Why the World Needs Deflation

"The simple power of technology is that it allows for abundance without the same amount of jobs or income...if we let it.” - Jeff Booth in The Price of Tomorrow: Why Deflation Is the Key to an Abundant Future

In a previous blog post, I shed light on the downsides of inflationary policies. Namely, any policy that incentivizes spending necessarily discourages saving. While spending may drive increased growth for the economy at-large, an economy with low savings leaves its citizens fragile to shocks and uncertainty. While most mainstream economists stand firmly in favor of inflationary policies, they may be even more ardent in how much they dislike the idea of deflation. But is deflation really a boogeyman that must be avoided at all costs? 

For purposes of this post, deflation is simply a decrease in overall prices. While this sounds amazing (everything gets cheaper!), one of economists’ greatest fears is a deflationary spiral where credit markets freeze and people stop spending money into the economy. It is important to note that not all deflation is created equal. The deflationary spiral that economists fear can be an incredibly painful event resulting in halted economic progress and lost jobs. These spirals occur due to excess credit in the system, which is a downstream effect of the incentives in most modern economic systems. While we want to avoid deflationary spirals, deflation in and of itself is not inherently bad. In fact, deflation is the natural result of human progress and innovation. 

Consider one of the most innovative areas of human society today: electronics. Each and every year, televisions, computers, and smartphones become more capable and less costly. The march towards dematerializing everything has led to decreased costs for a plethora of products and services--in other words, deflation. This is not the deflationary spiral that economists fear. Rather, it is a natural process. All new innovations are inherently deflationary. 

Consider a village that relies on fish as food. Before the fishing pole is invented, people must catch fish by hand. This may require half the village to work an entire day in order to feed everyone. However, as soon as someone invents a fishing pole, the amount of time required to feed the village is driven way down. Now, a small handful of fishermen can feed the entire village, while everyone else’s time is freed to work on something else to benefit the village. Not only does innovation free up people’s time—it also pushes prices down as fish become abundant. As soon as the fishing pole is introduced, the supply of fish will skyrocket as people can catch far more fish per hour. As the supply of fish shifts from limited to abundant, the price of fish will plummet. In this world of technological innovation, deflation is a clear benefit to society. 

In today’s world, central banks target 2% inflation. In other words, their goal is to increase prices by 2% each year. Meanwhile, entrepreneurs are busy innovating, which, as we saw in the fishing pole example, decreases prices. At a macro level, prices in today’s economy are driven by whoever wins the battle between central bankers and entrepreneurs. If central bankers win, prices go up; if entrepreneurs win, prices go down. As the pace of technological innovation continues to increase, central banks are required to create more and more money in order to reach their inflation targets. Perhaps in the past the natural rate of deflation resulting from innovation was low—say 1% per year. This means that central banks would need to create enough money to offset the 1% deflation and drive prices up by 2% beyond that. However, as technology grows, the natural rate of deflation goes up. Creating enough money to offset 1% deflation is barely noticeable, but creating enough money to offset 10% deflation will be felt by the entire economy. 

When innovation occurs, the gains should accrue to society in the form of lower prices and/or increased freedom of time. We can easily see this in the fishing pole example, as (1) the price of fish declines for everyone, and (2) many people who were stuck fishing by hand all day are now free to focus on solving a new problem. However, when inflationary policies fight against the deflationary forces of innovation, these gains are stripped away from society at-large. Rather than enjoying lower fish prices, society pays the same (or 2% higher) price for fish, all but ensuring that they must continue to put in similar amounts of time and energy in order to afford to eat. These gains for society at-large do not simply vanish. Rather, the benefits of innovation simply accrue to a smaller subset of society. 

When prices are pumped upwards, stripping fish buyers of more affordable fish, the real beneficiary is whoever is nearest to the price pumping (this is called the Cantillon Effect). If the price pumping occurs by giving fish buyers more money to buy fish, then the fish buyers would benefit. In this scenario, even though the price of fish is higher than it would have been without inflation, fish buyers also have more money than they would have without inflation, so the result is similar. Unfortunately, rather than widely distributing the price pumping, it is usually done in a concentrated manner where a small number of participants have easier access to newly created money than everyone else. In short, inflationary policies take gains that would accrue to society at-large and stuffs them into a much smaller group of insiders.

Where does Bitcoin fit into the inflation vs. deflation debate? Bitcoin does not fight against the natural forces of progress, nor does it actively do anything to incentivize increased innovation. Rather, Bitcoin provides an immutable monetary policy that prevents meddling altogether. Simply put, Bitcoin removes humanity’s ability to micromanage and tinker with complex systems. It allows technology to do what it should: provide benefits which widely accrue to all of humanity. Rather than shift societal gains to a small group of insiders, Bitcoin gives maximum breathing room for the natural phenomenon of innovation to (1) drive prices lower for everyone, and (2) increase humanity’s optionality for how to spend its time and energy.