In an article in the Australian Financial Review today, 28 July 2010 ("Prospect of deflation looms as the next big threat" by Philip Baker), Ben Bernanke was cited as having said eight years ago in a speech that "Sustained deflation can be highly destructive to a modern economy" because it would apparently lead to (these are Baker's words now) "slow death from a rising real burden of debt".

Also, apparently, "Policy makers don't like deflation because it is difficult to stop. .. [Policy makers] can't use the traditional tool of rate cuts to spur growth and stop inflation." Therefore, Gerard Minack (a Morgan Stanley equity strategist) is cited as saying, "no one is more scared of deflation than today's cohort of central bankers."

That this fear of deflation is totally irrational can be demonstrated in two minutes. Let me do so briefly, here, in a simplistic analysis that aims to get the main points across.

1. Price is determined by the convergence between supply and demand. 

2. People always want more, and as their income increases, they keep asking for more of everything (including bigger, better, more quantity, etc.). Therefore except in highly exceptional circumstances, demand does NOT decline. Let's therefore assume it to be fixed or increasing, at least for the most part.

3. If demand is constant or increasing, then the ONLY way for prices to fall is through increased supply. And when can supply increase? Only when production increases! That is the typical case in a modern society, through increased innovation.

In brief, DEFLATION IS A SIGN OF PROGRESS. It is without progress that prices would rise. Consider the price you've been paying for virtually anything – gadgets, cars, etc. Every price has been falling in real terms, even, often, in absolute terms. Falling prices are therefore the only genuine signal of progress.

So why do we have inflation? The only reason we have inflation is because of central banking. If they regulated money instead of issuing it, and allowed free information provision through free markets in money, there would be no, or minimal inflation.  It is central banking that creates inflation, not progress! Had progress not been as rapid as it has been, we would have experienced far greater inflation than we have. Get rid of central banking and you'll get rid of inflation. That's the message here. 

Ben Bernanke needs to prove why, in a free banking economy, deflation would be destructive of the modern economy. He would fail to do so, since the ONLY way for progress to be reflected in the long run is through a decline in real prices. 

The fact that central banking exacerbates asset bubbles is by now clear to anyone but the most mean headed economists. A way should now be found for central bank to completely shift its role. I have made some suggestions in another article (here).

Indeed, the basis of free trade is comparative advantage, that helps to DROP prices in both nations that trade. Trade and competition REDUCES prices. Without exception. Maybe Ben Bernanke needs to read up ECON 101. There is NO LOGICAL REASON UNDER THE SUN for prices to increase as a society advances.

[What about investors? Will then invest if they know that prices will fall? Of course!! Ask ask farmer. He knows that the more he produces because of good weather conditions the more others will produce and so prices will fall. And yet revenue R is NOT equal to P (price) but PXQ (where Q is quantity). The quantity produced generates a sufficient return on investment, that is why the farmer produces even in the face of falling prices. Just because mobile phone prices are falling dramatically does not mean that mobile phone producers won't invest in making them. After all Q increases dramatically over time. For instance I owned one mobile phone at one time. Today we have 8 working mobile phones in the house!  There are more TVs in Australia than the number of people. And so on. Ben Bernanke should not forget Q! Or is his view that Q is fixed in modern society!]

Examples of what progress should mean: 

When the price of an international phone calls falls to zero (it is now $0.005 per minute from Australia to Japan, Singapore etc – see gotalkmobile.com.au).

When the price of mobile phone calls is almost zero (it is now 1 paisa per minute in India – which is $0.0005!)

When the price of a super-powerful desktop computer falls to $300 (My first desktop computer for DRDA Dhubri in Assam in 1986, supplied by NIC – see my book on that early computerisation – was 20 times more expensive – not controlling for inflation or better AUD-INR exchange rate which would effectively mean it was 80 times more expensive !)

When antivirus software is free (I've been using avast! successfully for a few years now: no more annual payment to anyone)

When medical information becomes free (I found the answer to my heel pain on the internet. Local doctors and physios had NO CLUE ABOUT IT!  The demand for local doctors is now starting to fall to zero, and their price will soon fall close to zero as well. All I need to go them is for a medical certificate once in a while but if my employer agrees that I can diagnose my own viral flu, and self-certify, then half the doctors will go out of business).

When knowledge becomes cheap (I rarely have to go to libraries now: many books are found on google books (including mine), Gutenberg, etc.).

When the price of food barely moves. I've been paying $3.50 per kilo for chicken over the past 10 years in Australia because each time it is on sale I buy it in bulk and store it in the deep freeze. If a deepfreeze could store more cheaply, I could buy for an entire lifetime in one go and save my shopping time – and money!

When each car you buy is better for the same nominal price (i.e. lower real price).

ADDENDUM

Two key arguments are offered against deflation:

a) It reduces aggregate demand. Apparently as prices fall, "consumers delay purchases because prices will be lower tomorrow than they are today". This reduces demand, leading to further price falls. 

This is only partially true. As prices fall, demand for normal goods increase. 

- Some purchases cannot be postponed. Just because one knows that milk prices will fall tomorrow one does not reduce consumption of milk today. Instead, one may consume more in order to smooth consumption. Forty years ago ball point pens were pretty expensive. Today they are so cheap I buy 50 at a time and don't really care whether I lose one. Similarly one can't postpone buying a car or TV. Consumption smoothing requires a uniform consumption across the future. I know I can get a really nice and cheap computer just one day before I die. Will I therefoe postpone my consumption of a computer?

- Some purchases can be postponed, things like an investment property. If I want to buy a house to rent out, I'd like to buy it reasonably cheap. But what do I do with the money I've allocated for the house today? Put in the bank? Buy shares? Possibly. I would expect that in a rational market the returns on all classes of assets would maintain a relatively similar proportion. 

It is also true that the value of the total product can decline if the prices fall fast enough. That might mean a lower GDP in nominal terms, but a higher GDP when controlled for the real value of money.

In conclusion, the claim that demand falls is not quite obvious. The actual situation can go either way. 

b) It "causes the cost of borrowings to rise, and this starves the economy of vital spending by businesses." How? E.g. If nominal interest rates are zero and deflation is 10 per cent a year, then the borrower must pay repay the loan with dollars that with purchasing power more than the amount originally borrowed. So businesses delay borrowing which exacerbates the downturn.

This is only partially true. If I am a business that manufactures computers, I KNOW that prices of inputs will continuously fall over time. And yet I invest because all I care for is the net profit after tax and interest. If I keep my costs down, then even if the revenue falls, my profits net of taxes and interest does not. As a savvy businessman I anticipate price falls and work accordingly. There is the issue of sticky wages, but that, too, can be controlled through appropriate design of wages in a free market.

Very rarely could the price of a product determine a business decision. It is always the next return on investment that drives decisions. If interest rates are low, then net profit rises by an amount that potentially offsets reduced revenues.

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