Deflation: The Good, The Bad and The Ugly

by | Dec 18, 2001

This commentary continues a series intended to address some of the misconceptions in the flurry of recent media reports about deflation. My last commentary (“Deflation: The Basics”) began by defining deflation as strictly a monetary process, and one that is solely in the control of the Federal Reserve: deflation is the revaluation of the monetary […]

This commentary continues a series intended to address some of the misconceptions in the flurry of recent media reports about deflation.

My last commentary (“Deflation: The Basics”) began by defining deflation as strictly a monetary process, and one that is solely in the control of the Federal Reserve: deflation is the revaluation of the monetary unit of account. In the US, the monetary unit of account is the dollar. When it is revalued — by the Fed issuing too little money for the needs of the economy — the nominal price of goods and services measured in dollars goes down.

Deflation causes nominal prices to fall, all else equal, but “falling prices” is not the definition of deflation. Mistaking the result of deflation for deflation itself has recently led many commentators into some important conceptual difficulties.

For example, James Paulsen — the perceptive and articulate chief investment officer at Wells Capital Management — wrote in his October Economic and Market Perspective that there is a distinction between “good deflation” and “bad deflation.” This has a nice ring to it, but we’ll see that, upon examination, it’s a framework that confuses more than it illuminates.

Paulsen writes that “good deflation” is when businesses are “able to constantly produce goods at lower and lower prices due to cost-cutting initiatives and efficiency gains. This has allowed GDP growth to remain strong, profit growth to surge and unemployment to fall without inflationary consequence.”

As an example, Paulsen points out that “In the late 1990s, computer price deflation fell to negative 40 percent a year! The result was an annual growth rate in real unit sales of computers surging to almost 80 percent!”

Indeed, the unit prices of many technology goods have fallen consistently — and, indeed, this is good. But this “good deflation” is simply productivity growth, or “efficiency gains” as Paulsen puts it. And so “good deflation” is good because productivity growth is good — and that’s because productivity growth means wealth growth.

When productivity grows, producers may elect to share their growing wealth with consumers in the form of lower prices, perhaps in an attempt to expand the overall size of their market or to meet competitive challenges. That’s clearly what has happened with technology goods over the last several decades. But under other circumstances a producer might elect to keep the wealth all to himself in the form of higher profits by not lowering prices. Either way the economy grows thanks to increased productivity — it’s just a question of whose pocket the growth ends up in. So it’s not just falling prices that make the “good” in so-called “good deflation.”

Moving on now to “bad deflation,” Paulsen writes that currently “

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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