Paul Krugman explains why deflation is bad:
So first of all: when people expect falling prices, they become less willing to spend, and in particular less willing to borrow. After all, when prices are falling, just sitting on cash becomes an investment with a positive real yield – Japanese bank deposits are a really good deal compared with those in America — and anyone considering borrowing, even for a productive investment, has to take account of the fact that the loan will have to repaid in dollars that are worth more than the dollars you borrowed. If the economy is doing well, all this can be offset by just keeping interest rates low; but if the economy isn’t doing well, even a zero rate may not be low enough to achieve full employment.
And when that happens, the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed. That’s the deflationary trap we keep worrying about.
Okay, so there is just no industry where people watch prices falling and falling and still continue their purchases, even if they can get a better deal a few months down the line. Not one such industry. Oh wait. Let me check the darn thing I’m seeing this on.
I bought the first of my 19” monitors in 2006. It cost me Rs. 20,000. Twenty thousand. Today it costs Rs. 5,000. I should have waited four years, because guess what, for years before that, monitor prices were falling. But okay, perhaps I wasn’t being rational.
I bought a 1.2 lakh “projection” TV in 2003. On a 36 month interest free loan. [Don’t ask.] That TV would cost Rs. 20,000 today, and for 45,000 you get much much better LCD or LED TVs.
I paid Rs. 6 lakhs for a Fiat Palio 1.6 in 2002. It costs about Rs. 50,000 less today, for a vastly improved version. A Hyundai Accent costs Rs. 40,000 less than it did in 2002 – EIGHT whole years ago.
I paid Rs. 10K per night for a hotel in Goa in 2005 – Fort Aguada, All meals, Cottage Garden View. The price today: Rs. 19,100 for two nights, and it’s a substantially better cottage. I should’ve waited, darn.
The computer industry by and large, the cell phone industry, mobile telephone, the internet, hotel package prices in Goa, uhem.
Let’s not even account for the fact that food, regardless of inflation, is a necessity, and you’ll pay whatever it costs (or downgrade what you eat) simply because you need it now, and can’t wait. That argument however doesn’t apply to any of the stuff I mentioned above.
This may sound anecdotal – but here’s the thing: the car industry in India, the cellphone industry, mobile telephony, internet access, computer parts – all of them have dramatically higher revenues and profits today, despite falling prices. That means people are buying despite prices falling. And not just because they need the darn things.
Krugman’s argument doesn’t work. Some may consider the above industries as silos (a term meaning something that seems to operate independently of everything else) that don’t reflect the global industry, but that’s hardly true, is it?
The problem with deflation is it keeps asset prices low. So if you bought crap that you expect to value, you have a problem. Especially if you bought on credit. So if you bought a house and you took on debt, but the house price falls, it hurts your “net worth”. Because now your assets are lesser than your liabilities. But that’s a stupid way to look at it at a personal level, because when you take a loan for anything other than a house (a TV, a laptop, a holiday) you have a negative net worth to that extent.
The house you live in is not really an asset – it’s a liability which you, as a rational individual, decided to pay much higher money than equivalent rent because you want the nice warm feeling in your heart. Or, looked in another way, it’s an asset like a car, whose value depreciates every year. The concept of looking at a house as an asset should have been history by now, at least in the west, but it’s so entrenched in society today.
A house you live in is a mega-expense. People who pay only 20% down – and this is supposed to be the really creditworthy people – are buying a very highly levered expense. If I told you to buy a TV with 20% down, and pay the remaining over the next twenty years, would you still be worried that TV prices went down? Sure, the bank might be worried, especially if it has a truckload of TV loans it thinks people might default on and then it has to sell the TVs. But banks aren’t the economy, no?
Now the picture comes together. Deflation is, in a way, bad for the bank. The guy who lent you the money. Because when the bank tallies up the collateral, it doesn’t add up to the value of the loan outstanding. That makes it go crazy about “asset-liability mismatches” and it does stupid things like threaten to take away the TV; and when you hear the same bankers are paying themselves big fat bonuses, you tell them to go take the TV, you ain’t paying. They lose money and go crying to the politicians who instantly realize that the only way bankers will leave them alone is to inflate asset prices somehow. In America the government has gone to the extent of actually buying these deflated assets.
The further complication is that along with the government, banks own these assets. With a highly leveraged system, even a small destruction of capital is enough to destroy your assets.
As prices fall, a creative destruction process emerges. Someone’s willing to pay at lower price points. When house prices fall, people get worried – but the worry should not be that house prices are falling; there will be a price point when it’s a damn good bargain, and the buyers will come back. Why not let things go there?
The answer: bank leverage. When banks, for every dollar in capital, have borrowed $10 and then lent out $10 for such loans. If the value of the collateral falls 10%, their “equity” is wiped out, meaning they are out of business.
Technically this means the bank should be shut down, and the remaining $9 on their books should be sold to other people – maybe for $6 to sell it fast – and the smart people who know it’s really worth $9 will pay $6 for it. The people who lend the bank $10 lose money, but that’s the nature of the game.
At this point, if this were to play out, most banks in the US will go bankrupt. But the systemic effect may actually benefit us – since all cross holdings of debt will be wiped out. What will emerge is smaller banks which can buy the pieces. But as the big banks go belly up the issue is who loses money – and the answer is “pension funds”, a conclusion that is not politically palatable.
But if the bullet is not bit now, we will see all the crap assets being bought by the government, and then the cost moves not just to pension funds but to every single taxpayer; with the way money multiples inside the banking systems, taxpayers will be on the hook for a lot more if they wait. And it’s not entirely clear that pension funds will be very hugely affected – if we let it all play out, just the squaring off of various cross liabilities might result in a lot lesser dollar amount, though there will be a few panic situations. I think the better way – thinking of the next 10 year period – is to do the damage now. Let deflation happen, let asset prices crash, let the banks fail, and push the smaller banks to buy the pieces and indeed, fund them.
And in the process refuse to allow a 10x leveraged system to build up. The concept of people paying 40% of their pre-tax income to a housing loan, on which they have only 20% down is crazy – for something that makes you negative on networth, you need to be putting more down, or use less % of income. [While applies for every ot
her kind of loan]
One more thing: If we’re worried about asset price deflation, then why are we using silly metrics that include prices of consumer goods, or food or oil? Consumption goods seem to work very well as prices fall. Only assets are a problem, no?
Okay, rant over. Krugman makes excellent other points which, if I start talking about, my computer will crash. But I’ll do it another day; after all, replacing the computer will get cheaper.
