The news that consumer price inflation fell to 0.5% in March 2014 set some worrying that prices generally might be about to fall. Such fears raise a paradox.
An economist’s view on deflation
From one perspective, it’s obvious that a falling general price level is a bad thing. If prices fall significantly, governments will see their tax revenues fall as prices and wages fall. But because interest rates on government debt can’t fall below zero, fears would re-emerge that southern European governments in particular face mounting debt.
The same thing is true for heavily indebted companies and households. They too would have to repay rising debt with falling incomes. This would plunge some into bankruptcy, causing banks to lose money as they don’t get back the money they lent. Worse still, if some companies or workers are slow to cut prices or wages – that is, if there’s "nominal rigidity" – struggling companies might find themselves priced out of business as competitor prices fall while theirs don’t. It is easy, therefore, to see why so many economists are scared by the possibility of deflation.
Happiness experts are not so sure…
But there’s another side to this story. Economists who have researched the question of what makes us happy agree upon one thing – that higher inflation makes us miserable. For example, research by Andrew Oswald at Warwick University has found that a one percentage point higher annual inflation rate makes the average European less happy by the same amount as would a loss of $70. From this perspective, we should welcome the end of inflation.
“Deflation may produce a welfare gain”
But why does inflation make us unhappy? Part of the answer lies in simple irrationality. Inflation means a rise in prices and wages. But we don’t see it like this. Instead, we focus upon the bad side (rising prices) and fail to appreciate that our rising wages are part of the same inflationary process.
However, this isn’t the whole story. Back in 1969 the Nobel prize-winning economist Milton Friedman pointed out that "deflation may produce a welfare gain". His reasoning was straightforward. We want to hold cash so we can get at our money quickly if we need it, and save ourselves trips to the bank. But inflation reduces the real value of this cash. It acts just like a tax. And just as a tax on anything else makes us worse off, so too does a tax on holding cash.
Friedman proposed that the ideal rate of inflation was slightly negative, as this abolished the inflation tax. Exactly how great the benefits of removing inflation are depends upon some tricky calculations about the sensitivity of our demand for cash to changes in inflation and interest rates. But most economists agree that they are positive.
Deflation and taxes
This, though, isn’t the only advantage from removing inflation. If prices and wages are falling, some of us will drop out of higher income tax brackets. Insofar as high tax rates deter some people from working, this is a good thing. Deflation would reduce the distortions caused by high tax rates.
It would also reduce the taxes upon savers. If inflation is 2%, interest rates are 5% and we’re taxed at 20%, our post-tax real interest rate is 2%. However, if inflation is -1% and interest rates are 2%, the same pre-tax real interest rate gives us a post-tax rate of 2.6%. This makes savers better off, and reduces the degree to which the tax system affects our decision to save or not.
The deflation paradox
What we have here, then, is a paradox. Viewed from a macroeconomic perspective, deflation is a terrible prospect. Viewed from a microeconomic perspective, it could be a good thing.