Saturday Morning Musings - deflation

In an earlier discussion, kvd asked why deflation - a fall in prices for the goods and services we buy - was a bad thing.

If you look at the Wikipedia article on deflation, you can see that deflation is often associated with major economic shocks where cause and effect become intermingled. You will also see how conventional economic analysis has focused on changes to the money supply as a cause of deflation. Then, too, you have productivity effects where long term productivity increases cause prices for goods to fall.

Current worries about deflation are a little different. There is plentiful liquidity - the world is awash with money; global economic growth has slowed, but there is not a global recession; and yet, inflation is very low or even negative in many places. It's unusual, with central banks trying to increase inflation rates, something that would have seemed inconceivable a few years ago.

This post traces some of the effects of living in a deflationary world. Nothing profound. Just trying to work things out. For the sake of simplicity, I am assuming that deflation stays in the 2-3% per annum range.

Households know that things will be 2-3% cheaper in twelve months, their money will be worth 2-3%, so they save a little more, parking the money in the bank. There is a transaction cost to the bank in holding the cash and paying it back. If they were just holding the cash, they would want to charge the customer that cost plus a profit margin, a negative interest rate, as some central banks are doing.

The bank wants to lend the money, to make a profit.

As consumers save a little more, business sales drop. The firm knows that its input costs other than labour will be 2-3% lower at year end. It lags investment a little since capital equipment will be a little cheaper. Labour costs are sticky, so firm margins drop. The firm sees to reduce staff or lower wage rates to accommodate this. It borrows less.

Governments can buy a little more with a given dollar, but its tax revenues drop, in part because bracket creep has gone into reverse. Debt servicing costs on existing debt rises as a proportion of government revenue. Some indexed government payments such as pensions drop as indexing goes into reverse. Governments seek to pay back debt because this will save money later. Spending drops.

In the housing market, there is downward pressure on rents to bring them into line with falling price levels.  Those with existing loans seek to pay them back more quickly or to refinance to lower interest rates. Investors who have based their equations on the combination of rising rents with nominal dollar capital appreciation are especially affected.  

Banks facing lower demand for personal, housing and business loans lower interest rates. Loans become shorter term as the rising real value of money is factored into return equations. Credit cards remain, but credit card debt drops as consumers and business reduce their exposure. Credit card fees grow as cards become more focused on transactions. A new credit card structure emerges, with fees for those who just use the cards for transactions, discounted for those who who are use the cards for loan purposes and are still paying interest.

Share prices fall initially, but then stabilise. Dividends probably increase as a proportion of earnings since this gives investors cash that will increase in value.

At this point, I will pause and leave it to you to respond. I am sure that there are errors. And what about super funds?