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Deflation is Not the Point

Recently someone shared this video with me:

In it, Mark Who Teaches Economics claims that we should target 4% deflation. But he goes even further than that and states that deflation is the whole point of economics. The video is bullshit, so let’s break it down.

Right out of the gates he makes it clear that his whole argument is based on a logical fallacy. Basically, he implies that:

  • Deflation is caused by increases in productivity
  • Increases in productivity are good
  • Ergo, deflation is good

I am paraphrasing, but watch the video and let me know if this is a mischaracterization. Did you catch the logical fallacy? Let me make a similar, parallel argument to make it a bit clearer.

  • Pollution is caused by productive human activity
  • Productive human activity is good
  • Ergo, pollution is good

For the sake of argument, let’s assume that his first two points are correct. But the conclusion does not follow because deflation is a byproduct of increasing productivity, not the point of it.

Of course, since Mark isn’t completely uninformed he goes on to explain to us (correctly) that the impact of deflation is closely related to something called “sticky wages”. That is, he points out that wages are “downwardly rigid” so it is hard for employers to cut wages. So if inflation happens, all employees will naturally get an automatic increase in wages. Great! Free money!

Interestingly, he briefly points out a very negative potential impact of this. Namely, he agrees that this would reduce sales and at the 1:40 mark he says “if your employer’s sales go down 50%, he’s not going to cut wages by 50%. Chances are he’ll lay you off.” Ok, so deflation is great for everyone except employers (who start to lose sales and can’t maintain profitability at the new price levels) and all those employees who get laid off by these employers. In other words, deflation is just great except that it will hurt business and cause unemployment.

A bit later (at 3:25) on he mentions that if input prices go down, business won’t actually be hurt because they can make an even greater profit. And of course, if there is deflation input prices will go down because that’s basically the definition of deflation. But wait a minute, his whole argument about why deflation is good is that the price of at least one input (labor) won’t go down. So those businesses who don’t hire anybody will be just fine. If all they do is buy and sell goods, they can get the same margins because the prices of inputs and outputs both go down!

But as soon as we start talking about businesses that hire actual people, we’re fucked, because as he himself admitted 2 minutes ago, those businesses won’t be able to decrease wages, so he won’t be able to compete at the new price level and he will just have to lay off employees.

Hold on though, there is historical evidence! At 3:48 he points out that in the 1800’s we had deflation and things were just fine. Except look at the list of recessions in the 1800s. There were more recessions in the 1800s than the 1900s, so that wasn’t exactly a monetary golden age.

But why would he go back over a hundred years anyway? What about more modern history. Take a look at this chart of inflation/deflation over the last century:

From https://realeconomy.rsmus.com/making-sense-of-inflation-what-we-can-learn-from-post-recession-recoveries/

Basically, there were a number of of deflationary episodes in the 1900’s and all of them were associated with recessions. Specifically, deflation typically caused by recessions. However, because of the unemployment effect Mark himself pointed out at the beginning of his video, too much deflation can extend a recession (or depression) because it causes unemployment.

From https://www.frbsf.org/economic-research/publications/economic-letter/2009/march/risk-deflation/

Anyway, moving on. The next head scratcher is that at 4:35 Mark claims that the Federal Reserve targets a “Wicksellian” natural rate of interest. This is simply not true. The Federal Reserve is required by law to target “maximum employment, stable prices and moderate long-term interest rates.” They tend to interpret this as meaning a combination of a 2% inflation target and low unemployment (historically, about 3%).

The last little tidbit from the video I want to mention is found at 5:45, where Mark claims that if we had 4% deflation, and I quote, “we’d all get rich.” Given that for the last century deflation has pretty much exclusively been associated with recessions and unemployment. Now, this isn’t to say this is the only time deflation could happen. It just means that looking to deflation as the solution to all our economic problems is just snake oil.

All About Bitcoin

Let’s take a step back for a moment. Why would a huckster like Mark be “selling” deflation? The answer is that there are people who like to hear it. But why?

Well, the idea that you could just hold onto money and it would grow in value is pretty appealing. And conversely, the idea that if you hold onto money its value will be eroded because the government seems unfair. In fact, this is one of the big reasons behind a lot of the support for Bitcoin.

So let’s talk about Bitcoin. The growth in the supply in Bitcoin is limited, and will eventually level off, so doesn’t that make it a better form of money? No, it doesn’t. As many Bitcoin enthusiasts are quick to point out, money serves different purposes, including: store of value, medium of exchange, and unit of account.

If something is constantly losing value, than it stands to reason that it isn’t a very good way to store value. But guess what? No one who has any sense stores their value in currency anyway (unless they are required to by law, like banks or they are just storing a little bit for emergencies). Currency doesn’t really do any work, so it is much better to store you value by purchasing assets like stocks, bonds, real estate, etc. Some of them carry risk, but some assets are pretty safe and are very good at storing value.

