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The Real Incomes Objective, inflation and deflation.
A note

Hector McNeill1

Today there are less dire warnings about the "dangers of deflation" from monetarists. This is largely because central banks and policy makers think deflation can be avoided by pumping more and more money into the economy and thence into assets. However, this has led to a depreciation of the value of the currency and purchasing power of wage earners in an environment of creeping inflation in the transactional economy where deflation is a definite advantage to consumers. The result is that monetary policy has exacerbated income and wealth disparity; something central bankers wish to deny.

This note outlines some of the inter-relationships which govern monetary policy decision making in attempting to control the inflation-deflation equilibrium.

Deflating or inflating the price of what?

When policy makers declare deflation to be a bad thing it is important to ask, " deflation of what?" Clearly anyone who holds an asset of some kind would be happy to see the value of that asset increase over time. Where the assets is a rentable assets such as land, a house or a building, there is the added advantage of not only possessing an object that is increasing in value but also one that can earn an income from rent.

On the other hand, for the majority of the population, with regular outlays for essential items and services an increase in unit prices is not welcome. This establishes fairly clearly a distinction between asset and transactional consumer markets. Asset owners welcome price increases or inflation whereas those who regularly consume items do not, indeed, consumers prefer deflation.

Here we see an obvious divide which in summary reads:
  • For assets deflation is bad
  • For regular consumption items deflation is good
Central banks don't get too involved in the intricacies of supply side economics where the unit prices of consumption items are decided by unit price-setting by companies and individual producer-sellers. However, they are aware that when someone purchases a house, based on a loan, the house is the collateral of the bank until everything is paid off. It is therefore beneficial for banks to maintain a stepwise rise in the value of houses since this not only reduces their own exposure when loans can't be paid back, it also appears to benefit house owners. However, the risk in such mortgage arrangements lies entirely with the house buyer even if due diligence procedures have been carried out. The overall exposure of buyers to risk lies in the hands of the central bank. So when inflation rises in consumption items, no matter what is happening to asset prices, central banks apply higher interest rates to "reduce inflation" and government can bring into play fiscal decisions, such as raising tax rate, with the same end. These result in people having less disposable net income and many will no longer be able to pay their mortgages leading to repossession of houses and loss of that asset in exchange for a devalued collection of cash minus the remaining debt on the mortgage compounded at the new rate of interest.

Income growth impulse

The resultant impression promoted by monetarists is that deflation leads to a form of depression with reference to such historic inflationary events such as the Weimar Republic. Various scenarios around this event have been used to discourage "talk" or "promotion" of deflation. Unfortunately the lack of adequate options analysis on this topic has resulted in the potential of deflation in generating real growth being marginalized.

Whereas the Weimar crisis was caused by excessive issuance (printing of the currency, a common monetary policy error. The central role of technology and technique in generating real economic growth through the mechanism of deflation achieved through innovation, cost and unit price reductions while generating compensatory incomes is too often ignored by macroeconomic theory and practice. The best example of this process has been the development of digital devices.

Not by digital systems alone

Although electronics and digital systems have a particular advantage in terms of miniaturization, lower energy consumption and rising digital power, the state-of-the-art productivity levels of technologies associated with all economic sectors are only attained by 25% of producers and the difference in productivity can be as much as 300-400%. As a result, even without further advance, the dissemination and take up of currently available operational systems can revolutionize the productivity and the gains from deflation in most sectors.
Therefore, to minimize the risk of consumers facing such dangerous monetary policy decisions, it is necessary to consider the ways to ensure that the mechanisms that can achieve deflation in consumption items be brought into play. This is important because with deflation consumers can save more of their nominal incomes as the cost of their outgoings fall. If not saving, then they could pay off a mortgage more quickly reducing their period of risk to possible rises in interest rates.

Technology and techniques as the deflationary engine

It is well established that 60%-80% of real economic growth arises from learning by doing and the accumulation of tacit knowledge and explicit knowledge surrounding regular tasks leading to the development of ways to improve how tasks are accomplished resulting in innovation. Innovation usually results less time being required to complete tasks and a gradual reduction in resources leading to reductions in costs.

The reduction in costs works through into reductions in unit prices as a result of producer price-setting to take advantage of the reduction in costs to capture market share.

Saving without banks

Under current circumstances monetary policy has liquidated the benefits of bank savings accounts because of close to zero interest rates and inflation eroding the value of money. However, with a steady deflation rate, the value of money rises as it would with an interest rate but without the need for a bank savings account. When interest rates were slightly higher this is not a situation banks would favour since people would have less need to use bank savings accounts or even credit. Which, in terms of consumer risk, is preferable. Therefore, while not referring to these consumer benefits directly, this could be another reason banks tend to support statements that relate "deflation" to untold dangers. Under the current circumstances of QE, a more effective consumer products and service price deflation rate would enable people to pay off their mortgages more quickly as a result of making use of the savings resulting from the gradual falls in outgoings. This would lower the overall cost as a result of shorter feasible terms of mortgages.

From the microeconomy to the macroeconomy

The impact of marginal unit price reduction of consumer items and services as a progressive process of deflation is something that emanates from the supply side and more precisely as acts by millions of separate entities setting their unit prices. The degree of impact of this effect is governed by the price elasticities of consumption (pEc) for items and services (see Price elasticity of consumption ) which has a real incomes growth multiplication effect which affects the whole macroeconomy (see The real growth multiplier ).

Initiating growth

The fundamental question facing economic analysts is linked to the phrase "pushing on a string" which indicates monetary policy can impact some aspects of the economy but is unable to influence people's motivation to act to deliver the intended outcomes. Monetary policy, with post-2008 quantitative easing (QE) has lowered interest rates to almost zero and made available very cheap money to banks. Originally with the objective of helping banks "sort out their balance sheets" and to "stimulate growth" this policy has failed to stimulate growth. It has generated massive inflation in asset markets and close to recession in the transactional consumer markets. This is an example of the policy having pulled money into asset markets and benefiting banks but being unable to improve the state of affairs of the majority of constituents in the transactional consumer products and service markets. There has been no impulse at the macroeconomic level to generate any real income multiplier effect in the supply side economy. Monetarism is incapable of pushing on the string to change the market circumstances.

The reason monetary policy cannot stimulate real growth is because it doesn't make use of simple microeconomic principles and especially those related to technological innovation and deflation. Policies designed to promote the Real Incomes Objective (RIO) can generate a real growth impulse which can affect the whole economy ( see Growth Impetus ). Under the Real Income Objective there are several policy options all of which permit the policy makers, "push on their strings" to keep the economy in a sustained state of real incomes growth which is something monetary policy has never attained.

1 Hector McNeill is the Director of SEEL-Systems Engineering Economics Lab.

2 Input costs rise to the extent that loans are used either as credit for consumption or loans for investment.

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