Deflation increases Wealth

Let us perform two mental exercises. Well, you can skip the mental exercise part and jump straight into the analysis.

Mental Exercise (Inflation)

You have 10 million $, and your neighbor has 10 thousand $ in net wealth. Suppose the inflation rate is 10% per annum; this included income, assets and wealth inflation. At the end of the year your net wealth increases to 11 million $, and your neighbor’s 11 thousand $.

Everybody is richer, see calculation below

Calculation

You – Started $10 mil, end $11 mil, wealth accumulated $1mil.

Your neighbor – Started $100 thousand, ended $110 thousand, wealth accumulated $10 thousand.

Conclusion

You made $990,000 more than your neighbor in the inflationary environment. You should be very happy! Although you still want more!

 

Mental Exercise (Deflation)

You have 10 million $, and your neighbor has 10 thousand $ in net wealth. Suppose the deflation rate is 10% per annum; this included income, assets and wealth inflation. At the end of the year your net wealth reduces to 0.9 million $, and your neighbor 9 thousand $.

Everybody is poorer, see calculation below

Calculation

You – Started $10 mil, end $9 mil, wealth reduced $1mil.

Your neighbor – Started $100 thousand, ended $90 thousand, wealth reduced $10 thousand.

Conclusion

You lost $990,000 more than your neighbor in the deflationary. You should be sad!

Deflation increases Wealth

But Everybody will be Happier?

Happiness is about relative comparison not absolute weath. This is a well know pyschological phenomena and is acknowledged by the Gini Coefficient.

If your neighbour lives a standard like you, then you’ll be happy because you did not underperform. If your neighbor drives a big car, lives in big house with a big garden,  you will not be happy with what you have got. You will want to strive harder to achieve what your neighbor has; and occassionally wondered what on the earth went wrong. Why am I so under-performing? You’ll want to borrow to achieve this kind of lavish lifestyle of your neighbor’s.

The above example showed that with the same inflation, you will out-perform your neighbor in absolute terms by $999,000. This ought to make you really happy. However, deflation will cause you to underperform your neighbor by $999,000 because he lost lesser than you. Actually, more will turn out happier.

Why?

The overall wealth improves because those that lost $10 thousand are actually better off by $990,000 although no money is transferred (Check out Tim Harford, The Undercover Economist Strikes Back, 2013, who recalled two muscians who burnt way their million pound…http://timharford.com/ )

There  are much more people with $100 thousand, losing $10 thousand, than there are people with $10 million, losing $1 million. The multiplier effect kicked in, creating a Flywheel Effect (Check out Jim Collins, Good to Great, 2001) for the society.

Summary

Next time someone said inflation is good, chances are they’ll benefit more from it. The best policies are the policies that nobody comes out from it happier. Deflation is treated like a monster by economists and politicians etc, but deflation is our friend.

In the society where increasing population (or inflation)  is a non sustainable way to growth, the solution normally lies in the reverse of it.

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