Why We Should Fear
J. Bradford DeLong
University of California at Berkeley, and
National Bureau of Economic Research
For the Brookings Panel on Economic Activity,
March 25-26, 1999
After more than sixty years, deflation has reappeared
as something to worry about. In the past six months major newspapers
printed 438 articles classified under the keyword "deflation"--compared
to 36 such in the first half of 1997 and 10 such in the first
half of 1990. For sixty years, ever since the middle years of
the Great Depression, next to no one had worried about deflation.
Next to no one had seen actual falls in the price level as even
a remote possibility. Now people do.
The post-Korean War 1950s and the early 1960s saw measured
rates of inflation as low as those of today. Yet then people
worried not about deflation but about inflation. Only in the
late 1990s, not in the 1950s or 1960s, have inflation rates of
two percent per year or less called forth fears of deflation.
Source: Bureau of Labor Statistics.
In the past, low inflation did not induce forth fears of deflation
because observers believed that the institutions created
by the Keynesian revolution had a bias toward inflation. Yet
today this belief is gone, or at least greatly attenuated. What
happened to the built-in bias toward inflation that past economists
believed was inherent in post-WWII institutions? I suspect that
the institutional bias toward inflation was never as large as
many economists believed, and that it has recently been reduced
or eliminated by the growth of countervailing forces.
Given that deflation is back on the agenda, should it be feared?
Perhaps we should not worry about deflation because the probability
that it will come to pass is infinitesimal. Perhaps we should
not worry about deflation because it is not especially damaging.
If costs of inflation and deflation are roughly equal--if our
social loss function is symmetric around zero as a function of
the deviation from price stability--then there is more to fear
from renewed inflation than from deflation, for the price level
is still rising.
I tentatively conclude that there is reason to fear deflation.
The probability of serious deflation or of events that do the
same kind of damage to the economy that deflation does is low,
but it is not zero. There is good reason to fear that our social
loss function is asymmetric: that deflation does more macroeconomic
damage than an equal and opposite amount of inflation.
The root reason to fear deflation is that the nominal interest
rate is bounded below at zero. Significant deflation--even completely
anticipated deflation--thus generates high real interest rates
and large transfers of wealth from debtors to creditors. By contrast,
significant anticipated inflation does not generate abnormally
low real interest rates (although significant unanticipated inflation
is associated with large transfers of wealth from creditors to
Deflation's high real interest rates depress investment, lower
demand, and raise unemployment. Deflation's transfers of wealth
from debtors to creditors diminish the economy's ability to keep
the web of credit and financial intermediation functioning. Such
disruption of the financial system puts additional downward pressure
on investment, demand, and unemployment.
Thus it seems to me to be hard to argue that our social loss
function is symmetric, and that deflation is not to be especially
feared. It is easier to argue that the chances of deflation coming
to pass are very low. Yet I suspect that they are not as low
as we would like to believe, for the Federal Reserve's power
to offset surprise downward shocks to the price level is low.
From its beginning the Keynesian Revolution brought fears
of inflation. Before the ink was dry on the copies of Keynes's
General Theory, Jacob Viner already warned that:
A quarter century later in his AEA presidential address Arthur
Burns argued that Viner's fears had come true: that the post-World
War II world was one of constant wage-push inflation.
Viner's and Burns's fears have been developed and sharpened
by Finn Kydland and Edward Prescott, who pointed out that a benevolent
central bank possessing discretion and the ability to induce
unanticipated shifts in aggregate demand will be under great
temptation to try to take advantage of any short-run Phillips
curve boost employment and production. The rational expectations
equilibrium will be dissipative: workers and managers will expect
such actions from the central bank, and in equilibrium production
and unemployment will be unaffected but inflation will be higher
This Kydland-Prescott framework suggests two ways to counter
this institutional bias towards inflation created by central
bank possession of discretion and concern over high
unemployment. First-- Kydland and Prescott's preference--make
sure central banks are bound by rules and do not possess
discretion. Second--a line of thought associated with
Ken Rogoff--appoint central bankers who are unconcerned high
The pattern of economic policymaking in the 1990s suggests
that both of these ways of modifying institutions to diminish
inflationary bias have been adopted. The U.S.'s central bank
today appears to follow the rule (in the sense of Blinder
(1998) although perhaps not in the sense of Kydland and Prescott
(1977)) of giving first and highest priority to attaining near
price stability. The past decade has seen the flowering of a
common culture of central banking in which control of inflation
comes first, and always taking the long view is applauded. And
some central bankers at least appear to have been appointed with
an eye toward their relative lack of concern with--or disbelief
in their power to affect--the level of unemployment. The result
is a situation in which long-time inflation hawks criticize the
European Central Bank for pursuing overly-tight monetary policy,
and in which the ECB president announces--with euro-zone inflation
approaching one percent per year and euro-zone unemployment approaching
ten percent per year-- that the ECB "will act, should the
need arise, to prevent either inflationary or deflationary pressures..."
