I grew up being taught that Inflation is bad and deflation is even worse. This was because the people I viewed as teachers just repeated the common “wisdom” of the time. If I could make those quotes more sarcastic, I would, because I’ve come to realize that what I was taught was only a half truth. And half truths are the worst kind of lies.
Let’s start with Inflation: the sustained rise of prices over time. That’s a terrible definition that only makes sense if you don’t think about it. But neither Wikipedia nor Investopedia clear things up much. In order to understand what inflation means, you have to understand how it’s measured and what its various causes are. I’d like to say that once you get that, everything feels right in the world, but understanding inflation only opens your eyes to how useless the term really is.
What inflation means
A rise in prices doesn’t necessarily mean things are getting more expensive. Inflation is supposed to represent a reduction in the purchasing power of currency. You need more dollars to buy the same amount of stuff, but you’re also getting more dollars for your work, so you’re not really any worse off. So Ideally, the measurement of inflation should remove fluctuations in the real prices of goods not attributable to currency devaluation and isolate the reduced purchasing power of the currency. It doesn’t.
How inflation is measured
In order to determine how much prices are rising over time, you have to aggregate a bunch of different products and watch how their prices change over time, to oversimplify. This measurement is called the Consumer Price Index (CPI). The problem is that sometimes prices change because of innovations that reduce costs or scarcity that increases costs. These price changes are not the result of currency devaluation, but they are included in the overall price changes nonetheless. Inflation simply express price changes, regardless of whether the underlying reasons are good or bad. In order to be precise, every time we talk about inflation, we have to be clear about the reasons behind it. A word that requires clarification every time you use it is not a very useful word.
The good and bad causes of inflation and deflation
Now is a convenient time to start talking about deflation too. We don’t need to go through everything all over again because deflation is defined and measured the same way as inflation except prices fall over time instead of rise. I won’t go into detail on every cause of inflation and deflation, but I’ll touch on three.
Changes in amount of money supply
When more money is put into circulation, people look to spend it. Demand rises, and prices rise in response. The market self-corrects and more money doesn’t make everybody rich. When this happens in the opposite direction, you get deflation. Whether or not changes in money supply are good or bad depends upon the magnitude.
Mild changes are fairly harmless. Some might even argue that a mild increase is good because it stimulates the economy. But I think that notion comes from an imagined causal link between increased money and real increases in demand. The point could be argued, but that’s not my purpose here. Large changes in money supply can be devastating. When this type of inflation gets out of control, you have situations like the famous hyperinflation of 1923 Germany. Both Hyperinflation and hyperdeflation create serious distortions of the market with unquestionably negative consequences.
Changes in productivity or efficiency
Changes in productivity are pretty straightforward. When productivity or efficiency improves, we produce more for less and prices fall. This produces deflation and it is most definitely a good thing. In fact, improved productivity is the number one thing we want to happen in a healthy economy. When there is decreased productivity, prices rise. Even mild inflation as a result of reduced productivity is a bad thing.
Changes in quantity demanded
Sometimes there is an increase in the quantity demanded of a product or service, and the price goes up. This is just the market signalling that more resources should be allocated to produce the desired good or service, and it’s okay. When the opposite happens, that’s okay too. Of course buyers and sellers will benefit or lose as a result of the price changes, but the economy overall is indifferent. I’d say that these sorts of price changes are generally good because they drive the efficient reallocation of resources.
Changes in cost
Changes in cost not directly attributable to productivity can ultimately be traced to another layer of either demand or productivity, so I’ve already covered them as much as I want to.
The terms inflation and deflation can be worse than useless. How many arguments have been fought because people are using the same words to encapsulate different ideas? I understand Scott Sumner’s frustration that led him to ban inflation. Because I’m willing to accept the possibility that ‘inflation’ and ‘deflation’ might have value in our vocabulary, I’d suggest we treat these two words like guns, and leave their use to trained professionals who know how to handle them without getting hurt.