Deflation, Savings, and Where We Go Next

The Japanese media has recently been obsessed with defure, or deflation.  The September annualized rate of deflation for Japan was 2.24%, compared to September annualized deflation rates of 0.18% in the U.S. and 0.80% in China.  Canada, the U.K., Australia, and the European Union had very low rates of annualized inflation in September.  Why does the media panic about anomalous low-single-digit deflation while ignoring the well-documented effects of seventy-five years of chronic inflation?  The rationale for the panic is that deflation can lead to a liquidity crisis (government stimulus is rendered impotent) and/or a deflationary spiral (hyperdeflation); yet, blind to the lessons of history, inflation is considered a necessary evil, and the possibility of an inflationary spiral is underserved. 

First, an explanation of the relevant terms.  Originally, inflation meant an increase in the money supply, and deflation meant a decrease in the money supply.  However, modern understandings of the terms are more nuanced; now inflation and deflation are related more to purchasing power and price levels.  Because when there is more of something it becomes less valuable, inflation is now understood as a devaluation of currency.  Deflation is when a currency becomes more valuable.  Usually during economic booms, there is a robust rate of inflation as people move their collective wealth from cash-based resources into assets; there is more cash around, so people treat it with less respect and tend to spend frivolously.  During recessions, people tend to value security over potential profits, and attach more value to cash-in-hand; a dollar is worth more as a result.  Deflationary periods indicate increasing aversion to risk among the population, but not necessarily recession: in the late nineteenth century the U.S. experienced both persistent deflation in the absence of a central bank and high rates of economic growth.

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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? 

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A Rumination on Deflation

Recently, the Japanese media has been obsessed with defure, or deflation.  The September annualized rate of deflation for Japan was 2.24%, compared to September annualized deflation rates of 0.18% in the U.S. and 0.80% in China.  Canada, the U.K., Australia, and the European Union had very low rates of annualized inflation in September.  However, it is inconsistent for the media to panic about anomalous low-single-digit deflation while ignoring the well-documented effects of seventy-five years of chronic inflation.  The rationale for the panic is that deflation can lead to a liquidity crisis (government stimulus is rendered impotent) and/or a deflationary spiral (hyperdeflation); yet, in apparent blindness to the lessons of history, inflation is near universally considered a necessary evil, and the idea that inflation could lead to an inflationary spiril is underserved. 

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