Thus it appears that attempts to reform institutions to eliminate
inflationary bias have been successful, or perhaps that the bias
toward inflation seen in the 1960s and 1970s was not so much
the result (as Kydland and Prescott theorized) of the game-theoretic
structure of the interaction between central bankers and the
economy or (as Burns theorized) of the absence of fear of high
cyclical unemployment, but instead the result of painful misjudgments
about the structure of the economy and the slope of long-run
Phillips curves that were corrected after the 1970s.
Why We Should Fear Deflation: Economic History
In the early 1920s most economists treated "inflation"
and "deflation" as symmetric
...evils to be shunned. The individualistic capitalism of
today, precisely because it entrusts savings to the individual
investor and production to the individual employer, presumes
a stable measuring rod of value, and cannot be efficient--perhaps
cannot survive--without one.
Deflation was dangerous because entrepreneurs were necessarily
long real and short nominal assets:
...the business world as a whole must always be in a position
where it stands to gain by a rise... and to lose by a fall in
prices.... [The] regime of money-contract forces the world
always to carry a big speculative position [long real assets],
and if it is reluctant to carry this position the productive
process must be slackened.... The fact of falling prices
injures entrepreneurs; consequently the fear of
falling prices causes them to protect themselves by curtailing
their operations; yet it is upon the aggregate of their individual
estimations of the risk, and their willingness to run the risk,
that the activity of production and of employment mainly depends...
The fact of falling prices bankrupted entrepreneurs. The fear
of falling prices led them to unwind their positions, close down
productive operations, and reduce output and employment.
The coming of the Great Depression, however, shifted economists'
focus away from balanced fears of inflation and deflation and
to the conclusion that deflation was deeply dangerous, and to
be avoided at all costs. Economists' analyses of the root causes
of the Great Depression were (and continue to be) widely divergent.
Nevertheless, alomost every analyst of the Great Depression placed
general deflation--and the chain of financial and real bankruptcies
that it caused--at or near the heart of the worst macroeconomic
disaster the world has ever seen.
Each analysis focused on a different channel. Irving Fisher
stressed that past deflation meant bankruptcy or near-bankruptcy
for leveraged operating companies and nearly all financial institutions.
Friedman and Schwartz stressed the harm inflicted by deflation
on banks' balance sheets by reducing the nominal value of collateral
and diminishing debtors' ability to service loans: resulting
financial-sector bankruptcies led to sharp rises in reserves-to-deposits
and currency-to-deposits ratios, lowering the money stock and
aggregate demand in the absence of adequate Federal Reserve response.
Peter Temin focused on rising risk premia on corporate debt over
1929-1933: deflation-driven corporate balance sheet deterioration
increased risk and drove a wedge between low short-term interest
rates on safe assets like government bonds and high long-term
interest rates on corporate debt.
Barry Eichengreen wrote of the fear that countries would depreciate
their currencies, and how this fear forced country after country
to adopt deflationary policies to reduce the price level and
shrink the money supply. Charles Kindleberger wrote of how currency
depreciation exerted deflationary pressures: a small country
that reduced the value of its currency discovered that its businesses
and banks had borrowed abroad in gold, and could no longer
service their debts. Christina Romer argued that even those who
were not heavily long equities found it advisable to cut back
on spending and increase liquidity margins in the aftermath of
the 1929 stock market crash.
All of these channels share common features. First is that
nominal interest rates cannot fall below zero. Hence banks could
not respond to anticipated deflation by paying negative interest
on deposits: if they could, then the key banking-crisis channel
that Friedman and Schwartz see as the principal cause of the
Great Depression would have been much weaker. Businesses could
not rewrite their debt contracts ex post to diminish the
effect of falling demand and prices on their balance sheets:
if they could, then the wedge between Treasury and corporate
interest rates that Peter Temin focuses on would have been much
smaller. Exchange rate depreciation did not, in 1931 any more
than in 1997, carry with it a writing-down of the hard money
or hard currency debts that domestic firms owed to foreign nationals:
if it had, then the channel that Kindleberger notes would have
been much weaker. The increases in uncertainty and falls in consumer
wealth that Romer focuses on would have had only trivial effects
on purchases of durable commodities had not consumers feared
that in the future they might want to have very liquid balance
sheets of their own.
