Deflation is a good thing

If a litre of milk costs $1.00 at your local Woolworths (ASX:WOW), would you prefer to pay $0.90 instead? Most people would of course answer 'yes'.

Instead of comparing prices today, what if we compare prices over time? Again, most people would prefer their milk cost less rather than more in a year's time. Their preferences are unlikely to change if we instead look two, five or even ten years ahead, or if we substitute almost any good (or service) for milk.

Whilst most people aren't economists, they understand intuitively that, all things equal, the lower the price of a good or service, the higher their standard of living (as they have more money left over to spend on other things). And vice versa.

Note that even if your income doesn't increase, your standard of living will still rise if prices decline. In fact, your standard of living will still increase if your income declines less than prices.

Unfortunately, economists are different to most people and prefer the opposite, arguing that you should pay more for milk in a year's time than today. This is because they prefer inflation, or rising prices, to deflation, or falling prices.

They do so because they believe consumers will postpone purchasing a litre of milk if they think they can purchase it more cheaply in future. Under this theory, this leads to a reduction in 'aggregate demand' and a slowing economy. To stop this belief becoming widespread among Aussie consumers, the Reserve Bank cut interest rates to a historically low 1.75% earlier this week. 

Evidence lacking

Yet this theory isn't backed up by evidence in the real world.

As Kerr Nielsen of Platinum Asset Management (ASX:PTM) recently noted, the evidence from Japan over the past twenty years, where deflation has been a fairly common experience, is that 'there was no deferral of consumption whatsoever'.

In reply to those who suggest Japan may be a historical anomaly, other even longer historical periods of deflation also disprove this theory. For example, from the late 1700s until the creation of the Federal Reserve system in 1913, deflation was the norm in the United States, only punctuated by periods of inflation during the War of 1812 and the Civil War. As you can see from Minneapolis Federal Reserve data, prices in 1913 were nearly 40% below their level in 1800, a material deflation by anyone's measure.

Yet during this period US economic growth powered ahead, causing the average American's standard of living to increase at the fastest rate that had ever occurred in history up to that point. The evidence from the UK in the 1800s paints a similar picture.

This incredible economic growth and rise in the average standard of living couldn't have occurred if the theory that consumers defer consumption in periods of deflation were correct.

A four letter word

So why are the world's central banks nonetheless doing their utmost to prevent deflation and increase inflation, to the extent that official interest rates are now negative in the EU and Japan?

Well, other than just mechanically following their theories, another reason is the sheer amount of debt now held by governments, companies and individuals. If inflation picks up, amounts borrowed today can be repaid with tomorrow's inflated (ie less valuable) dollars, euro or yen.

To me, though, instead of just inflating debt away, the solution is to discourage the accumulation of debt by governments and citizens in the first place by encouraging them to spend within their means.

As such, I believe central banks should return interest rates back to reasonable, albeit still below-average, levels. The idea that a business will cancel a proposed investment because the Federal Reserve raises official interest rates from 0.25% to 0.50% or even 1.00% is absurd.

Instead, the solution to today's low-growth environment is for governments to pursue structural reform and provide increased incentives for people to create wealth, such as tax and regulatory reform, lowering trade barriers and the like. In other words, the exact opposite of the policies they've pursued since the GFC.

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