Deflation can be “good” or “bad”, it depends on the circumstances. Once again, don´t reason from a price change

David Andolfatto has a recent post where he questions the “evils of deflation”:

Everyone knows that deflation is bad. Bad, bad, bad. Why is it bad? Well, we learned it in school. We learned it from the pundits on the news. The Great Depression. Japan. What, are you crazy? It’s bad. Here, let Ed Castranova explain it to you (Wildcat Currency, pp.160-61):

Deflation means that all prices are falling and the currency is gaining in value. Why is this a disaster? … If you hold paper money and see that it is actually gaining in value, it may occur to you that you can increase your purchasing power–make a profit–by not spending it…But if many people hold on to their money, this can dramatically reduce real economic activity and growth…

In this post, I want to report some data that may lead people to question this common narrative. Note, I am not saying that there is no element of truth in the interpretation (maybe there is, maybe there isn’t). And I do not want to question the likely bad effects that come about owing to a large unexpected deflation (or inflation).  What I want to question is whether a period of prolonged moderate (and presumably expected) deflation is necessarily associated with periods of depressed economic activity. Most people certainly seem to think so. But why?

The first example I want to show you is for the antebellum United States (and shows a version of this chart):

Deflation Evil_1

Following the end of the U.S. civil war, the price-level (GDP deflator) fell steadily for 35 years. In 1900, it was close to 50% of its 1865 value. In the meantime, real per capita GDP grew by 85%. That’s an average annual growth rate of about 1.8% in real per capita income. The average annual rate of deflation was about 2%. I wonder how many people are aware of this “disaster?”

People should know that there are “good” and “bad” deflations. In the picture above we see that the real output-price outcome was the result of a shifting AS curve (positive productivity shock).

The next picture gives an example of “bad” deflation, the result of a contraction in AD. In 1933 the opposite occurs when FDR delinked from gold and monetary policy was expansionary, allowing real output to grow strongly with minor impact on prices (given all the “slack” generated by the GD).

Deflation Evil_2

The Great Inflation is the prototype example of inflation “running wild” due to excessively expansionary monetary policy.

Deflation Evil_3

So, in some cases deflation is really a “disaster”.

And in this day and age of inflation targeting, allowing inflation to fall below target (and letting the price level remain permanently below the “inflation target associated price level”) is tantamount to monetary tightening. More expansionary monetary policy would result in the “counterfactual per capita income”. In this case we don´t have deflation but “inadequate inflation” (in reality, inadequate nominal spending), which can also be (very) bad.

Deflation Evil_4

3 thoughts on “Deflation can be “good” or “bad”, it depends on the circumstances. Once again, don´t reason from a price change

  1. And in this day and age of inflation targeting, allowing inflation to fall below target (and letting the price level remain permanently below the “inflation target associated price level”) is tantamount to…”

    Dereliction of duty by central bankers of a fiat regime under a mandate of price stability. (My sniping genes made me say it🙂 )

  2. Well, I think deflation is nearly always bad in a modern economy.

    If there is a true deflation, then there is a deflation in real estate. Once property values start going down, banks stop lending on property. Once banks stop lending on property, values start going down. Oh, it’s circular!

    Maybe this is a “structural impediment” or more accurately, and “institutional imperfection.” Whatever, such lending and credit expansion is deeply embedded in modern economies. If you have a few decades, maybe real estate deflation will play out. Or maybe not, see Japan.

    Then there is a problem in that huge swaths of Americans have their “savings” in the form of the house they bought. So if their home values start going down…egads, you get all sorts of problems.

    I prefer Market Monetarism, but if inflation-targeting is the path chosen then the Reserve Bank of Australia’s 2-3 percent “band” approach seems okay to me.

  3. Even in an anticipated deflationary environment, you have trouble pricing debt. Lets say prices are falling by 5% per year, but the real “natural rate” of interest is 1%. Why bother to lend anyone money when you can get 5% by holding cash? Conversely who would borrow money to pay real interest rates of 5% when the natural rate was 1%? So lending and borrowing will be substantially depressed versus the normal situation. Now presumably (eventually) this could be dealt with by moving to some kind of equity system rather than a debt based system. But it would be hard and would require significantly different institutions to what exist today.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s