Second is a common focus on financial fragility: the belief
that the interruption of the chain of financial intermediation
has disastrous consequences for production and employment, whether
the disruption occurs at the level of bank creditors (as in Friedman
and Schwartz, in which it is increases in currency-to-deposits
and reserves-to-deposits ratios that does the work), of operating
companies (as in Keynes's or Fisher's stories of entrepreneurs
unhedged against price level declines), of banks themselves (as
in Temin, in which the deterioration of bank debtors' balance
sheets does the work), of companies with foreign liabilities
(as in Kindleberger), or of consumers who no longer dare to be
short in nominal terms to finance their purchases of durable
assets (as in Romer).
In all of these channels sharp deterioration in debtor balance
sheets leads to desires on the part of both debtors and creditors
to unwind their positions and boost their liquidity, and to sharp
reductions in business investment and consumer spending.
Economists do not have satisfactory theories of why borrowers
choose to borrow and lenders choose to lend in unstable units
of account, or of why demand is so sensitive to credit-market
disruptions. Economic theory tells us that debt contracts are
good ways to reduce the principal-agent problems that arise when
investors confront entrepreneurs and managers who have vastly
greater knowledge of a firm's circumstances and opportunities.
Economic theory tells us that when borrowers' balance sheets
are impaired such debt contracts no longer work. But there is
no theoretical reason why such contracts should be written in
potentially unstable units of account, or why they should not
condition on observed macroeconomic variables.
Nevertheless, debtors borrow and creditors lend in nominal
terms--whether consumers financing purchases of durables, banks
taking deposits from households, real estate developers pledging
land and property as collateral, or companies borrowing from
banks. Such debt contracts interpret nominal deflation and the
consequent difficulty in servicing or repaying the loan as a
signal that the debtor has failed to properly manage their enterprises,
and hence that the enterprise needs to be restructured or liquidated.
This confusion of nominal deflation with entrepreneurial failure
is what makes a deflation such a dangerous exercise.
How dangerous? We do not know. We do not know how financially-fragile
the U.S. economy is today, either in the sense of how vulnerable
financial-sector and non-financial-sector entrepreneurial net
worth is to deflation or how much reduction in aggregate demand
would be caused by impaired financial-sector and non-financial-sector
balance sheets. The U.S. economy has not experienced deflation
since World War II. We know that economic historians blame debt-deflation
and financial-fragility channels for the greatness of the Great
Depression. We have no reliable evidence on the strength of these
The (relatively poor) data on aggregate movements in production
and prices before World War II can be used to support the claim
that the association of price changes and output changes is non-linear,
with larger falls in prices associated with proportionately greater
falls in output. A simple regression of peacetime annual changes
in industrial production on the change and the squared change
in the wholesale price index is certainly not inconsistent with
the existence of a powerful non-linear deflation channel--as
long as the World War I years are excluded, and as long as 1920-1921
is excluded as well.
Source: NBER Macro History database.
There is sound reason for the exclusion of the 1920-21 data
point as an outlier. Coming immediately after the World War I
inflation, the 1920-21 deflation came before businesses and financial
institutions had had sufficient opportunity to rebalance their
portfolios and readjust their degrees of leverage. Thus financial
and non-financial balance sheets were unusually strong, and financial
and non-financial net worth were unusually high in 1920-1921.
The economy was thus less vulnerable to the channels through
which deflation reduces production: the fact that 1920-1921 does
not fit the correlations found in the rest of the data can be
read as evidence for, not evidence against, the importance of
debt-deflation channels back before World War II.
But an economist willing to try hard enough can always find
sound reason for excluding an influential and inconvenient observation.
Moreover, these (relatively poor) pre-World War II data on
industrial production and wholesale price index changes are of
doutbful relevance for the U.S. economy today. And we lack data
and convincing theory needed to identify how much of the correlation
between changes in prices and changes in industrial production
back before World War II reflects movements along an aggregate
supply curve and not any destructive consequences of deflation.
Why We Should Fear Deflation: Present Vulnerability
Alternative Channels that Impair Balance Sheets
If the danger of deflation springs from its effect on net
worth and depends on the degree of financial fragility in the
economy, then economies may well have more to fear than declines
in broad goods-and-services price indices alone. If securities
and real estate holdings have been pledged as collateral for
debt contracts, then large-scale asset price declines also trigger
the confusion of macroeconomic events with entrepreneurial failure
that makes deflation feared.
