I hate to be such a broken record on the subject of why deflation isn’t necessarily bad, such as this post from a few weeks back.  But I do it because this very wrong-headed fear leads to utter disaster.  For example, a big reason for Mr. Bernanke and Mr. Greenspan pushing the U.S. to negative real interest rates from 2002-2005 (which helped create the mortgage bubble which we are still recovering from) is a fear of deflation.   When prominent economists get this wrong, it leads financial reporters to reinforce this.  So today we have a story in Bloomberg, which is wrong in every one of its main points.  I will post their points, with my response below.

“Why Falling Prices are Actually a Really Bad Thing”

1. When shoppers see persistent price declines, they hold out on buying things. They ask, will I get a better deal next week, next month, next year? As a result, consumer spending flails. For most nations, that’s a big chunk of their economy, and any slowdown in consumption threatens growth.

Why is this wrong?  Ask yourself this question, will you wait a year to buy the new computer or new cellphone if you want one?  You know it will be cheaper next year (or equivalently, much higher quality/performance).  The bottom line is that people make purchases based on, in economic speak, the utility gain that the purchase makes vs. the next best alternative.  Waiting a year is not cost free–the utility forgone must be compared to utility gain (which must be discounted) of the additional purchasing power in the future due to the cheaper price.  It’s not clear at all that people will hold out, as seen by most technology examples.  Further, given our present-oriented culture, people don’t seem to postpone much consumption now.

2. Businesses behave pretty much the same way. They postpone buying raw materials, hoping to get a break on costs, and delay investing in that splashy new facility or hiring an extra hand.

Actually businesses do behave pretty much the same way, but exactly opposite this reporter’s thinking.  Firms will buy investment goods as long as the return on the investment exceeds their borrowing costs (or the return they could have made on retained earnings).  The closest to reality on this point is that firms will try to buy even more “just in time,” but given the tremendous progress already in this area, this is not likely a large effect.

3. Additionally, their pricing power — the ability to charge more — vanishes. That makes it harder for them to grow profits.

Wrong again; profits due to rising prices are ephemeral.  If prices are rising, input costs will rise as well, eliminating the initially higher prices.  Firms actually grow profits by increasing productivity and satisfying consumers, not by being the beneficiary of central bank inflation.

4. Lower profits = less money to go around to workers. Employees don’t get the raises they were expecting, they cut back on spending even more, and the ugly cycle repeats. That’s why they call it a deflationary spiral.

Since profits are not from inflation (my rebuttal from #3), this point is wrong too.

5. The sad thing is, even when prices are falling, the amount you owe doesn’t. Borrowers get crushed under the weight of that debt. In a mild scenario, companies and consumers hold back on other purchases to continue meeting their obligations. When things get really bad, they go bust altogether.

Only sort of true, and virtually irrelevant now.  As inflation falls, so do nominal interest rates.  So yes, if you have a home mortgage at 10% and then we have deflation, you will pay a much higher real rate.  But most loans are short term, or you have the ability to refinance.  Given we’ve been near zero interest rates for a while, this is not a factor (with a relatively low deflation, say 1-3%).  If we do get a collapse in the money stock, we could have the nasty deflation I do warn about.  Deflation is only a problem when the monetary authority allows a collapse in the money stock.  That’s why QE1 was probably the right thing to do in the 2nd best world we live in.

6. Policy makers usually have an antidote to economic slowdowns, but it’s trickier when interest rates are already near zero. That’s exactly the situation with the ECB and much of the industrialized world. That forces officials to turn to unconventional tools.  Policy makers have been raising and lowering interest rates for a long time but quantitative easing — a Japanese invention from the 2000s — is a relatively untested tool. Its effectiveness is still controversial among many economic circles.

This problem assumes that you want policy makers to “fix” the economy.  Given I blame most of our current economic problems on policy makers, I’d like them to have no tools, not just unconventional tools.  I consider this to be a feature, not a bug.  But I agree that QE is controversial.  There is little evidence that it has done any good (arguably since QE1).  The only support could be the same thing they say about the stimulus:  it would have been much worse without it.  Could be true, but hard to know.

So I find this article not only uninformative, but positively harmful to correct thinking about our economy.

EDIT UPDATE 26 Jan

Former Reagan budget director David Stockman takes the same article to task on similar basis (w/some charts that are helpful).  One of his points:

At the end of the day, the whole “deflation” bogeyman is a case of pure ritual incantation——incessantly repeated and amplified by mindless journalists like Chandra. In a heartbeat they will point to Japan’s allegedly long-standing and traumatic experience with deflation and never once acknowledge the obvious. Namely, that Japan has never, ever experienced anything remotely resembling deep and abiding consumer price deflation.