Because in actual practice people store their value in assets, not currency, you don’t really need your currency to store value. (I personally own some Bitcoin and I think it is a good asset to own…blah, blah not investment advice, etc).

But a currency does need to be a good medium of exchange. Whether something is useful as a medium of exchange depends on things like how easy it is to transport, and how easy it is to transfer from one person to another.

The blockchain offers some pretty big advantages over traditional forms of money transfer (i.e., no need to trusted intermediaries). Howver, the Bitcoin network can have some pretty high transaction fees, as high as $60USD for a single transfer, which tends to make it unusable in practice as a day-to-day medium of exchange.

In addition to (and perhaps a prerequisite to) being a good medium of exchange, a currency also needs to be a good unit of account. And what makes a good unit of account? A good unit of account is something with a stable value. Any inflation or deflation can undermine the value of something as a unit of account because it forces business and consumers to constantly recalibrate their prices (and wages). This doesn’t happen for free.

Of course, businesses and consumers are constantly changing prices anyway, so a mild, predictable inflation (or deflation) doesn’t necessarily invalidate something as a potential currency. But what does invalidate something as a useful currency is this:

You simply can’t have your unit of account fluctuate that much…even if it is deflationary. Imagine you got a mortgage in 2016 denominated in Bitcoin. Within a few years your debt would have ballooned to 10X the original amount. This is completely unacceptable, and unless Bitcoin ever settles down and stops going up in value so damn fast, it will continue to be a good asset and a terrible currency.

What About Mild Deflation?

Ok, but what if we don’t really care about Bitcoin? Mark wasn’t actually shilling Bitcoin anyway. He was just arguing that we should have 4% deflation. Is that mild and predictable enough?

Whether it is predictable depends on the mechanism for maintaining it. And although he isn’t exactly clear about his exact plan, it seems like Mark is and advocate of not doing anything at all to maintain the stability of the currency. And in this case, random fluctuations of undetermined size around 4% deflation probably doesn’t make a very good currency.

But what if it was stable at exactly 4% deflation? Then we have an interesting case. Also, like Mark, let’s assume that wages are stickier than prices so prices get adjusted before wages. What would I expect to happen? Is everyone going to get rich?

Well, some employees who wouldn’t get a raise otherwise would end up getting regular wage hikes. However, this means that hiring people would be more expensive. So some employees (mostly the bad ones who don’t deserve a raise) end up getting slightly better wages. But we also get a higher base rate of unemployment. This sounds a lot like the tradeoff for a higher minimum wage! I wonder if Mark is also a fan of high minimum wages?

It also means that anyone can very easily save their money and get a 4% rate of return. This is a pretty neat aspect of our fantasy economy, but when you realize how easy it is currently to invest in stocks (which average a 7% real return) most people still wouldn’t keep their money under a mattress.

For similar reasons, lending markets would look utterly different from how they do now. Currently, if you hold onto cash you lose value every year from mild inflation. If this wasn’t the case, people, and especially banks, would prefer to hold more cash and this would make it harder to borrow money. Note that interest rates wouldn’t necessarily be higher. In fact, they would probably be lower. But paying back that interest would be harder because, in a deflationary regime, future money is more valuable than present money.

This would also make home ownership more challenging because low real mortgage interest rates wouldn’t be available. For example, interest rates are now about 3%. Recently, inflation has jumped to about 5% which makes the real interest rate about -2%. But this probably won’t last. But let’s be clear, people are basically buying homes at basically 0% real interest. With 4% deflation it would be much harder to get a loan below a 4% real interest rate. So fewer people buy homes (or people buy more modest homes).

So, compared to our current mild inflation, I would expect mild deflation to have the following results:

  • Some (mostly marginal) workers earn more income over time
  • More unemployment (which again, mostly affects marginal workers)
  • Slower overall economic growth (due to more difficulty lending money)
  • People buy smaller houses and rent more

This is a mixed bag — It’s not the end of the world but it’s definitely not the “everyone gets rich” kind of good that Mark makes it out to be. If extended deflation is caused by a period of massive technological growth, as in the period of 1870–1890, it’s probably not such a bad thing. On the other hand, the Lost Decades of Japan represent a period of mild deflation that are generally thought to be pretty stagnant, and represent the decline of Japan as a global economic force. So yeah, definitely a mixed bag and definitely not the whole point of economics.

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Icewater builds blockchain technology for the future. Our primary product is H2O, a stable coin that focuses on long-term stability

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Patent Attorney, Crypto Enthusiast, Father of two daughters

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