Wednesday, February 25, 2009

During most of our lifetimes, the prices of things we buy have generally increased over time.

From Casey Mulligan:

"Deflation – Let’s Not Try That Again!




The Great Depression years 1929-33 featured a large and prolonged deflation. January 2009 reversed a deflation pattern for 2008 that was ominously similar to 1929’s.

During most of our lifetimes, the prices of things we buy have generally increased over time. We can name some exceptions, such as toys over the last decade and computer equipment over the last couple of decades, but otherwise most items (even houses) have prices that are higher now than they were ten, twenty, or thirty years ago.

This general increase in consumer prices – often called inflation – has become familiar. Employees expect regular pay raises, and employers can normally afford them because they are increasing the prices of the products they sell.

Just as important, familiarity with inflation comforts lenders who offer loans to consumers and businesses under assumption that those borrowers will tend have incomes that rise together with all other prices. That is, lenders typically arrange for repayment at regular intervals in specific dollar amounts – such as the regular monthly payment on a home mortgage – and inflation helps borrowers “grow into” their loan payments.

On rare occasions, consumer price trends suddenly change directions.

Nineteen twenty-nine was one of those occasions. Consumer prices were pretty constant during the 1920s. The chart below picks up the story in January 1929 with the red line. That line measures the (seasonally unadjusted) consumer price index in each month through July 1930, normalized so that October 1929 is 100 (for example, the value of 97.9 in April 1929 means that prices then were 2.1 percent lower than they would be in October).



Prices were heading up in the spring and summer of 1929, during which time lenders might have expected that the typical home owner would obtain a pay raise and the typical farmer would someday fetch more for his crops – in both cases making it easy to pay back their respective mortgages.

In the fall of 1929, the inflation stopped (incidentally, the stock market crashed in late October of that year) and prices headed down, falling almost every month for almost four years. By the spring of 1933, this deflation brought prices down almost 50 percent from their 1929 peak. It was difficult for homeowners and farmers to make their mortgage payments when their paychecks had been cut in half.

The blue series in the chart shows the consumer price index for 2008 and 2009. Like the 1929 series, the 2008 series is normalized so that October is 100.

The chart shows how consumer prices also rose in the spring and early summer of 2008. Inflation had stopped by the fall (there was a stock market crash in October 2008, too), and consumer prices headed down. In fact, the deflation at the end of 2008 brought prices down more than four percent in a couple of months, as compared to the one percent drop at the end of 1929.

Price reductions since the summer of 2008 have been credited to declines in prices of commodity– such as fuel and food. That’s not the whole story, because other prices (notably housing prices) were falling in 2008. Moreover, the role of commodity prices adds to the similarity between 1929 and 2008, because commodity prices were falling in 1929-33 too.

If the Great Depression consumer price parallel were to continue beyond 2008, we would be in for a sustained deflation until the year 2012. At that point, with most borrowers earning less than half of what they were when they applied for the loan, today’s mortgage problems would seem minor. Thus, January’s C.P.I. report released on Friday was a welcome return to something familiar: inflation.
"

Me:

Blogger Don said...

You're correct. One of the main reasons that Deflation is a disaster is that it's disorienting, and causes people to panic, as if they're in a foreign and unfriendly landscape with no way out. It's a panic magnifier.

Don the libertarian Democrat

February 25, 2009 8:14 AM

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