I am beginning to understand how reading the newspaper can cause people to have a chicken-little complex about most things having to do with economics: we’re told that inflation is bad, then we’re told that lack of inflation is bad. What gives? Maybe some cartoon friends can help…I’m not sure I support the tone of this video, but the “Ben Ber-nank” part cracks me up every time for some reason. (Pay particular attention to the part about deflation- there will be a quiz at the end.)
Regarding deflation, the critter on the right says “Isn’t it good? Doesn’t it mean that people can buy more of the stuff?” and the critter on the left answers in the affirmative. The problem is that the left critter isn’t exactly right, despite the fact that it is intuitively appealing to think that if inflation is bad then deflation is good. To see this, put yourself in the shoes of a business owner rather than of a consumer for a second. Deflation refers to a decrease in the overall price level, which obviously does make “the stuff” cheaper. This means that more people will *want* to buy your stuff…but are you going to want to sell more of it? (Recall that, in markets, it takes two to tango.) Imagine I said to you “Hey, guess what? You know that stuff that you used to sell for $5? Now you can only get $4 for it because prices have dropped.” Would you want to direct as many resources to producing this stuff as you did before?
Technically, it depends. You would want to know whether the cost of the stuff that you use to make your stuff went down by as much as your price went down. If all of your costs went down by 25 percent, then the decrease in the price of your output isn’t likely to change your production decisions. Keep in mind, however, that inflation in the U.S, is measured by the “consumer price index,” which tracks the overall price level of stuff that households typically buy. (Note that deflation doesn’t have to mean that the prices on all items go down, just that the price decreases outweigh the price increases. The observation potentially explains the critters’ objection to the claim of falling prices.) Therefore, it doesn’t have to be the case that the prices on what companies buy and use change by the same amount as the prices on what consumers buy. If the price that a company can get for its stuff decreases but it’s costs don’t decrease as much, it’s going to cut back production.
This concept can be shown most clearly by taking labor costs as an example. As an employee, how pissed off would you be if your employer said “Hey, we noticed that the consumer price index is falling, so the stuff that you buy is getting cheaper. As a result, we’re going to be cutting your wages by the amount of the price drop”? Technically, the change wouldn’t make you worse off, but people tend to be very attached to their dollars:
(Source: Daniel Kahneman, Jack L. Knetsch and Richard H. Thaler, “Fairness as a Constraint on Profit Seeking: Entitlements in the Market”)
This suggests that employers are in a bit of a bind when prices go down, since they likely can’t adjust wages downward to match in order to compensate without risking projectile rotten tomatoes, rioting, etc. from their employees. Since costs don’t completely adjust to match the new price level, the firms cut back production. If firms cut back production, people get put out of work. Putting this all together, we see that deflation can actually be counterproductive in battling a recession.
Classical economists don’t worry about this too much, since they contend that all prices and costs adjust in response to price changes in order to bring the economy back to its “normal” level of output. Unfortunately, they come to this conclusion by glossing over certain aspects of human nature such as the one noted above. So where does this leave us? Can some inflation actually be a good thing?
To a degree, the answer to that question depends on who you are. Personally, I have a lot of fixed-rate debt (read, a mortgage) compared to savings, so inflation could actually make me better off, especially if inflation means that I can raise my prices and therefore my effective wage. If I were an employer, I might also welcome some inflation if it meant that I could raise the price of my output before I had to give in and adjust my employees’ wages for cost of living changes. This would (temporarily) increase my profits and give me an incentive to increase production. (This is how “the Ben Ber-nank” can say that inflation creates jobs.) If I were the Fed, I might welcome some inflation since it could encourage employers to invest and produce more in the short run, both because the real cost of borrowing would be lower (for the same reason that mortgage-heavy me is fine with inflation) and because the price of “the stuff” would go up. If I were a senior citizen (or trust fund baby) living on a fixed income, I would probably hate inflation unless I had invested in inflation-indexed securities. (Note to self: invest in some inflation-adjusted securities.) If I were a generally risk-averse person, I would dislike inflation in general because I value stability…but then I would hate deflation as well.
In summary, inflation is a lot like alcohol…in moderation, it’s not a huge deal, but it becomes very problematic if it gets out of control.
In case you were curious as to the validity of the “economists are against quantitative easing” point, the evidence for that claim is mixed. For example, some economists/journalists/businesspeople/etc. wrote an open letter to “the Ben Ber-nank” expressing their disapproval of his policies. Other economists think it’s less of a big deal. Some are even remarkably neutral and even use Scrooge McDuck to explain what is going on. As such, I kindly request that the video critters stop putting words in economists’ mouths.
(Sidenote re the video, in case it wasn’t obvious: buying Treasury bonds from the Treasury wouldn’t have the desired effect on the money supply since it wouldn’t put any money in the hands of the public, so it’s not really a relevant option to be discussing.)