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What is Deflationary Bias?


The term 'Deflationary Bias' is included in the Economics edition of the Financial Dictionary. Get yours now on mazon in ebook or paperback format. Read more here...

Deflationary Bias refers to a government approach to managing inflation versus deflation. Inflation means that prices are rising, whereas deflation signifies that the prices of goods and services are decreasing. It is helpful to consider a real example of these two opposing concepts in order to understand them and the problems deflation can quickly cause.

If individuals go to their local grocery store and discover that bread has increased to $2.50 instead of the previous price of $2.00, they will not be happy. This is inflation and represents inflationary bias. On the other hand if the individuals went down to the car lot and discovered that a car which sold for $25,000 before is now selling for $23,000, they would be ecstatic. This is deflation and represents a deflationary bias. In general, consumers will always prefer deflation to inflation, at least on the surface.

The picture becomes more complicated when debt is considered. On a consumer level, as home prices decline, the home owners suddenly find themselves holding a mortgage that may be higher than the house’s actual value proves to be. As this becomes a severe problem, individuals who own the house and are paying down the mortgage little by little (over likely 30 years) will not be able to sell and move simply because the mortgage is so much greater than the value of the house. The debt laden homeowners become unwitting victims of deflation in these cases. As a result, they are unable to move to expand their job hunting possibilities and will likely cut back on spending as they realize that they are upside down in the home thanks to the ravages of deflation.

This logic similarly applies to business as well. Because contracts exist in fixed terms not real terms, as real prices rise or fall, losers and winners emerge every time. As inflation occurs, sellers in a contract prove to be the winners, along with debtors whose debt is priced less in real terms. When deflation happens, prices fall and the sellers and debtors become the all around losers as their debt now costs more to repay in real terms. The buyers and creditors are the winners in this deflationary scenario. Ultimately this means that regardless of accounting tricks and confusing statistics, both deflation and inflation create income transfers with zero sum game losers and winners.

Governments attempt to smooth out the precarious extremes of either deflation or inflation utilizing monetary policy. The problem occurs as some prices rise at the same time as others fall. Gas prices may be declining at the same time as new cars are becoming more expensive. This is where the various monetary policies of governments meet their match. As these policies are effectively massive but blunt instruments, it is impossible for them to flexibly address the two extreme scenarios simultaneously.

This leaves policy makers with one of two unappealing choices. They will have to show one bias or another in their approach to managing an economy. Will they pursue an inflationary bias or instead a deflationary bias? With the inflationary bias they will be favoring greater employment levels and higher growth over the shorter term time frame. With a deflationary bias they will be favoring lower employment and less growth over the short term. The problem is that these biases similarly impact both sellers and buyers of any assets as they cause the assets to be less or more valuable in real terms as the debt in which they hold them is constant.

The reason that central banks and policy makers hate deflation so much is because of the real world effects on holders of debt. They are in terror of deflation since it alters consumer and business psychology and spending. With the Western societies that are so heavily indebted, deflation is the greatest possible enemy. This is true for the consumers, businesses, and especially the debt-ridden sovereign governments alike.

It is why the policy makers around Europe and the U.S. are desperate to re-inflate their respective economies. Japan has been caught in a deflationary spiral for decades now. The terrifying result has been a long period of economic stagnation and malaise from which they have never escaped since the end of the 1980s.

The term 'Deflationary Bias' is included in the Economics edition of the Financial Dictionary. You can get your copy on mazon in Kindle or Paperback version. See more details here.