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Deflation is Really Bad: Or, What Is Krugman On?

Paul Krugman explains why deflation is bad:

So first of all: when people expect falling prices, they become less willing to spend, and in particular less willing to borrow. After all, when prices are falling, just sitting on cash becomes an investment with a positive real yield – Japanese bank deposits are a really good deal compared with those in America — and anyone considering borrowing, even for a productive investment, has to take account of the fact that the loan will have to repaid in dollars that are worth more than the dollars you borrowed. If the economy is doing well, all this can be offset by just keeping interest rates low; but if the economy isn’t doing well, even a zero rate may not be low enough to achieve full employment.

And when that happens, the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed. That’s the deflationary trap we keep worrying about.

Okay, so there is just no industry where people watch prices falling and falling and still continue their purchases, even if they can get a better deal a few months down the line. Not one such industry. Oh wait. Let me check the darn thing I’m seeing this on.

I bought the first of my 19” monitors in 2006. It cost me Rs. 20,000. Twenty thousand. Today it costs Rs. 5,000. I should have waited four years, because guess what, for years before that, monitor prices were falling. But okay, perhaps I wasn’t being rational.

I bought a 1.2 lakh “projection” TV in 2003. On a 36 month interest free loan. [Don’t ask.] That TV would cost Rs. 20,000 today, and for 45,000 you get much much better LCD or LED TVs.

I paid Rs. 6 lakhs for a Fiat Palio 1.6 in 2002. It costs about Rs. 50,000 less today, for a vastly improved version.  A Hyundai Accent costs Rs. 40,000 less than it did in 2002 – EIGHT whole years ago.

I paid Rs. 10K per night for a hotel in Goa in 2005 – Fort Aguada, All meals, Cottage Garden View. The price today: Rs. 19,100 for two nights, and it’s a substantially better cottage. I should’ve waited, darn.

The computer industry by and large, the cell phone industry, mobile telephone, the internet, hotel package prices in Goa, uhem. 

Let’s not even account for the fact that food, regardless of inflation, is a necessity, and you’ll pay whatever it costs (or downgrade what you eat) simply because you need it now, and can’t wait. That argument however doesn’t apply to any of the stuff I mentioned above.

This may sound anecdotal – but here’s the thing: the car industry in India, the cellphone industry, mobile telephony, internet access, computer parts – all of them have dramatically higher revenues and profits today, despite falling prices. That means people are buying despite prices falling. And not just because they need the darn things.

Krugman’s argument doesn’t work. Some may consider the above industries as silos (a term meaning something that seems to operate independently of everything else) that don’t reflect the global industry, but that’s hardly true, is it?

The problem with deflation is it keeps asset prices low. So if you bought crap that you expect to value, you have a problem. Especially if you bought on credit. So if you bought a house and you took on debt, but the house price falls, it hurts your “net worth”. Because now your assets are lesser than your liabilities. But that’s a stupid way to look at it at a personal level, because when you take a loan for anything other than a house (a TV, a laptop, a holiday) you have a negative net worth to that extent.

The house you live in is not really an asset – it’s a liability which you, as a rational individual, decided to pay much higher money than equivalent rent because you want the nice warm feeling in your heart. Or, looked in another way, it’s an asset like a car, whose value depreciates every year. The concept of looking at a house as an asset should have been history by now, at least in the west, but it’s so entrenched in society today.

A house you live in is a mega-expense. People who pay only 20% down – and this is supposed to be the really creditworthy people – are buying a very highly levered expense. If I told you to buy a TV with 20% down, and pay the remaining over the next twenty years, would you still be worried that TV prices went down? Sure, the bank might be worried, especially if it has a truckload of TV loans it thinks people might default on and then it has to sell the TVs. But banks aren’t the economy, no?

Now the picture comes together. Deflation is, in a way, bad for the bank. The guy who lent you the money. Because when the bank tallies up the collateral, it doesn’t add up to the value of the loan outstanding. That makes it go crazy about “asset-liability mismatches” and it does stupid things like threaten to take away the TV; and when you hear the same bankers are paying themselves big fat bonuses, you tell them to go take the TV, you ain’t paying. They lose money and go crying to the politicians who instantly realize that the only way bankers will leave them alone is to inflate asset prices somehow. In America the government has gone to the extent of actually buying these deflated assets.

The further complication is that along with the government, banks own these assets. With a highly leveraged system, even a small destruction of capital is enough to destroy your assets.

As prices fall, a creative destruction process emerges. Someone’s willing to pay at lower price points. When house prices fall, people get worried – but the worry should not be that house prices are falling; there will be a price point when it’s a damn good bargain, and the buyers will come back. Why not let things go there?

The answer: bank leverage. When banks, for every dollar in capital, have borrowed $10 and then lent out $10 for such loans. If the value of the collateral falls 10%, their “equity” is wiped out, meaning they are out of business.

Technically this means the bank should be shut down, and the remaining $9 on their books should be sold to other people – maybe for $6 to sell it fast – and the smart people who know it’s really worth $9 will pay $6 for it. The people who lend the bank $10 lose money, but that’s the nature of the game.

