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The Beauty Of Deflation

This post is yet another attempt to explain why deflation is not harmful at all and is, actually, a good thing for the economy. It is intended for those who are familiar with the argument. I haven't yet met an explanation that would fit in a small blog post, yet be simple and complete enough. So here it is.

Before we start though, one simple note: people tend to confuse what inflation and deflation really are. One definition is that inflation is an increase in prices, while deflation is a decrease in prices. I don't like it because it doesn't really tell us what's going on. A better definition for those terms would be increase and decrease in money supply. You can have rising prices and money supply deflation at the same time—it depends on the circumstances, of course. Just keep in mind that I mostly assume the latter meaning of inflation and deflation in this blog post, but many people don't use those terms in the said way.

There are three major arguments which attempt to explain why deflation is bad. It is said that:

  1. People become less likely to spend and the economy stops working
  2. Loans become very expensive and no one is going to borrow
  3. Investors become less likely to invest, because it's more profitable to hoard than to risk investing

Let's start with the first myth, because it's easier to debunk. The answer is that the decision to spend is based not only on how much money you have, but also on the momentum at which one has this money. For example, if I happen to have 1 golden coin which is going to be worth twice as much next month, but I have to eat something not to starve to death, I'm gonna spend this golden coin now. Obviously, this golden coin is worth much more to me today than 2 golden coins next month, because I won't be alive to enjoy this wealth if I decide to hoard. Similarly, I may wait with the purchase of a new car and hoard money until it is worth 2 cars, but the real question is how willing am I to do it: if I live in place with no public transporation and vast distances, then I might not prefer to wait.

If you ever wondered how to defeat consumerism, deflation is your answer. What the principle mentioned above tells us is that in a deflationary economy people would still spend, but they would be much more likely to spend carefully, buying only things they truly want. This, in turn, would stimulate job creating in sectors of the economy which people consider necessary. By reallocating the job-force into those sectors, it would raise the competition and lower the price of end goods and services for consumers. This is the opposite of the current situation in which people are working on products and services which represent value to consumers only because they are anxious to get rid of their money (anxious because, obviously, they don't want to have a currency on hands that loses value each day due to inflation). This tends to lessen the job-competition in the truly important sectors and raise prices for end products and services there.

Now the second argument that deflation is bad luck for those who borrow is just a misrepresentation of the reality. Supposedly, creditors will always want a higher return, so if they loan you 10btc, they will want 12btc back. And because the price of each unit of a deflationary currency is rising, it would be that much more difficult for loaners to pay off. The problem with this is the implicit assumption that creditors want a bigger number. What creditors really want, is a surplus in value. If a creditor loans you $10 and you return him $12 and these $12 are worth less than the $10 you borrowed, then the creditor lost. Similarly, if you borrowed 10btc and returned 9btc, which are worth more than the original 10btc, then the creditor made a profit.

Now the last argument against deflation is really interesting. Suppose it is correct and investors stop investing, each expecting the value of their savings to grow. But why does the value of units of a deflationry currency grows? If we neglect the speculatory fluctuations, ultimately it's because the number of products and services in the economy increases, while the number of units stays the same—that is, you can buy more food for less money because more food was produced. But if no one invests, no additional products and services are being produced, thus the value of everyone's savings is not going to grow until someone invests.

Now an investor may think: why should I invest - I'll let the other fella do the job, and simply profit from it. And indeed, it is perfectly possible with a deflationary currency. However, the one who invests also profits! It's an ultimate win-win. So the incentive to make an investment first among others is this: if you want to make money, you can wait until somebody else invests (which you don't know when is going to happen) or invest yourself and make money now.

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