Home > Deflation, Economic Fallacy, Economics, Economy, Epistemology, Financial Crisis, Inflation > Economic Fallacy V: Can CPI measure Deflation?

Economic Fallacy V: Can CPI measure Deflation?

In a recent post Woodford warns of deflation threat as CPI drops to 3% CrisisMaven found another instance of the widespread belief that not only sinking prices (misspelt “deflation”) are harmful as they cause buyers “to strike” but that the housing market has “deflated”.

(See statistical material in our References section!)

Of course, metaphorically speaking, real estate markets all over the world with the notable exception of the housing and commercial property markets in systemically superior China which allegedly unfairly profits from an undervalued currency have seen their unsustainable bubbles pricked, which, when it happens to your inflatable Gym ball, is called “deflation”.
However, CrisisMaven thinks there is a dangerous misconception underlying all these “received wisdoms” about “deflation” in the sense of “falling prices are always bad as they cause more harm than rising prices”.
Unsuitable analogies aside (“rising temperatures lead to the body healing, falling temperatures mean you’re actually dead”, as rigor mortis begins to set in to explain the dangers of deflation or “like blood volume grows in infants so must the money amount in economies when they grow” etc.) we need to ask ourselves

What has become of the venerable law of supply and demand?

For thousands of years, surely even before the introduction of money as a means of exchange, even illiterate barterers would know that falling demand or rising supply would mean falling, and the opposite, all other things being equal, rising prices. Still, in one and the same week the president of Germany can openly call for higher gasolene prices to nudge the automotive industry to design more fuel efficient cars while other politicians simultaneously call for a cap on fuel prices “like Luxemburg practices” and be equally publicly welcomed like that was no contradiction.
Make no mistake: consumers will always want lower and merchants and manufacturers always higher prices. And as everyone understands, as they can’t have both, they must eventually “meet in the middle”, i.e. the end result is what economists call a “market clearing price”. That is the price that will just about “satisfy” everyone in that they grudgingly will either buy or sell at that price. Raise it only a little and at last some items will remain unpurchased gathering dust, lower it too much and not only will there be some buyers longing to buy but not finding offers but also sellers not willing to sell.
So, let’s sum up: when prices are too high buyers won’t buy. (Before unsustainably cheap mortgage offers came to market, the very reason we’re now in a mess, it was quite normal that certain people couldn’t afford certain houses!).
Now some economists and their epigones have invented a new theory: when prices are perceived to fall, people won’t even buy when for them (individually) the price is right.
So now we’re in a fix: people won’t buy when prices are too high, people will equally not buy when they are low.
The “opposite of opposites”, if the first premises were true, should then equally be true: people won’t sell when prices are too low, people will equally not sell when they are high.
I think we can agree, the first part always holds true – buyers will not buy if they perceive prices as too high and sellers won’t sell, if they perceive prices as too low. That is because in both cases market clearing prices are not reached, stuff remains either unbought or unsold. But don’t worry, in cycle two buyers will either accept higher or sellers offer lower prices to stay in business.
The “deflation [sinking prices] is scary” argument actually tries to be more convincing by saying “no, it’s not the absolute price level but the direction into which it moves that determines if buyers will buy or not”. (I have a surefire remedy: just as the Fed discontinued publishing the M3 monetary aggregate only publish CPI when prices rise!)
So, as long as prices fall buyers will refrain from buying but the direst necessities. CrisisMaven has his doubts: let’s say, you always wanted a house and a car, “the American Dream” so to speak. You have just married and when you did, it looked as if you couldn’t afford both at the same time. Since a few days prices have “deflated” so much that now you would be able to fulfill that dream, but no, you’ve read that your buyer colleagues in the AFB/CBO (American Federation of Buyers/Congress of Buyer Organizations) have called a nationwide boycott of all goods that are too expensive in what their council has deemed a “fair price”, so you wait, and wait, and wait. Never mind, your wife has since run off with that yuppie and now lives in that nice little home in suburbia and they already have two grandchildren, however, you don’t even speak with such scab scum, you wait and wait and wait … Even the late (very late) Keynes once said “in the long run we’re all dead”.
Now, this argument doesn’t hold water or if it did, the opposite must equally be true: that sellers don’t sell as long as, due to (price) inflation, they can hope to get a “better” deal tomorrow. As long as no one has disproved the latter we hold that it disproves the former.
So, why are house prices declining? Why was oil declining? Because there is not enough demand to clear the market at the higher prices! Have people stopped refueling when oil prices sank? Not at all, if anything, they began to travel and hence buy more gasolene than in the months before when prices were high. People will buy what they need, for the rest let them, and them alone, decide when “the price is right”!
Anyone who tries to interfere with this only mechanism apart from private ownership that truly distinguishes market societies from failed centrally planned regimes, and from poverty, invites further disaster. While falling house prices might mean that month after month more homeowners will be left with negative equity, the recipe against that is not to take these houses from those who can’t afford them and sell them at a higher price to people who can even less afford them even at today’s prices but who only sit on the sidelines not because they wait endlessly as long as prices sink ever so slowly, but who still don’t buy even at these “deflated” prices because for them, and for their means and wants, those prices are still not low enough!

So does the Consumer Price Index measure “deflation?

Certainly not. Apart from “measuring prices” being a statistically untenable unscientific methodology (which we will cover in upcoming posts) it only measures what the respective statistics office thinks people are consuming (or rather “should consume” – because neither you nor I actually do). While it is already stupid to manufacture shoes for the “average American” (about half of you would lose them, roughly the other half would require orthopaedic treatment) there is no way that you can determine an “average price level”. Anyhow, where inflation currently would be “measurable” is where they don’t measure, e.g. in the stock markets, the housing market in China etc. While what they “measure”, e.g. cars or household purchases in general, largely is on the retreat because people either can’t afford to buy more or, like through cash for clunkers, or in the housing market which includes DIY purchases as well (!), demand has been saturated for the coming years.
In other words: the CPI shows nothing what would not be expected by the coveted law of supply and demand, there is also nothing that can be done about it. What would the doomsayers suggest? Extend more foul credit to make people buy more stuff they can’t afford? Now that they’re either out of work or fretting about it? And what about the backswing deflation when payback time comes? Or is that not in the big picture?

Central bankers and economists who don’t understand this sophomore stuff should go cleaning. Because the cleaners who are currently desperately waiting till prices are so low that they can afford to buy would surely do a better job if the two classes of theorists swapped positions!

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  1. 2010-04-14 at 17:59

    Intelligible argument and certainly fun to read.
    It has always struck me as strange that those who deplore the falling in housing prices are actually advocating that a contorted price structure (houses beeing far too expensive in relation to people’s income) should be upheld (by fed or/and government subsidies and/or by preventing legal action in case of nonperforming loans).

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