Good & Bad Deflation

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Paul O'Neil

My wife and I visited an animal sanctuary with our five year-old last month.  A young bloke demonstrating sheep shearing explained electric shears were not only faster than the old manual clippers and less inclined to nick the sheep, allowing a closer shear that gave a bigger yield per sheep. Consequently, the cost per tonne of wool went down dramatically.

In diverse ways, a competitive economy delivers steady downward pressure on production costs first, followed by sale prices afterwards. The efficient producers are rewarded for their productivity and the consumer is benefited gradually as their advantage is eroded by their competitors. This is called deflation and it should be the norm. This “good” deflation, falling costs driving lower prices, is an underlying characteristic of a healthy economy. Our cost of living goes down, our standard of living goes up.

On the other hand, inflation is an exclusive governmental creation. Usually it’s created by an independent central bank and channeled into the economy through the commercial banks and lenders, via cheap loans to individuals and businesses. The political consensus is that 2% is the Goldilocks inflation rate – not too hot, not too cold, just right. Although slow deflation should be the norm, any deflationary pressure, even of the good sort described at the animal sanctuary, is treated with suspicion.

“Bad” deflation is the rapid plummeting of sale prices first before costs can adjust, so income drops faster than costs. Bad deflation happens when monetary inflation is being brought back into check. Interest rates are kept too low for too long and loans kept so cheap that almost everyone gets one.

Soon commercial lenders notice increasing default rates, which signals to lenders to tighten their lending criteria and reduce the amount of new loans approved. Eventually the bubble bursts and bad inflation occurs.

The bubble-creating historically low interest rates and cheap loans are here and happening right now. The future is on its way and it promises to carry with it a heavy price for these cheap loans.

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