Luc Vallée is chief strategist at Laurentian Bank Securities.
It's common wisdom that too much inflation is bad and that hyperinflation is terrible. But it seems even more ingrained in our psyche that even mild deflation is the real devil. Why?
The quick answer is that deflation inflates the value of debt and makes it difficult to deleverage. Tales of the Great Depression are laced with ghosts of the deflation that inflicted pain and prolonged the economic crisis of the 1930s for over a decade.
But isn't even mild inflation just as bad? Inflation deflates the value of assets, destroys wealth, renders its accumulation near impossible and, in the end, erodes purchasing power. As a matter of fact, the consequences of inflation are similar to the ones attributed to deflation – except that inflation negatively affects investors and asset holders, while deflation afflicts borrowers and debtors.
However, in a world in which government collects taxes on the income derived from investment, inflation is even more costly to asset holders than it appears.
Inflation and taxes make a powerful cocktail of wealth destruction. Think of it this way: A nominal 4-per-cent return in a 2-per-cent inflation environment, in a country where the tax rate on investment income is 50 per cent, yields a pre-tax real return of 2 per cent but an after-tax real return of zero.
Contrast that to the situation in a slightly different world where inflation is -1 per cent, rather than the supposedly ideal 2-per-cent rate targeted by most central banks in industrialized countries. In this deflationary world, the nominal return required to yield the same 2-per-cent pretax real return would be 1 per cent. In other words, getting a 1-per-cent nominal return on an investment when deflation is 1 per cent yields the required 2-per-cent pretax real return. However, in this case, an investor would net an aftertax real return of 1.5 per cent. Here's why: The nominal return of 1 per cent on the invested asset (taxed at 50 per cent) would only provide a net yield of 0.5 per cent, but due to the 1-per-cent deflation, the asset would grow in value by an extra 1 per cent (just as the asset would depreciate in value with inflation).
Even with a zero-per-cent nominal return (potentially a lower bound as investors could keep their cash in a deposit box to avoid negative interest rates), the after-tax real return would be positive as no taxes would be levied and the assets would grow in real terms at the rate of deflation. Note that in Europe, some interest rates are negative but the few dozen basis points of negative return do not exceed the cost of holding on to cash.
As mentioned above, while creditors would be advantaged, debtors would obviously be worse off in a deflationary environment. The latter would see their debt grow in real terms as deflation inflated the value of their liabilities, even if they paid no interest at all on their debt. So who's afraid of deflation? Debtors.
Truth be told, for the past several decades, except when central banks were tightening monetary conditions, the effective after-tax real returns on risk-free assets were mostly negative – effectively implying that borrowers, including governments, have been paying negative real-interest rates on their liabilities. Said otherwise, the interest borrowers paid on their debt was less than the depreciation of their debt due to inflation. No wonder they piled on debt. Conversely, bond investors have been receiving after-tax returns that were insufficient to maintain the real value of their assets and saw the purchasing power of their assets erode over time.
In a deflationary world, the situation would be reversed: Investors would see their assets grow in value with deflation as the after-tax real rate of interest would be positive – a big change but a situation more in line with what one would expect in a world where investors should be rewarded for lending their money to borrowers, who should pay for such a privilege. In an inflationary world, awkwardly, investors pay for the privilege of lending their assets to borrowers.
In a highly leveraged world, like the one we are living in today, some asset holders may also be afraid of deflation because if the real after-tax return were to become positive due to deflation, vulnerable debtors could start defaulting, implying that lenders could lose their capital. But isn't this exactly what they are already experiencing over time with inflation, as their asset depreciates in value because their after-tax returns are insufficient to mitigate the destructive effect of inflation?
Moreover, a little bit of deflation would certainly provide debtors with the incentives and the motivation to orderly reduce their nominal debt level over time in order to keep their "real" indebtedness in check.
Policy-makers would argue that such deleveraging, if it were to happen today on a large scale, would add to the headwinds that are already weakening the global recovery. I would argue that it would lead to a better allocation of capital and a less risky global macroeconomic environment that would largely compensate for such headwinds and, potentially, contribute to abate them over time.
Finally, if deflation is too difficult to swallow for our indebted governments, which often resort to debt to finance growth and to inflation to increase fiscal revenues and lower the value of their liabilities and debt obligations, here is a compromise: Instead of tinkering with the idea of raising the inflation target to 3 per cent, as recent research has suggested, begin taxing returns on an inflation-adjusted basis. Asset holders would then probably not mind tolerating a little inflation, since it wouldn't penalize them any more. Moreover, the temptation of governments to resort to inflation would likely evaporate, as it would no longer provide its distorting benefits. Removing the distortion of taxes on nominal returns should create a more stable inflation environment over the long run. The strategy might even also help reduce the overall cost of capital over time.
Otherwise, middle-class investors, looking to retire one day, should be happy with a little bit of deflation. As showed above, it would allow them to shelter some of their returns from the hands of the taxman, and finally accumulate a little bit of wealth.