Every time I read about deflation it comes with a wealth warning. But why?

Is it possible that a period of deflation could actually be of benefit to us?

We have been fed the constant message that 2% inflation rate will somehow keep our economy growing at about 2% too. Good for everyone we’re told. But at that rate of growth, our economy would double in size every 34 to 35 years. How can that possibly be sustainable? Especially if everyone on the planet is at it.

We have now talked ourselves into the position of fighting deflation at all costs. To get an idea of why you need to look at who wins and who loses with regard to the inflation / deflation argument.

Amongst the inflation winners is the government because it can borrow and watch the debt be inflated away over time. It can also engineer tax thresholds to increase the overall take every year. With deflation, the national debt would effectively get bigger year on year.

The people with the money in the big financial firms also rely on inflation, highly geared private equity firms for example.

Also anyone in overall debt will benefit from inflation.

How about the deflation winners then. Savers win, because just keeping their capital means it gains in real value over time. The consumer also wins, because prices drop over time.

So the big boys argue and lobby constantly to keep inflation going, whilst those with no voice have to live with it.

The main argument against deflation is ‘the deflation spiral’. This is where no-one buys anything because they’ll wait for the price to drop further, and further, and further ad infinitum. The economy will grind to an inevitable halt the argument goes. So it is bad and must be avoided at all costs.

This is a fallacy. If we allow deflation to occur naturally prices will drop for a while and a few firms (probably the right ones) will go to the wall. Then inflation will return for a while. This will also allow the economy to adjust in size to meet the requirements of the people. At the moment we have a state where we are trying to manage the people to fit the economy (spend, spend, spend).

We now though find ourselves in position where we have spent so much time and money on fighting deflation, that any correction will have to be big and painful (for government and big business). Consider how much money is being injected and the hammering that sterling has taken with only a small effect so far on inflation.

Expect to see even more printing to benefit the government and financiers.

We would actually be better off now managing deflation, not trying to force inflation.

Originally posted 02/04/2009

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