Smarsh wrote some excellent comments, coming from a traditional macroeconomics background (on a side note, would you say you are more Keynsian or Chicago?) I was going to write a response in the comments, but it got too long and I decided to turn it into a post instead.
Smarsh:
The scenario that you have illustrated is certainly bad for people who would like to invest in "real assets".
If by "invest in 'real assets'" you mean buy things, we are in agreement. I'm sure you're aware of the current level of personal and corporate debt financing.
deflation ... leads to lower consumption and hence GDP, which further exacerbates the rate of deflation.
This is actually a very complex statement - bear with me while I unpack it.
Earlier, deflation was defined as:
[The state in which] good[s] will be cheaper tomorrow than they are today.
What this means in macroeconomic terms is that deflation is the state in which the growth of the economy is more positive than the growth of the money supply.
There are only two ways to stop deflation: cause the money supply to grow faster than the economy or cause the money supply to shrink more slowly than the economy.
The claim that a decreasing GDP "further exacerbates the rate of deflation" can only be true in a world where the economy is heavily debt financed. In such a world, a decrease in consumption decreases the demand for new debt and causes bankruptcies when old debt can no longer be serviced - causing the money supply to contract faster than the GDP.
One important thing to note is that the negative effects rest entirely on the monetary effects of deflation - the increasing cost of debt - as the driver of losses. The fiscal effects, if there are any, work to counter deflation.
However, the current US economy is largely driven by consumption. If savings in this environment were actually being directed to investments instead of capital being horded then a higher savings rate could potentially offset the precipitous decline in consumption.
Perhaps you are conflating deflation with recession?
1 comments:
By invest in "real assets" I do not mean buy things. I mean plants, machinery, land and durable goods used for production.
The feedback loop between declining consumption and price level I was referring to comes from the "Equation of Exchange" and its modern dynamic economic model equivalents which is a tautology which says the nominal amount of money in circulation times the speed at which a dollar is rotated through unique transaction is equal to the price level times the index of expenditures. The index of expenditures can be thought roughly to be equivalently to the "real" value of a good or service. The problem with this scenario we are living out is that the velocity of money is falling very fast, while no new money is coming out of banks. In other words the left hand side of the equation is falling fast which could normally be mitigated by the fed lowering interest rates and therefore pumping out money. Unfortunately, the fed is useless right now because interest rates really can't go lower. The three month treasury yesterday actually was trading at below its nominal amount. So this means the right hand side of the equation has to give somewhere. Well its not likely to come from the index of expenditures, things are worth their intrinsic value (or at least until the world goes completely Mad Max). So it comes from the price level falling. I'll use some extreme numbers to prove a point. I'll need a new car in say one year. I could continue to repair my current vehicle or buy a new car. If my expectation is that cars are going to be $5000 dollars more expensive in the near future(high rate of inflation) and that my wage is not likely to increase commensurately to offset this price increase, then my incentive is to buy today. If however I expect the car to be $5000 cheaper tomorrow I will continue to repair the car I own to gain from the lower price tomorrow. In the second scenario, the velocity of money has further slowed, meaning the price level is going to fall further. I hope you can see how the vicious circle works now.
To answer your last question, was I conflating deflation and recession. I believe not. Although most recessions do have a natural downward pressure on inflation, which can be observed in the Phillips Curve.
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