Tuesday, August 3, 2010

What Is So Terrible About Deflation?

The Federal Reserve and most other major central banks of industrialized nations follow a price stability mandate or goal.  Usually the goal is around 2% annual inflation and anything lower is discouraged.  Price stability is not quantified as inflation at zero or even near zero (0% - 1%).  In the following discussion we assume that the Fed has been pursuing a zero inflation target (even though they are currently clearly trying to avoid deflation) as that is most clearly where we (the United States) currently are.  The following problems are brought up with such low realized level of inflation (from Mishkin's Monetary Policy Strategy, pg. 359):
"One reason relates to downward nominal wage rigidity.  If the inflation rate were to approach zero under the condition of downward wage rigidity, it would be difficult to achieve real wage adjustment in response to changed market conditions, such as a negative demand shock.  The result would be higher-than-desirable real wages, higher unemployment, and lower economic growth"
In layman's terms: If prices fall and wages are resistant to falling with them, then real wages have gone up and more workers are going to get whacked.
"A second reason relates to the impossibility of reducing nominal interest rates below zero, which means that if inflation is close to zero, real interest rates cannot be pushed below zero when this might be necessary to in order to stimulate economic activity"
A third issue with such a low level of realized inflation, which let me repeat myself by saying would be equal in our case with a hypothetical zero inflation target by the Fed, is that:
"A zero inflation target may lead to periods of deflation, which could promote financial instability and make it harder to conduct monetary policy because interest rates no longer provide a useful guide to the stance of monetary policy"
Deflation is also a key factor promoting episodes of financial instability in industrialized nations because debt contracts in industrialized nations frequently have long maturities.  This means that a deflation leads to an increase in the real indebtedness of both households and firms, which in turn leads to a decline in their net worth and a deterioration of their balance sheets.  Taking the "credit view" with decreased net worth, adverse selection (defined as the problem created by asymmetric information before a transaction occurs: The people who are the most undesirable from the other party's point of view are the ones who are most likely to want to engage in a financial transaction) and moral hazard (the risk that one party to a transaction will engage in behavior that in undesirable from the other party's point of view) problems increase for lenders, who therefore cutback on lending.  Mishkin describes the following outcome:
"The decline in net worth also leads to a decline in the amount of collateral a lender can grab if the borrowers investments turn sour, and the reduction in collateral therefore increases the consequences of adverse selection, because loan losses resulting from default are likely to be more severe.  In addition, the decline in net worth increases moral hazard incentives for borrowers to take excessive risks because now they have less to lose if their investments fail."
Apparently Paul Krugman wrote about this as well.

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