Is the United States today potentially vulnerable to large-scale
asset price declines in this way? In real estate no. In the stock
market yes. Perhaps fundamental patterns of equity valuation
have truly changed, as investors have recognized that the equity
premium over the past century was much too large--in which case
stock prices have reached a permanent and high plateau. But it
seems more likely that there are substantial risks of stock market
declines on the order of fifty percent back to Campbell-Shiller
Source: Robert Shiller (1987), Market Volatility.
A second source of potential deflation-like pressure--seen
during Sweden's exchange rate crisis of 1992, during Mexico's
exchange rate crisis of 1994-5, during the East Asian crises
of 1997, as well as in Great Depression-era events like the Austrian
financial crises of 1931--arises out of large-scale foreign-currency
borrowing by banks, companies, and governments in countries whose
exchange rates then sharply depreciate.
Exchange rate depreciation is a standard reaction to a sudden
fall in foreign demand for a country's goods and services exports
(on the current account) or property (on the capital account).
When demand for a private business's products falls, the business
cuts its prices. When demand for a country's products falls,
a natural reaction is for the country to cut its prices, and
the most way to accomplish this is through exchange rate depreciation.
But if governments, banks, and non-financial corporations
have borrowed abroad in hard currencies, depreciation writes
up the home-currency value of their debts and impairs their balance
sheets in the same fashion as conventional goods-and-services
price index deflation.
We know that other countries certainly have been vulnerable
to this form of financial market disruption. Is the U.S. vulnerable?
Not today. U.S. gross external obligations of $7 trillion or
so are overwhelmingly equity or dollar-denominated investments.
But will they still be dollar-denominated come the end of the
year 2000, when they will amount to perhaps $9 trillion, and
when these gross obligations are part of a net investment position
of more than -$2 trillion?
The Limits of Monetary Policy
Moreover, even a pure commodity price deflation may not be
as unlikely as we hope.
How adept is monetary policy at controlling the price level?
The answer has always been--or at least since Milton Friedman
stated that monetary policy works with "long and variable
lags"--"not very." Power and precision are two
Modern estimates of the impact of monetary policy shocks on
production, employment, and the price level continue bear out
this assessment. Authors like Christiano, Eichenbaum, and Evans
are very pleased that they find substantial agreement on the
qualitative impact of changes in monetary policy (as measured
by the short-term interest rates that the Federal Reserve actually
controls) "in the sense that inference is robust across
a large subset of the identification schemes that have been considered
in the literature." But the confidence intervals surrounding
their point estimates are large. Moreover the time delay in the
effect of a change in monetary policy is large as well: not until
some eight quarters after the initial interest rate shock has
the impact of a change in interest rates had anything near its
long-run effect on the rate of inflation (or deflation). According
to Christiano, Eichenbaum, and Evans, a one percentage point
upward shift in the federal funds rate is associated with a less
than one tenth of one percent decrease in the annual rate of
inflation even ten quarters out.
Monetary policy remains the tool of choice for stabilization
policy. The lags associated with Presidential and Congressional
changes in spending plans and tax rates are even longer and more
variable than the lags associated with monetary policy. But in
the UnitedStates today monetary policy has no appreciable effect
on the rate of price change for a year and a half after its implementation,
and has nothing close to its full long-run effect on the rate
of price change until two and a half years have passed. Moreover,
there are important policy recognition and policy formulation
lags as well in the making of monetary policy. The FOMC's reliable
information flow is at least one quarter in the past. The FOMC
is a committee that moves by consensus guided by its chair, and
committees that move by consensus rarely act quickly.
How Large Are Price Level Shocks?
If we today could reliably and precisely forecast what the
price level would be two and a half years hence, the long and
variable lags associated with monetary policy would not be worrisome.
But we cannot do so. In the years since 1950 the standard deviation
of the price level two and a half years hence is 6.6%. A little
of this variation can be attributed to systematic policy. Conditioning
on the level of CPI inflation today accounts for less than a
third of the two and a half-year-ahead variance in the price
level, and reduces the standard error of the price level two
and a half years out to only 5.5%. Conditioning on both inflation
and unemployment reduces the standard error of the price to only
5.4%. And conditioning on inflation, unemployment, and current
nominal interest rates reduces the standard error only to 4.8%.
