Deflation and Property

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    I am currently in a discussion with someone over the value of inflation vs deflation. I argue that deflation is a good thing. My antagonist disagrees and wrote an example that I feel I need help understanding.

    As for your point about deflation being good, I could possibly agree if we were talking about a short term deflationary spike, but persistent, long term deflation has a lot of extremely terrible negative consequences. To illustrate this, let’s talk about buying land. Let’s say I buy a plot of land today for $100,000 with a 30 year mortgage. Now as land prices go up (inflation), I am still paying off my land at the price for which I bought it but if I wanted to I could turn around and sell my land for significantly more than what I bought it for since prices have been slowly but steadily rising in the intervening years. What this essentially means is that inflation encourages property ownership in the lower and middle classes because when people make a large purchase that can not be paid off all at once the burden of paying it off gets easier and easier as time go one. In 2020 I am paying off this land that is priced in 2014 with 2020 dollars. The real cost of paying this off gets cheaper and cheaper over time. Now lets say there is persistent deflation and I want to buy. The inverse of the previous situation will hold true; the real cost of paying off that land over time will become more and more expensive. If I buy land in 2014 and prices continue to drop consistently (deflation), the value of my land will continuously go down as will my wages (just like wages slowly creep up with inflation). So that $500 a month land payment wasn’t so bad when I was making $3000, but after 15 years after prices and wages have fell a bit that $500 a month payment becomes much, much more difficult to make while I am only making $2000 a month. And if I want to sell that land, I will have to sell it for lower than what I paid for it because prices have fallen. This is a bit of a simplified explanation and leaves out the roll of interest, but the same basic principle holds true, deflation puts an unnecessary burden on anyone who ever needs to take out a loan, which discourages people from doing so.

    My immediate thoughts:
    – Why is it that the wages will fall quicker than the cost of land?
    – Isn’t the situation with inflation similar to the recent housing crisis? In reality people couldn’t afford a new house, but they bought one any way because it would be easier to pay.
    – Isn’t the boost in the housing industry with inflation happening at the expense of other sectors of the economy?

    Can you deconstruct this situation for me and explain what might be wrong with it?


    As Irving Fisher pointed out, debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount. So deflation exerts a depressing effect on spending by raising debt burdens, which can lead to another kind of vicious circle, in which depressed spending because of rising real debt leads to further deflation. In a deflationary economy, wages as well as prices often have to fall and it’s a fact of life that it’s very hard to cut nominal wages (wages are sticky downwards) there’s downward nominal wage rigidity. What this means is that in general economies don’t manage to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept those wage declines. Estonia and Latvia are tremendous examples of this. In fact, we have a lot of data about countries that have had extended periods of deflation and in no case in human history has persistent deflation been a net positive for an economy. This is one of the few things that all economists agree on, even Austrians and other heterodox schools, that persistent, long term deflation is bad.

    I guess to let you know where I am intellectually, I’ll explain what I think is happening here and you can correct me.
    – Deflation causes people to spend less. I get that and know what that isn’t true. But what does my antagonist mean by “by raising debt burdens?”
    – He’s making some kind of argument about wages. What does this mean that they’re sticky down? Does that mean wages don’t fall at the same rate as deflation occurs? What is “nominal wage rigidity,” why is it necessary that unemployment follow?
    – I’m not much interested in the empirical data, but is this really proven by Estonia and Latvia?
    – I understand why perpetual deflation could be bad, but prices wouldn’t just perpetually fall, right?


    As Joe Salerno points out there are different types of price deflations. One type is caused by economic progress which leads to increased money demand relative to the money stock. This type is benign to the operation of the economy. The U.S. experienced this so-called growth deflation in the latter part of the 19th century. Another type is an increase money demand in reaction to a previous bust. It too is benign and part of the liquidation and reallocation process that corrects the malinvestments of the boon. A third type, which is malignant is brought about by an intentional monetary deflation by the state.

    The hypothetical scenarios, such as your antagonist poses, in which price deflation is at rate great enough to create social problems would never occur in a market economy. These scenarios always assume that people have no alternative to the money that is generating a long-term price deflation. But, of course, if people have selected a commodity as money which experiences price deflation, then as the purchasing power of the money rises, the profitability of its production increases which leads entrepreneurs to produce more of the commodity money which mitigates the price deflation. Furthermore, if people have selected a commodity as money for which extra production in the face of rising profitability from price deflation is insufficient to mitigate the price deflation, then entrepreneurs will offer people a different commodity as money. If gold is subject to excessive price deflation, then people will use silver. If silver becomes subject to the same problem, then people will use copper, and so on.

    For the economic analysis of deflation, take a look at Guido Huelsmann on deflation:


    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.


Let’s stipulate that CB inflation means that the CB inflates the money stock through bank credit creation so that the economy experiences 2 percent price and inflation and that CB deflation means that the CB inflates the money stock through bank credit creation enough to cause 2 percent price deflation. (Implicitly, then, we’re stipulating that economic growth of output is greater than 2 percent.)

Given those stipulated conditions, the effects of either price inflation or price deflation depend on how people adapt to them. To the extent that people correctly anticipate price inflation or price deflation, the effects are diminished. For example, if people correctly anticipate 2 percent price inflation, then entrepreneurs will bid input prices up today 2 percent higher than otherwise and the owners of inputs will accept 2 percent higher prices for their inputs without changing their supply of the inputs. The rate of return, then, would be unaffected. So there would be no wealth transfer between lenders and borrowers. Even if people only anticipate price inflation somewhat accurately, lenders will insist on higher interest rates to compensate for the price inflation they anticipate and borrowers will be willing to pay higher rates according to their anticipations of how much the purchasing power of money in the future will be diminished. Once again, these speculative activities reduce the wealth transfer from lenders to borrowers. Even the holders of money can reduce the erosion of their wealth from money’s falling purchasing power if they can adjust to receive the newly created money earlier in the social process of it coming into existence and then being spent again and again. It is in the micro-economics of the money creation process that the inefficiencies of monetary inflation reside.

A similar analysis could be done for the price deflation case. There, too, the ill-effects of price deflation are mitigated to the extent that people anticipate the price deflation.

In both the price inflation and price deflation cases, the inefficiency from CB monetary inflation and credit expansion comes from the micro-economic distortions in prices, profit, production, and investment. This inefficiency occurs whether or not the monetary inflation and credit expansion generates price inflation or price deflation. CB monetary inflation through bank credit creation pushes the interest rate below its time-preference level and the borrowed money gets spent along particular lines of production, for example housing, which alters the profitability of production processes ancillary to housing. Patterns of production, resource allocation, and investment shift during the boom. The bust inevitably follows in which the malinvestments are liquidated and the capital structure reconfigured to satisfy time preferences.

For more details on how the boom-bust cycle has played out in its current iteration, take a look at Joe Salerno’s article:

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