Deflation

I was listening to NPR in the car yesterday, when a report came on about the implications of deflation — which apparently is the latest concern regarding financial markets. The report nearly made me fall out of my seat from bewilderment and frustration.

Adam Davidson, the NPR reporter, waxed eloquent about how deflation turns normal economic and investment calculus on its head.  But his explanation was so poor that he ended up saying exactly the opposite of what he should have said.

Here’s how it went for me:

Davidson: “Ladies and gentlemen, I have an amazing investment opportunity for you. Give me $100, just a hundred, and in one year I promise it will be worth 93 bucks. We call it the deflation special.”

My reaction: No, sir! Under deflation, $100 today would increase in value to $107 (assuming your implicit rate of deflation).  Help! Stop the car! …Wait, I’m the one driving…what just happened?

Davidson: “All right, seriously, nobody is giving anybody a hundred bucks just so they can lose seven.”

My reaction: No, no, please, please take my money! I’d give you a million dollars if I had that amount. I really would!

Davidson: “That’s the opposite of an investment opportunity, which is precisely why economists and central bankers get terrified when they hear the word deflation.”

My reaction: Well, a small amount of deflation can be consistent with flexible prices. It’s only rapid spiraling deflation that we should worry about.  But the same is true about rapid spiraling inflation.

Davidson: “Technically, deflation means that the prices of all kinds of goods and services keep falling, rather than what they normally do, which is rise. And deflation means that not just one investment but all investments are worth less next year because the currency they are based on — like the U.S. dollar — is going to be worth less next year.”

My reaction: That word “technically” should be banned from his vocabulary.  Again, the confusion here arises from using the word “currency.” Deflation means lower prices tomorrow compared to today and, therefore, a higher value of each dollar.  Indeed, all debts appreciate in value in a deflationary environment.

Davidson: “Why pay money to build a new factory or buy a house or hire an employee or go to school if the payoff will be worth (less) than the money you put in?”

My reaction: Lenders would be happy to lend money for investment projects because deflation implies a higher rate of return on them. It’s the borrowers and entrepreneurs who would not want to borrow funds because deflation escalates the real value of debtors’ liabilities.

Davidson: “Deflation, once it starts, is extremely hard to stop. Which is why the Federal Reserve is doing everything it can to prevent it.  Although, all the tools used to prevent deflation, like increasing the money supply and keeping interest rates incredibly low, can cause another problem: inflation.”

My reaction: What is it that you want, man? Make up your mind!

Davidson: “Now, central bankers tend to think that they can stop inflation more easily than deflation. So given the choice, they’ll inflate.”

My reaction: Those horrible Fed officials! I always suspected they were up to no good — always ginning up inflation. Now I know why!

I wonder which economics school Davidson (and his editor) attended. My guess: none. Let’s see … what’s on the next radio channel?