Saturday, November 12, 2011

The deflation fear bias

Central banks seems to have a significant almost primal fear against deflation. Central banks believe they can control inflation but they do not have good strategies for dealing with deflation. With deflation, there is a strong decline in financial assets and bank stocks. There are further declines in housing values and overall wealth.

There is no money illusion when there are price declines. Tangible assets clearly will be worth less and all borrowers will be negatively affected. Borrowing or leverage becomes more dangerous. Perhaps more clearly, there is a fear of asset price deflation by central banks which is much greater than any fear of general price increases. Is because central banks are part of the creditor class? Hard to say. It is also unclear that central banks are able to control inflation. Look at the periods of hyperinflation. What is clear is that deflation cannot be easily solved and will have a strong wealth effect and central banks want to avoid this problem at all costs.

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