A Rumination on Deflation and Savings

This is the second part of a two-part series.  For the first part, please click here.

People have started saving recently, after years of taking on debt. However, the fact that the savings rate has increased recently seems inevitable: from zero, there's nowhere to go but up.It is often suggested that deflation encourages savings over investment or consumption.  This is because as the value of currency rises, or, as people notice the value of currency rising, they forego unnecessary purchases like new automobiles and that extra Christmas present, and instead save, that is, do not invest and do not consume.  This analysis makes sense logically, however, the impact of deflation largely depends on the decisions of individuals relative to an awareness of persistent deflation.  If individuals were rational in an aggregate sense, they might hold on to their money, but most people are too excited about ten-dollar DVDs and supermarket sales to wait for prices to get even lower.  Plus, if there is 0.18% deflation now in the U.S., is that really enough to reverse 75 years of persistent inflation? 

Were we to think about currency like any other commodity, getting into currency makes sense during periods of deflation.  Foregoing unneccesary expenses, making deposits to savings or CD accounts, being more wary about stock investments, and thinking twice before purchasing property are encouraged by a deflationary economy.  Those are terrible things, right?  Don't Americans need to be out buying Cabbage Patch Kids, self-help books, and unaffordable mortgages?  Aren't we supposed to solve the credit crisis with more spending? (On the contrary, economist Irving Fisher believed that deflationary spirals could occur when there was excess debt.)  Or does it make sense to weather the effects of the economic pendulum's swinging back to a rational equilibrium?       

For many years in the U.S., saving money has been the ultimate sucker's bet.  (In the past, saving was often the only recourse for low-income-earners, but for several years now, there have been companies like E*TRADE and Charles Schwab, whereby investing small amounts of money is possible.)  If you deposited 30,000 1964 dollars into a typical compound-interest-yielding bank account in 1964, you would have over 100,000 2008 dollars today; but in real terms, you would have actually lost over 100,000 2008 dollars!  If, on the other hand, you put your 30,000 1964 dollars into a piece of property on the outskirts of a major city or along the new interstate highway system in 1964, you would have profited by over 800,000 2008 dollars.  No wonder Americans don't save!  We're finally starting to get it.  Saving is totally illogical in a chronically inflationary economy.  The wealthy, more than anybody, know this, and put their money in assets, like real estate, immune to chronic currency inflation.  Like the lottery, inflation is essentially a stupid-tax, and, if you've had a large bank account not tagged to inflation all these years, the joke's on you. 

Nevertheless, all these years of inflation came back to bite us when asset values dropped dramatically a year ago, because we had nothing to fall back on and instead had to refinance the macroeconomy.  It seems a significant savings parachute would be prudent to save us from aggregate mistakes in the future.  Ironically, a deflationary economy renders central bank monetary policy impotent, which may suggest a conflict of interest. (However, the Federal Reserve and Congress hedged against this by spreading the stimulus through several years.)  Whether one believes in the efficacy of a central bank-led, top-down monetary policy or not, perhaps allowing the deflationary river to break through the dam and adjusting to it is best for now.  Everything in moderation prevails: When the credit crisis hit a year ago, Americans had a near zero saving rate.  Now, they are starting to save a little, and saving a little is good for the macroeconomy; we have something to use on a rainy day as well as money to start new businesses, invest, or treat ourselves to something nice once in a while.  For now, with the stock market rising at a moderate rate, and unemployment still a major problem, a modest, deflation-based reallocation of resources could be good for us.