At this point, if this were to play out, most banks in the US will go bankrupt. But the systemic effect may actually benefit us – since all cross holdings of debt will be wiped out. What will emerge is smaller banks which can buy the pieces. But as the big banks go belly up the issue is who loses money – and the answer is “pension funds”, a conclusion that is not politically palatable.

But if the bullet is not bit now, we will see all the crap assets being bought by the government, and then the cost moves not just to pension funds but to every single taxpayer; with the way money multiples inside the banking systems, taxpayers will be on the hook for a lot more if they wait. And it’s not entirely clear that pension funds will be very hugely affected – if we let it all play out, just the squaring off of various cross liabilities might result in a lot lesser dollar amount, though there will be a few panic situations. I think the better way – thinking of the next 10 year period – is to do the damage now. Let deflation happen, let asset prices crash, let the banks fail, and push the smaller banks to buy the pieces and indeed, fund them.

And in the process refuse to allow a 10x leveraged system to build up. The concept of people paying 40% of their pre-tax income to a housing loan, on which they have only 20% down is crazy – for something that makes you negative on networth, you need to be putting more down, or use less % of income. [While applies for every ot
her kind of loan]

One more thing: If we’re worried about asset price deflation, then why are we using silly metrics that include prices of consumer goods, or food or oil? Consumption goods seem to work very well as prices fall. Only assets are a problem, no?

Okay, rant over. Krugman makes excellent other points which, if I start talking about, my computer will crash. But I’ll do it another day; after all, replacing the computer will get cheaper.

  • Jason Braganza says:

    >Pretty insightful! Bleddy Awesome! Now change that computer quick and continue… 🙂

  • Sachin says:

    >ha ha ha … excellent argument…

  • Anonymous says:

    >Nice article though a long one.

    I like to point out one more issue. You compared the price of Palio 1.6 in 2006 to 2010 price of a new car. The price reduction in this case is due to productivity gain. In case of home prices people compare what they paid with the current market price of the same old home that they bought. This is like comparing the purchase price of your 2006 palio to the current market price of your 4 year old Palio(which will be atleast 50% less). If inflation goes over the roof say like 30%/year even your old car will keep appreciating. so who ever bought a car in 2006 enjoyed the car for 4 years and still be able to sell it for a profit. This is what Mr Krugman is targetting 🙂 Buy a home, use it, still price appreciates above inflation rate so that no body have to work anymore… haha

  • Anonymous says:

    >I think that you are missing the point..

    Let us say that you have taken a 1crore loan on your flat based on current and projected income (and you have 50% down etc and loan to salary is a manageable 30% ) and that you are working in the telecom industry ..

    Now, imagine that the telecom players are beating themselves to the ground and are not able to lower prices further .. Now, imagine that they ask their employees to take a 20% pay cut to support still further cuts.. Loan to salary is now 37.5%…

    Consumption is down ( private school out to govt school in)..
    Now imagine the whole country is in this state.. and you can see why the central bank is worried.

    Now, the question is whether this will happen in India and the answer is no for the forseeable future.. But, the US is a mature economy barely able to hit 2% and you can see why Krugman is worried..

  • Arun K says:

    >I think you got the context wrong. Krugman talks about investment decisions and the examples you quote are not exactly investments.

  • kaho pyare says:

    >wrong comparision between house and car/electronics. car/electronics depreciate because it degrads over time. and degradation is speedier as compared to price rise of raw materials used. in case of electronics, additionally, technology is getting better because of that you can get VERY MUCH better product at less cost as time progresses.

    however houses appriciates over time. because degradation is slower than price rise of raw materials (land, cement, bricks, steel etc).

    also how does a self occupied house is different than house which is bought for purely investment? rent saved is rent earned, right ?.

  • raj says:

    >Your arguments have been used by the austrians for quite a while. I really like Ben Bernanke's speech about deflation to explain it.

    "Deflation is defined as a general decline in prices, with emphasis on the word "general." At any given time, especially in a low-inflation economy like that of our recent experience, prices of some goods and services will be falling. Price declines in a specific sector may occur because productivity is rising and costs are falling more quickly in that sector than elsewhere or because the demand for the output of that sector is weak relative to the demand for other goods and services. Sector-specific price declines, uncomfortable as they may be for producers in that sector, are generally not a problem for the economy as a whole and do not constitute deflation. Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines."

  • Deepak Shenoy says:

    >Thanks for the comments! Good points. Let me respond one by one.

    Anon1 – yes, the depreciated price of a car versus appreciated price of a house are strange. But then we have subsidies for housing so maybe that's what skews things.

    anon2: You don't consider that as telecom prices went down, they DID NOT fire, or reduce salaries – it's only perhaps now that life is a little tough (but they're still very profitable), but through the years of dropping prices, they paid their employees in full. That applies to carmakers in India, the five star hotels in Goa, the computer manufacturers. As I said, lower prices don't mean lower margins at all, productivity increases, tech advances and volumes can change things substantially.

