Friday, February 27, 2009

Bad, bad deflation

It seems that EU and USA currently fear deflation more than anything else. After all, the argument goes, decreasing prices motivate people to postpone consumption, which adds to the downturn.
This seems like an obvious truth but it is unlikely to be the only consequence of deflation, or even the most important one.
This is a banking crisis, during which the value of banks' assets decreased significantly. Plus, they perceive every asset as much more risky than before. Therefore, they are not willing to lend money because they do not have enough of the assets to feel safe. The deflation, plus at least in Czech Republic obvious hunger for deposits (interest rates are highest I have seen in the long time despite low rates set by CNB), motivates people to save. Saving on a banking account instead of in cash in the attic has twice as high rate of return and if there is one thing clear from this crisis, it is that the banks' deposits are safe.
Increased deposits will make banks to feel safer and to start lending again. This will re-start investment, which will require new employment, which will make everybody feel safer and start spending again.
From still strong reluctance of banks to lend, it seems that the government shortcut to just motivate people to spend seems unlikely to work, especially in the US, where the levels of consumption were not sustainable in the long term

P,S. I prefer to be a lender, not the borrower. Personally, I prefer deflation also because of this. But I believe that it may not be as harmful to the economy as everybody thinks so, given the type of crisis we are in.

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