Is Deflation Really a Monster? by Filipe R. Costa

Everyone seems to be concerned with what is seen as the largest economic tragedy of all time – deflation. If prices in Europe continue following the recent trend people are at risk of buying their bread, meat, fish, and clothing for less than usual. Can you imagine how chaotic paying less for your food, for a football ticket, and for dining out would be?

Deflation may be an economic enemy but it can be a friend of the consumer, who can just buy the same amount of goods for less, or, put another way, can buy more with the same amount of money. The purchasing power of a deflated currency is higher and so are the living standards of those who use it to make their day-to-day purchases.

But central banks, governments, and mainstream economists think otherwise.

They believe deflation is the worst enemy of our society, as it leads to recession and depression. They argue that when prices are low consumers tend to delay their purchasing decisions, as they expect prices to further decline in the future. This behaviour would lead to further price declines, culminating in a self-powered spiral that will most likely end in recession. They usually point us to the Great Depression, in particular to the period between 1929 and 1934, when prices declined at an average annual rate of 6.4% and growth declined at a 6.7% rate in the US. With their thoughts firmly set in this historical event, central banks now target a positive inflation rate near 2% and are willing to lower interest rates and engage in unconventional policy measures whenever inflation falls below that near-term goal.

With the above reasoning in mind, one can bring into the discussion two important aspects.

Firstly, if deflation is so heavily correlated with recession, as it is seen to delay consumer purchases, wouldn’t it be expected that inflation would bring forward purchases? If that was the case monetary policy would just have to concentrate on generating a 10% inflation rate. Wait, why not 20%, or even 2000% instead? The higher the merrier. The expectation of price increases would lead consumers to the front door of every shop in the country, making them willing to spend every penny or cent at the first opportunity. But hyper-inflation would most likely result in uncertainty, inefficiency and eventually in a collapse of the financial system with the currency being replaced by other means of exchange, which leads the central bank to cap the inflation level.

Secondly, there is no good reason to believe that deflation results in delayed purchases and consequently in lower growth. Common sense goes against that thought; economic theory doesn’t back such an idea; and historical evidence even points in the exact opposite direction.

The reasoning on deflation and delayed purchases is flawed from the beginning.

If prices decline and consumers expect further declines, then the nominal interest rate would also decline, reducing the reward for saving and offsetting any gains from delaying purchases.

Theory apart, let’s look at some recent evidence coming from a specific sector of our economy – technology. This sector has experienced a tremendous and continuous decline in prices over the last 20 years. Computers and technology-related products now cost much less than many years ago but that hasn’t prevented the sector from growing. In fact the share of tech products for consumer spending as a whole is now much larger than years ago. Decreasing prices didn’t prevent growth.

Let’s say you want to buy an iPad. If past price trends are good predictors for future prices then it would be rational for you to expect the iPad price to decline over the next couple of months. So, if you wait you will save some money. Will you delay your purchase? If you wait another 20 years you will buy a much better iPad for much less. But, at the same time, you wouldn’t enjoy the utility deriving from the use of the iPad, which in the first place should drive your desire to buy it.

Just because prices are expected to decline it doesn’t mean a consumer would delay purchasing forever, as the growth in the technology sector is evidence of. I wouldn’t expect a consumer to delay a haircut, the purchase of food, or his vacation just because he expects prices to decline further in the near future.

But we can do even better by looking at the historical evidence on deflation.

When we talk about deflation, we ultimately use the Great Depression and Japan as reference points, which are deemed as representative of the harmful effects of deflation on growth. Unfortunately, these events are misleading and contribute to the wrong idea people usually have.

As I already mentioned above, the Great Depression, in particular the period between 1929 and 1934, resulted in an annual price change of -6.4% and annual growth of -6.7%. But that was an isolated event in history. The decade before was characterised by deflation and growth. During the 1920s prices declined at 2.1% per annum, while growth was around 4%. In the specific period of 1920 to 1923, prices declined by 6.3% a year, while growth was as high as 5.2% in the US. In the UK growth was milder but still positive in the advent of deflationary pressures.

Deflation episodes repeat over history.

If we rewind the tape to the 27 year period of American history between 1869 and 1896, we find an annual price decline of around 1.8%, mixed with an annual growth rate of 4%. Deflation didn’t prevent growth occurring in a period of almost three decades.

But now let’s take a look at Japan. It is frequently mentioned in the press that Japan is seeing deflation and depression. Though one can say the country isn’t growing as it used to during the 1980s, it is untrue to state the country is facing depression. For the worst period on record, between 1995 and 2013, the country experienced a mild deflation rate of 1.04% a year, but mixed with a growth of 0.88% a year.

The main reason for the lack of growth has been the significant decline in productivity the country experienced and not deflation.

Considering all points, we cannot state that deflation and depression are part of the same reality. On the contrary, it is arguable that mild deflation may be desirable and the consequence of gains in productivity. The technology sector experienced huge growth even though prices have been declining over the years, as productivity was the main reason behind the price declines. Strong gains in productivity are the main reason behind healthy growth and declining prices are the consequence of such growth. There’s no better reason for a central bank to target an inflation rate of 2% instead of a deflation rate of -2%. As Prof.  John Cochrane from the University of Chicago very well puts it:

“…sudden deflation is bad, because it hurts borrowers, just as a sudden inflation is bad because it wipes out savers. But zero inflation, or even slow, steady, and widely expected deflation, are in fact much better in the long run. The financial system is much healthier with bundles of cash lying around, at no interest cost, than if everyone is engineering clever, but ultimately fragile, cash management schemes. The main argument for higher inflation and consequently higher nominal interest rates is that it gives the Fed more power to run the economy by occasionally lowering rates, i.e. to go back to driving the car by slightly starving it of oil, and then artfully adding a quart when needed. Given what a great success that’s been lately, maybe trading a more fragile financial system for greater Fed power isn’t such a good idea after all.”

While deflation shouldn’t be a concern for the consumer, who in fact may experience an increase in living standards as a result of it, it is a real concern for those who carry large amounts of debt on their balance sheets, as is the case with many governments.

One way of extracting wealth from creditors is through a default or haircut on the amount borrowed, as has been the case with Argentina, Russia and Greece. Another way is through an increase in the general price level, which acts as a decrease in the purchasing power of the money borrowed. The final effect is the same but the second case is much more indirect and overcomes potential legal matters.

In a monetary system that is based on fractional-reserve banking, under which banks lend much more than they carry as client deposits, money is created out of thin air and investment and consumption are always much higher than the pool of real savings would allow for. To keep debtors solvent, the central bank has no other option than to keep interest rates low and avoid deflation at all costs, otherwise the government and the whole financial system in which credit is based would collapse. That is the main reason why you read expressions as “unwelcome fall in inflation” and “inflation becoming undesirably low” in FOMC statements and qualifying words as “debilitating” and “destabilising” in the press, when referring to deflation.