Titolo

Seven Myths. Nay: Seven Follies (II)

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Those wrong investments, are bygones, they are lost. In order to grow again we MUST invest in new activities, hopefully in activities that will produce goods people would like to buy at reasonable prices, not houses that nobody wants. Do we agree on this?

I definitively agree on those two points.

Further, whoever is trying to purchase these goods and carry out these investments will look at deflation with mixed feelings. On the one hand, it is true, it may lower the market price of the goods they are selling but, on the other, it makes the land they purchase and the equipment and materials they need cheaper. It is not obvious that, overall, the final effect will be negative: it depends upon which prices will drop more or grow less. Again, deflation per-se is not the problem for these people, the change in relative prices and the availability of savings that can be invested is. That's the way I see it.

I think that in a recession deflation and inflation have not the same consequences.
It seems that we agree on the psychological side of the story: with deflation consumers hold their fire, spend less and save more. This worsens the recession. Now  let us concentrate on firms. You say that under deflation firms face two opposing effects: a) lower output prices,  and b) lower input prices. I totally agree. On average, and without considering the varying degree of competition in those markets, there are winners and losers. But, I add, the overall cash flows stays the same  whether deflation or inflation (because of recession cash flow is of course lower than in a boom). So the average effect of deflation (or inflation) on firms’ expenditure should be neutral at best. But here is the catch, there are rigidities and anomalies in the system that make deflation a haunting presence during a recession. First anomaly: salaries and wage are less flexible than prices, so during a deflation output and input prices decline but not the price of the most important input of all, labour. Thus understood, cash flows during a deflation shrink most often than not (this does not happen with inflation). Second anomaly, both consumers and firms have debt, with a significant part that is fixed. Deflation makes debt more expensive if interest rates are fixed (e.g., 25% of mortgages and 100% of the US corporate bond index by the now defunct Lehman Bros), while it has a neutral effect at best for those debts with floating and adjustable interest rates. So deflation had another negative dimension. A dissenter would say that debtors’ losses are exactly compensated by creditors’ gains. But here we have another catch, while the total credit in the system matches the total amount of debts (for now I assume that the international investment position of the economy is zero) creditors are more concentrated or less dispersed than debtors, making the depressing effect on debt more widespread than the galvanizing effect on fewer creditors.

To sum up,
1) with deflation the screwed up psychology of  consumers depresses their consumption expenditure and gives an option value to their wait-and-see posture. But we have more savings and higher real wages, with less employment because of recession.
2) with deflation there are winners and losers among firms, the overall effect of deflation in term of cash flow is neutral at best. But deflation and wage rigidities make more likely a negative effect on cash flows, at least for a while. This is less likely in the US than in Europe, but still wage rigidities matter.
3) with deflation, debts with fixed interest rates (which is not a trifling amount) become more expensive, with a further depressing effect on top of the ongoing recession. Even if total liabilities equal total assets, debtors are more numerous than creditors (i.e., assets are more concentrated).

In the best case scenario deflation/inflation should not matter. In the worst case scenario, deflation depresses the recession even further. Why to risk then? 

And so far neither Phillips curves nor adaptive expectations have been taken into account. My feeling is that deflation is not the mirror image of inflation for psychological and balance sheet reasons. Deflation+recession hurts more than inflation+recession.