The most significant improvement in forecasting comes from
conditioning on the identity of the Federal Reserve Chair, which
reduces the standard error to 3.8%. But fitting a step function
to any process will improve the fit. I see little in the views
and characters of Arthur Burns and Alan Greenspan that would
lead the replacement of the first by the second to generate an
immediate nine percent fall in one's estimate of the price level
two and a half years out. It strains credulity to believe in
a +26 percent effect on the price level from any chair, even
G. William Miller.
TABLE 1: STANDARD DEVIATION
OF 30-MONTH-AHEAD PRICE LEVEL CHANGES
Standard Deviation and Conditioning
5.5%: 12-mo inflation rate
5.4%: 12-mo inflation rate, capacity utilization rate
5.3%: 12-mo inflation rate, unemployment rate
4.8%: 12-mo inflation rate, unemployment rate, federal funds
4.8%: 12-mo inflation rate, unemployment rate, federal funds
rate, 10-yr Treasury rate
3.8%: 12-mo inflation rate, unemployment rate, identity of
Federal Reserve chair
Nevertheless, even a 3.8% standard deviation tells us that--if
the normal distribution applies appropriate--that there is once
chance in twenty that the price level two and a half years hence
will be more than seven and a half percent higher or lower than
we forecast. At current rates of inflation, an unanticipated
fall in the price level of more than five percent before the
Federal Reserve can react seems to be an event that would happen
once every forty years. Is this a high risk of a serious deflation?
No, but it is large enough to be worrisome.
Reasons for Confidence
Is such instability enough to make a debt-deflation spiral
set in motion by unanctipated commodity price declines a serious
threat? Probably not.
First, it may well be that it takes a bigger economic shock
to induce a certain amount of deflation than it takes to induce
the same amount of accelerating inflation or of disinflation.
If so, calculations of price-level variability from an era of
accelerating inflation and disinflation are unreliable guides
to the potential for deflation. It takes a much greater contractionary
impulse to cause deflation than to cause disinflation.
Second, a large chunk of the post-1960 variance in changes
in the rate of inflation comes from the relatively narrow period
of the turbulent 1970s. The years between 1971 and 1983 inclusive--one
third of the sample--account for ninety percent of the squared
deviations of CPI inflation around its mean. Since 1984 the standard
deviation of two-and-a-half year ahead changes in CPI inflation
is only a third the full-sample standard deviation. Perhaps episodes
of variability like the 1970s oil shocks and the breakdown of
confidence in the Federal Reserve's commitment to price stability
will not happen again because of increasing levels of knowledge
about how to make monetary policy.
It is easy to make such arguments in the United States, where
monetary policy makers have been skillful and astonishingly lucky
over the past decade. It is, however, harder to make this argument
from policy making competence elsewhere in the world. In Japan
producer prices are 5% lower than they were a year ago, and over
the past three months have fallen at a rate of 10% per year.
Estimates of the output gap relative to potential in Japan today
range between 8 and 25 percent of current GDP. In the euro zone
inflation is less than one percent per year, and unemployment
approaches ten percent. These macroeconomic problems are different
from those of the 1970s. They are not less serious. And they
do not appear to be consistent with greatly increased skill in
the making of monetary policy.
Our ability to forecast and control the price level at a time
horizon that corresponds to the effective range of monetary policy
is low. Our policy instruments are powerful, but they are imprecise
and are subject to long and variable lags. Moreover, other sets
of circumstances than general goods-and-services price declines
alone could set in motion the economic processes that we fear
Thus there seems to be reason to fear deflation.
But there is no reason-at least not yet--to be very afraid.
The institutional structures of our labor market provide us with
insurance against debt-deflation as in the argument of Akerlof,
Dickens, and Perry (1996)--although note that this insurance
comes at a substantial price: in their model the natural rate
of unemployment rises substantially as the inflation rate hits
zero. The relatively high price level variability of the 1970s
may truly be a thing of the past, not a thing to fear in the
But if the volatility of the 1970s does come again, and if
deflation is not much harder to cause than disinflation, and
given that monetary policy is an imprecise instrument that works
with long and variable lags, what then? If your loss function
is asymmetric--if moderate deflation is much more damaging than
moderate inflation--and if the variance of outcomes around targets
is large, then the conclusion is obvious: good monetary policy
should aim for a rate of price level change consistently on the
high side of zero.
After all, in a still-impoverished world, it is worse to provoke
unemployment than to disappoint the rentier.
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