The Big Deflation Monster

When I was a kid 200 years ago I sometimes had trouble sleeping because I was pretty sure there was a monster lurking around outside my bedroom window. If you knew the neighborhood where I grew up you’d know I wasn’t that wrong but I had real monsters in mind – monsters with horns who snorted fire and back in those days pajamas were not fire retardant.

Today kids don’t need to worry about such things because their parents are already very consumed by the deflation monster. If you read the newspapers you can see that deflation has all the central banks shaking in their boots. Most recently the European Central Bank confirmed this paranoia by setting a key interest rate below zero. That’s a pretty cold interest rate!

An article last Friday in the Wall Street Journal (page A7, Deflation More than Threat to Some) said, “Deflation posed a threat to the fragile recovery across the 18-national euro zone. But it has already taken hold in Portugal, Greece, Cyprus, and Slovakia.” The article writes about the many ways that deflation is a scary monster. The problem with this story is that it is only half complete and as such is at least half wrong in its policy prescriptions.

To tell this story properly we need a big glass of JD and for your neighbor to stop mowing the yard. First, what is deflation? One definition is that deflation tells you why your bicycle is harder to peddle. Another concerns a deflated ego and why you lack confidence at dance parties.  But a more relevant definition of deflation has to do with changes in the national price level. Let’s suppose Uncle Oscar gave you $100 last year which you tucked away in a safe hiding place under your Beautyrest Recharge Catskills Firm Pillowtop Queen Mattress. Over the year the price of a QFO Quad Fighter Mini-Quad RC Gaming Drone fell from $100 to $90. You would say that the price of this drone fell by 10%. You would be really happy that you waited because now that $100 bill will get you the drone and the optional but extra laser guided missile that goes with it. We would call that a price reduction. That is getting close to the idea of deflation, but no cigar.

Deflation relates to more than the price a single good as when we talk about the CPI – the price of a basket of goods. No not the price of the basket. All the goods the typical consumer buys do not fit into a basket! Anyway, the CPI refers to what is happening to the prices of all those goods and services consumers buy. Usually the price of this basket of goods rises over time. I charted CPI data since 1950 and found that in the last 64 years, the CPI increased in 61 of those years. In only three years did the CPI fall – 1949, 1955, and 2009.

In the USA we can say that we experienced annual deflation three times since 1950.  But deflation quickly reversed itself each time. In 1951 the CPI rose by 8%.  In 1957 it was up to almost 4%. In 2011, consumer prices rose by more than 3%. In 1949 I was approximately three feet tall and was cute as the dickens.

Now we know what deflation is. It is pretty rare though as the WSJ said, some countries have caught the disease. I am looking at a set of CPI figures and forecasts done by the OECD  (http://www.oecd.org/eco/outlook/economicoutlookannextables.htm ) for 32 countries from 2000 to 2015.

·        Between 2000 and 2008, only one country had one year of deflation (Israel in 2004).

·        Six countries had deflation during one year in the financial crisis (2009).

·        Japan encountered deflation or near deflation from 2000 to 2013. Only in 2008 was the inflation as high as 1.4%.

·        With respect to OCED forecasts we find deflation or near deflation for all three years from 2013 to 2015 in four countries: Greece, Ireland, Portugal, and Switzerland

Deflation is a real thing – yes. But it clearly shows no generalized global or macroeconomic patterns. Except for Japan it seems to come and go. The largest financial economic collapse saw deflation in only 6 countries in 2009. By 2011 Japan was the only country continuing to experience deflation. By 2011, 22 of the 32 countries had inflation rates of at least 3%. If deflation is a monster it does not appear to be trying to permanently take over whole neighborhoods, except in Japan. Is Japan where we are all headed? Or is Japan a special case? Read on.

Deflation is when the price level of a country falls. I have shown that it seems to be in hiding most of the time and in nearly all places but has a way of coming and going here and there. So it is worth thinking about what causes it. And what is bad about it. And possibly what is good about it.

Since deflation relates to all the goods and services we buy as a nation, we think of it as we do other macroeconomic indicators – as being determined by aggregate demand and supply. When aggregate demand is very strong and rising, firms are expanding output and employment, and firms raise prices. But when aggregate demand for goods and services is weak or falling we imagine the opposite kind of macroeconomic situation where prices are rising more slowly (called disinflation) – or are falling (deflation). So you can see that aggregate demand can be very important.

But we shouldn’t forget that aggregate demand is not the only game in town. At times, aggregate supply is the driving force of the economy. When AS is rising rapidly relative to AD, this is usually a time when business productivity is rising faster than business costs. Firms can produce more and/or price more competitively. Thus a rising AS brings higher output with lower prices.  In contrast, in times when business costs are rising faster than business productivity, we find output slowing and prices rising more quickly.

Central banks that worry about weak economic growth and attribute this to weak aggregate demand, therefore, are prone to offsetting this with an aggressive expansionary monetary policy. But what if the weak growth is coming from the supply side? What if structural problems and regulatory haze makes firms reluctant to invest and expand and weakness is attributable to supply rather than demand factors? Treating a supply problem with a demand remedy would be a mistake. It might prevent deflation but it might aggravate the supply problems.

Beyond choosing the correct remedial policy another challenge of deflation is the basic premise that deflation is bad for a country and needs a remedy. The data suggests that except for Japan, recent history finds deflation to be here today and gone tomorrow. Treating deflation with a national policy is a little like putting a cast on a stubbed toe. By the time you get the doctor’s appointment that toe is already feeling better.

And what is so bad about bouts of deflation? The standard story goes something like this. Deflation makes it harder for government to pay off debts. Deflation may also make some people more willing to wait to buy goods – buying them in the future when prices are lower. As people wait to buy the economy gets weaker and people lose confidence. Dismal expectations make the economy that much weaker.

That’s a pretty scary monster story and it seems to be relevant for Japan – and so we might take notice. But the data suggests that such deflations are few and far between. Are we really on the way to such a horrible set of outcomes? I doubt it and for reasons that are standard yet not often-enough discussed. Consider a few positive implications of deflation. As the price level in a country declines, its goods are cheaper. A standard demand curve suggests that lower prices stimulate spending. Lower inflation relative to competing nations indicates an international competitiveness that also should help improve the nation’s economy and trade balance. Lower inflation often brings lower interest rates and exchange rates which boost spending. Finally, if deflation is being caused by an expansion of aggregate supply then it is reflective of a stronger economy – not a weaker one.

There might be a monster outside our global window. That would be scary. But there might not be such a monster. Deflation is not always the sign of things going wrong. Deflation is often temporary. And deflation often has as many good as bad impacts on us. The ECB and the US Fed ought to be considering some of these things before they set their canons on a beast that doesn’t exist.