    Anon3: Is Krugman really talking about investments? He said Deflation. He didn't say asset price deflation. His above funda is about expenditure, not about investment. In any case, america's economy is substantially more about consumption expenditure than retail investment; so deflation being a systemic problem is related largely to consumption reducing, not investment.

    Kaho pyare: wrong comparision between house and car/electronics. car/electronics depreciate because it degrads over time. and degradation is speedier as compared to price rise of raw materials used. in case of electronics, additionally, technology is getting better because of that you can get VERY MUCH better product at less cost as time progresses.

    however houses appriciates over time. because degradation is slower than price rise of raw materials (land, cement, bricks, steel etc).

    I don't agree. The cost of a house isn't much about cement, bricks, steel. That stuff is perhaps 10% of hte cost of a house nowadays. The biggest cost is of the interiors (in the construction process) and interior prices, from granite to tubs to wash basins, have become much cheaper – in fact, for the same budget as 2003, you can get far better interiors today. Land price and house prices are directly linked so let's not confuse land as raw material. Houses do depreciate over time – a house that was made in 2000 will soon need pipes to be changed, waterproofing redone, wiring checked. New technology has made new houses seem much better like pre-built a/c and fridge coves, internal cabling for TV and internet, pool/gym complexes and so on. That the older houses are still priced way higher is just bubbly.

    also how does a self occupied house is different than house which is bought for purely investment? rent saved is rent earned, right ?.

    The interest you pay the bank is equivalent to rent. In many cases it is far higher than the rent you might otherwise end up paying.

  • Anonymous says:

    >anon2 again..

    I think that you are still missing the point..

    Productivity based deflation good (telecom example and everything example that you have cited)..

    Salary based deflation very bad..

  • Deepak Shenoy says:

    >Raj: Then, dropping house prices should not be a problem, if you can stimulate price rises everywhere else? The consumption sector where prices have been stagnant or falling was okay for the last 10 years, even though it was probably a substantial part of expense, and indeed, of GDP. Housing, which pushed expenses up in an incestuous manner, was and is considered sacred.

    The problem also is: How do you measure inflation, or deflation? The price indices are all screwed up – they underreport inflation when it did happen and they haven't changed reporting concepts, so price indices will continue to be understated.

    I wager that if you let house prices crash, the resulting drop in housing part of GDP will build better and bigger new sectors (from retail consumption to biotech to travel to what not) Plus, houses become more affordable at some point and transactions begin to happen, there's a new equilibrium.

    No, this is crazy kinds of deflation that we're having here – it's deflating entirely because we are trying to support prices. If we were to let go, then we'd reach equilibrium much faster. Big players will die, but that gives a chance for smaller players to grow.

  • Rathin Shah says:

    >Hi Deepak,

    Good arguments.


  • arghya says:

    Wonderful argument.

    Paul Krugman is talking the basic fundamentals of economics which is based on several assumptions and suits for an ideal economy which in fact doesn’t exist. As these fundamentals are basic building blocks of economics, you can’t reject these theories so easily. Let me mention few points in his favor.

    Deflation term used here should be used in a macro sense i.e you have to consider the entire economy, not for a particular sector like electronics and computing sector where the cost would decrease with technological advancement. This technological advancement creates product variation and increase sell and lower prices increases customer base which translates to higher profit.

    See it depends on personal capacity and income level, i.e where you are on the marginal profit graph. If you capacity is high you are at the top of marginal-profit curve; whether costs goes down or up it doesn’t matter to you – you would buy a car/LCD anyway. But that is not true for entire economy. Example – I am waiting to buy a iphone till it’s price come down to a level which I can afford comfortably.

    Deflation is bad because – We don’t have incentive to utilize (loan to other or invest) your money. You prefer to delay you expense and want to be on cash. This is the wastage of resource which ultimately harms the entire economy. Moreover growth creates inflation. Though the reverse is not true but growth can’t be achieved without inflation. It’s a package deal of gain and pain. I think nobody know the right balance of growth-inflation. For last two decades US is pegging inflation at 2% to achieve maximum growth. But are they sure that they took the right decision?

    Let’s don’t get into politics. But I do support you – “Let deflation happen, let asset prices crash, let the banks fail, and push the smaller banks to buy the pieces and indeed, fund them.” It’s a cycle, the sooner the next phase comes it’s better.

  • Anonymous says:

    You made a very good point on the worry about consumer price inflation. Central banks should've started worrying about debt inflation long ago. There are empirical studies on western economies that had already indicated that bank credit gets created first & reserves get created later to support the leverage. So the real driver for the economy becomes the willingness of private sector to expand their balance sheet through debt. So the proper response should've been to restrict debt expansion to sectors that do not create means of repayment.

    Observing the trends in Indian where the industrial credit banks found it more profitable to expand housing credit & industry houses now find it more profitable to expand their financial arms given that the tax structure that taxes production rather than interest/capital gains, we should not be surprised to see the same unbridled credit expansion in coming decades.

    — Chandra.