Why deflation is a good thing

Photo / Wikimedia Commons

I always wondered why my older relatives who were around during the 1930s Depression were so against the idea of taking on debt. I've always wondered too why central bank governors are so hung up on the idea of preventing deflation. What's so bad with debt and deflation?

The worst combination is when debts are high and asset price and wage deflation is deep. For example, if you have a debt of NZ$100,000, wages of NZ$50,000 and an asset worth NZ$120,000 then deflation of 20 per cent for both wages and asset prices will create all sorts of grief. It wipes out your equity and increases the real value of the debt. It also makes it much harder to repay the debt because the wages used to service and repay the debt have fallen.

This is often called a debt deflation spiral. Eventually the borrower simply cannot service the debt and the lender is forced to take a loss, restructure the debt and possibly force a mortgagee sale. This is what is happening in America right now and what happened globally in the 1930s.

There were actually many New Zealanders who did well during the Depression. Those who had no debt and solid salaries that did not deflate found themselves able to buy a lot more after deflation because consumer goods prices and asset prices had fallen. Those with debt and who lost their jobs were wiped out and had to sell what was left of their assets. Wealth was effectively transferred from the indebted to the debt-free as the debt-free bought assets at fire sale prices. The only way for the indebted to dig their way out was to slowly repay their debt. Often it took a generation.

Inflation, on the other hand, is fantastic for those with jobs and debt. As their salaries rose and asset prices rose their equity rose and the real value of their debt fell. I always wondered why my parents, who had their working lives during the high inflation era of the 1970s and 1980s, encouraged me to take on debt. The implication was: 'don't worry about debt because inflation will wash it away'. This era essentially saw wealth transferred from savers to borrowers.

Now we face another era of deflation. It is clear now from the United States, Europe, Japan and even China that prices of both assets and consumer goods are falling. Debt, however, is not falling. A new generation in America and Britain is emerging who live by the mantra of debt repayment and reducing consumption.

However, the realisation of the new debt deflation world hasn't happened here yet. Inflation has fallen to close to zero and New Zealand house prices fell 11.2 per cent from their peak to their trough, according to QV.

However, they're bouncing back again, albeit slowly. Debt levels continue to rise and obviously many home buyers believe wage inflation like they've seen in recent years, along with rising house prices, will solve their debt problems.

Deflation has, however, hit some parts of the housing market and served a real purpose. It has made property more affordable for some and stimulated housing construction, and therefore parts of the economy.

The Real Estate Institute's measure of median section prices show they fell 20 per cent from the peak of NZ$202,000 to the trough of NZ$160,000. In many fringe areas in provincial towns and some coastal strips the price falls have been greater, stimulating the return of first home buyers.

Rodney Dickens writes an excellent piece on how lower section prices are stimulating construction and the economy more generally.

My point is that deflation is a good way to get economies going again as long as wages don't fall too. Anyone doing any clothes or electronics shopping recently will enjoy the pleasure of lower real prices. It stimulates activity.

We shouldn't let the bubble merchants convince us that asset price falls are the worst thing on the planet. They are among the best things. The alternative is a sort of zombie economy where banks don't lend, people don't buy things or assets, and the economy stagnates for decades.

You only have to look at Japan to see what happens in a zombie economy.

- Bernard Hickey

Photo / Wikimedia Commons