I’d think that Central Bank (CB) deflation would be a little bit less harmful than inflation. For these reasons:
Deflation does not encourage risk taking. Borrowers do not get bailed out, so in a country with a history of CB deflation, they will be diligent of this danger.
CB deflation results in surplus savings beyond the person’s time preference. This is a recoverable error, they can simply draw down their balances.
Conversely, CB inflation destroys savings, and the saver has no way to recover
CB deflation diverts resources away from government.
Are there ways in which CB deflation is more harmful than CB inflation, that I’ve missed?
Does CB deflation cause a Bust/Boom cycle?
The CB follows a tight monetary policy, pushing interest rates above market.
Consumer spending is reduced, due to lack of credit, and because they are enticed to save by the artificially high rates.
Short term projects are reduced, and there is unemployment in the retail sector, and other short term ventures.
Long term projects are hurt by the high rates, and there is unemployment in the resource, construction, and other long term sectors.
Medium term projects are less affected. Thus the triangle is distorted, with relatively more resources in the middle. It’s not clear to me that these are malinvestments, they may well be good projects that are simply less affected by the monetary mayhem.
Gross Domestic Output (GDO) drops, and the CB reports that in-spite of their efforts, the economy is experiencing a retrograde advance due to circumstances beyond their control.
The general price level declines, placing downward pressure on interest rates, as do the additional savings.
Consumers realize they’ve been tricked, and begin to spend more, drawing down their balances.
Short term projects rebound, and employment increases in this sector.
Long term projects also rebound, with declining interest rates, as our builder realizes that he has more bricks than he thought.
The process transfers wealth from borrowers to savers. The retired are helped. Those that are lucky enough to keep their jobs are helped, as wages trail the general price level. However, as prices fall, if wages are inflexible, due to unions for example, we would expect more unemployment. So CB deflation is worse if wages can’t drop. Would this second round of layoffs hit the medium term sectors the hardest?
In the case of CB inflation the boom is followed by a bust, and the economy drops below trend. In the case of CB deflation, would the bust be followed by a boom, with the economy rebounding above trend? It seems likely, as the rebound could trigger a spending spree. In this case, the medium term projects would seem to be well placed to supply the demand.
mahasamoot