Inflation is falling so fast around the world that some analysts are already warning about deflation. The idea is that central bankers are behaving like my daughter trying to drive a boat. By constantly overcorrecting course, you end up with a zig-zag pattern. In economic terms, that’d be recessions and booms, or deflation and inflation.
Deflation is the zig following the inflationary zag we just had. It’s coming because central bankers have overcorrected to the recent bout of inflation. They’ve hiked interest rates so far and so fast that it’s going to cause a debt crash. Something like 2008 is coming, in other words.
As the economy goes into a tailspin from unaffordable interest rates, meaning that companies default and houses get repossessed, consumer prices will begin to fall – producing deflation.
This sort of deflation is indeed a bit of a worry. A “debt-deflation” is what it’s better known as. When prices crash because the economy cannot afford its debt, that is dangerous because it can be self-sustaining. The more prices fall, the less companies can afford their debt. The more house prices fall, the more people are forced to sell at negative equity. All this further depresses prices and the cycle begins again.
It’s all a bit of a nightmare. And that sort of deflationary boogie man may already be waiting under your bed in the second half of 2023.
It’s ironic that this can happen at all in a world with central banks which control interest rates. I mean, how incompetent do you have to be to have a debt crisis when you control the price of debt?
And yet, we constantly have such crises…
But falling prices aren’t inherently bad. That is because they don’t only happen because of debt deflation. Perhaps the boogie man of deflation is more of a cuddly toy, like in the film Monsters Inc. Which brings us to this reader’s question.
Dear Nick,
We hear a lot about the dangers now of a ‘deflationary shock.’ What exactly is so bad about deflation? Is it more the fact that such a deflationary shock would only be the effect of another great depression? If we have had, for argument’s sake, 10% inflation in 2022, what would be so bad about -10% inflation (deflation) in 2023? Wouldn’t that be wonderful and make everything more affordable again? Or have I missed something?
Feel free to publish my question if you think it could of general interest to readers.
Kind regards,
S.T.
I thought you’d never ask… (this happens to be a favourite topic).
Wouldn’t it be nice if the cost of living steadily got cheaper each year? After all, we’re mighty good at producing things these days compared to 100 years ago. Why should the things we buy become more expensive each year? Shouldn’t they be getting cheaper?
To be more specific, why would central banks target 2% inflation, thereby making us all 2% poorer each year?
The cynical answer is that inflation is a transfer of wealth, from the saver to the debtor. That’s because it devalues money. And debt and savings are denominated in money. If debt is worth less each year, it’s easier to repay. If savings are worth less each year, well, you’ve lost something.
Who are savers and who are debtors in our society? Investors are the savers. Debtors include the government and usually wealthy people who use their higher income to access leverage.
In other words, the 2% inflation target is class warfare.
The official answer to why we have the 2% inflation target is all about avoiding debt deflation. Our modern economy is so debt soaked that a bias towards inflation acts like a buffer for borrowers.
Because central banks are so bad at their job of achieving a specific rate of inflation, and because anything below 0% is so dangerous, we set the target at 2% and hope the zig and the zag keeps things between 0% and 4%.
Another answer is that 2% inflation acts as a sort of economic stimulus by encouraging borrowing. Which is, of course, a good thing…
It’s worth noting that presumed price increases are not true of all goods. Most tech-related products get dramatically cheaper each year. The cost of a gigabyte of storage is a tiny fraction of what it was ten years ago. And yet, the tech industry does rather well, by constantly innovating. Odd, that…
Wouldn’t it be nice if other industries had to constantly innovate and provide better products and services if they wanted to charger higher prices?
It’s also worth noting that Japan had long periods of deflation without facing disaster. But that’s a long story.
The bigger underlying question today is whether you can have good deflation – prices getting cheaper – without triggering a debt deflation as a result.
In a sense, the answer is simple. We’ve had it and it worked. They called it the Industrial Revolution, perhaps the greatest leap forward for living conditions ever. All the while, prices fell during that episode.
Industrialisation and mass production made it cheaper to produce more goods and the savings were passed on to consumers.
Although we carried less debt back then, it’s worth pointing out that interest rates simply adjust for this lack of debt. In real terms, 2% interest at 1% deflation is the same as 3% interest at 2% inflation. Both amount to a 1% interest rate, in real terms.
Unfortunately for all of us, our economies – and especially our governments –are so badly overindebted right now that the healthy sort of deflation is not on the menu. We need high inflation to keep our debts under control. The alternative is a financial crisis.
So don’t try and cuddle the deflationary boogie man under your bed after all.
What does all of this mean for a future world with central bank digital currencies (CBDCs)?
Well, CBDCs give governments and central banks far more direct control of the money supply. They might finally be able to engineer the specific rates of inflation they actually want. And if they do, my bet is that it’ll be well above 2%.
That’s why you need to escape now. Here’s how.
Nick Hubble
Editor, Fortune & Freedom
