Friday, July 9, 2010

A thought about deflation in the United States

As I have written before, I believe that the natural state of an economy that is progressing and becoming more efficient is a deflationary one.
In a closed economy, a rise in productivity increases the amount of goods provided, leading to price decreases as the number of good rises and the amount of money stays the same. In this scenario productivity increases and money supply growth can coexist and maintain price levels stable, even if a small amount of money is being printed.
That is an oversimplification, but it gets the general point across. If we keep the monetary base stable, increases in population or increases in productivity will both have the same end result: higher potential output and a lower nominal price level. We use monetary policy as a tool to protect ourselves from this monster because the people in control of the big money machine are economists, and economists believe that people are rational utility-maximizing machines. What that means is that if people get used to the idea that prices steadily decline, they will continuously put-off spending because things get cheaper, which will drive sellers to lower their prices, creating a self-feedback loop that eventually will end up in the economy grinding to a halt. Generally, this makes some sense, but I just want to throw this one thing out there:

American consumers collectively owe 830.8B in revolving credit alone. People buy stuff on their credit cards with 14% interest rates. 631.8B worth of stuff. In his speech linked above, Bernanke defines moderate deflation as "a decline in consumer prices of about 1 percent per year" when talking about Japan. You know how much cheaper that stereo would be if you waited a year instead of paying for it with a credit card (assuming one year to repayment)? 14%. Hell, maybe even more as some new, fancier stereo comes out.Does this sound like the kind of population that will outright stop consuming and let the economy collapse over price declines that are a couple of points?

People buy new cars or change leases every three to five years. Americans love new, shinny shit; they line up outside of stores over night to get the new sneakers first; they bid twice the price of things on eBay to be the first to get them; they camp outside Apple stores for iPads; they buy clothes at full price knowing full-well they'll be half the price in two months; and they charge it all to credit cards with 14% interest rates. People freezing all their spending over tentative price drops is the last thing I'm concerned with, seriously. It is true that people are lowering their debt burdens right now, but I suspect it's more of a case of having been over-extended than anything else. As interest rates drop and debt gets repaid, people will begin to lower their monthly debt burdens, which is when the price drops are going to make that extra money itch in the pockets. It's really only a matter of time before people go back to paying $200 for a 5th pair of sneakers and putting it on their Capital One. Seriously kids, the consumer is going to be alright.

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