the increased inflation they fear.

As inflation accelerates, people start spending more and more time defending against future price increases and trying to work the situation in their favor.  This means less time doing productive work.  At more advanced stages, capital investment in long-term projects slows, because figuring out its profitability may depend on forecasting accurately what inflation will be ten years hence–which has become impossible.  For the same reason, no one wants to hold fixed income securities, including government debt.

In the worst case, hyperinflation (think:  Japan or Germany close to a century ago, or Brazil twenty years ago), the economy comes close to collapse.

The (relative) good news about inflation is that it’s a well-understood phenomenon.  Any government knows what to do to remedy the situation:  restrictive policy (higher interest rates, plus maybe less government spending and higher taxes) until inflation begins to decline and expectations in the economy change.   The real stumbling block to an inflation cure is having the political will to implement it and a Paul Volcker-like central banker to oversee the process.

deflation

In its definition, deflation is the opposite of inflation.  It’s a steady, general fall in the price level.  To my mind, three factors make deflation something different from a mirror image of inflation.

1.  Deflation is weird. Other than the Great Depression or the Weimar Republic, it hasn’t occurred very often in the contemporary world.  Other than maybe the PC industry, no one is set up either psychologically or institutionally for deflation.  Suppose prices were falling at a steady annual rate of 2%.  What would you think of a government bond where you paid $1000, received no interest income and got back $900 in ten years?  Me, too.  Credit creation, and all the economic activity that depends on it, would stop dead in its tracks.

2.  Deflation makes outstanding debt that carries a positive nominal interest rate (in other words, all of it) a crushing burden.  Prices dropping 2% per year means, among other things, wages dropping 2% annually.  Let’s change the rate to 5% just to make the point easier to see.  At the end of five years, you’re making 77% of what you were before deflation hit (ignore the fact that falling wages suggests widespread unemployment and other horrible economic problems).  Yes, the cost of food and clothing has probably fallen in line with your income, but your mortgage and credit card payments haven’t.  If your credit payments were 25% of your income pre-deflation, they’re a third–and rising–of your income now.

The situation is worse for companies with operating leverage, whose profits can quickly disappear.  Imagine, too, the state of private equity or commercial real estate, which depend on high levels of financial leverage for their viability.  They’re toast.

This, of course, has knock-on negative effects on the banking system.  Look at the Thirties.

What a mess!

3.  Traditional money policy becomes ineffective.  The orthodox central bank response to recession is to lower short-term interest rates until they’re negative in real terms.  The fact that finance is in effect free is supposed to stimulate borrowing, and therefore reinvigorate economic activity.  But the central bank can’t push nominal (i.e., not adjusted for inflation/deflation) short rates below zero.  So in a deflationary environment, the central bank can’t achieve the “free money” outcome.

This means that a country depends completely on fiscal stimulus–increased government spending–to help the economy improve.  But legislative action may be slow.  There’s huge potential for spending programs to be applied in pork barrel ways that will do little more than run up the government’s debt burden (think:  Japan since 1990).

where are we now?

There’s good news and bad news, in my opinion.  Bad news first.

Government stimulus programs seem to me to have so far been focussed on whatever is “shovel ready,”  without much thought about addressing long-term structural problems like education.  Maybe that will change.  But to date Washington looks scarily like Tokyo circa 1990.

The good news–

Europe’s pain is our gain.  US government spending depends on the continuing willingness of foreigners, notably China, to lend Washington money.  Prior to the Athens-induced collapse of the euro, Beijing appears to be warming up to shift its lending activity away from the US.  Not any more.  So no matter how inefficient government stimulus may be, at least it does something positive, and it won’t come to a screeching halt.

Also, lots of companies are announcing that business has become good enough that they are beginning to raise wages again and reinstitute benefits cut during the recession.  Given that wages are the most important element of changes in the price level in the US, this suggests that the current near-zero inflation rate is a cyclical low point and that the price level will rise from here.  To some extent, this movement in the private sector will be offset by changes in state and local government workers’ payrolls (some studies claim that municipal employees are now paid 20% more than private sector workers for the same jobs).  Still,  I think the private sector trend is grounds for a loud sigh of relief.