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J. Bradford DeLong
U.C. Berkeley and NBER
November 30, 1999
Department of Economics, Evans Hall, #3880
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone
(510) 642-6615 fax
The inflation of the 1970's was a marked deviation from America's typical peacetime historical pattern as a hard-money country. We should expect America to continue to be a hard-money--low inflation--country in the future, at least in peacetime.
The low rate of future inflation that we thus forecast changes the balance of macroeconomic risks and opportunities. The risk of debt-deflation-mediated recessions is somewhat higher because a low trend rate of goods-and-services price index inflation somewhat increases the chances of deflation. But it does not raise such risks as much as one might think.
The failure of the Fisher effect to hold empirically means that a low inflation era will in all likelihood be a high real interest rate era. But such high real interest rates do not appear to significantly discourage investment or growth.
The burst of inflation that struck the United States in the 1970s shapes much American thought about macroeconomic policy. The decade of the 1970s saw GDP-deflator inflation rates peak at nearly ten percent per year. It saw consumer price inflation rates peak at three or four percent higher.
This burst of inflation was sufficiently high for economists' standard models to predict that it would significantly distort investment. Because America's tax system does not adequately adjust for the difference between nominal and real income, the interaction of inflation with the tax system twists incentives in harmful ways. The burst of inflation transferred substantial wealth from creditors to debtors. And it rendered thoroughly untrustworthy any accounting statements constructed according to generally accepted accounting principles.
In addition, the inflation of the 1970s has cast its shadow upon forecasts of the likely future of the American economy. Everyone's expectations of what inflation will be in the future are powerfully influenced by the memory of the 1970s, during the American price level did rise by more than eighty percent.
Yet a look back at history reveals that the sustained inflation of the 1970s was an anomaly in American history. The American economy had occasionally suffered peaks of inflation higher than the levels that were reached in the 1970s. The two highest peaks, however, had come during World Wars I and II--and one expects to see considerable inflation whenever one's country is engaged in a total war. The third peak in the twentieth century reached by inflation that was higher than the peak inflation rate reached in the 1970s took place in the 1930s. It was part of the recovery from the mammoth deflation of 1929-1933.
Such a momentary bounce-back inflation is different. It did not rapidly and substantially raise the price level above marks that had previously been considered normal. Instead, it restored prices to levels that had been considered normal before the coming of the Great Depression. It should be viewed primarily as an undoing of a previous rapid deflation, rather than as an inflation with significant consequences of its own
Moreover, these previous spikes of inflation had been very transitory. They lasted for no more than a few years. They did not last for the decade-plus period during which inflation was a principal economic policy concern which extended from the late 1960s into the 1980s. And these three episodes were clearly breaks from normal patterns of behavior produced by emergency circumstances. For the entire remainder of the century between the end of the Civil War and the coming of the Vietnam War, inflation in the United States as measured by the GDP deflator had usually been less than 3% per year. It had always been less than 5% per year. During peacetime, for the whole the century before 1968 the United States had been a hard-money country.
There is littlereason to think that the inflation of the 1970s marks a structural shift away from this peacetime history as a low-inflation country. The causes of the inflation of the 1970s were unique, and are unlikely to be repeated. More typical is that William Jennings Bryan lost the election of 1896 when he campaigned on the platform of free coinage of silver at a rate of 16-to-1 (see Goodwyn (1978)). Neither the Republican nor the Democratic Party sought at the end of 1970s to run on a platform of tolerating the "head cold" of ten percent per year's worth of inflation in order to achieve the benefits of a high-pressure economy. Both political parties today--save at their fringes--are eager to praise senior Federal Reserve officials who have pursued monetary policies that have successfully minimized inflation.
It is the inflation of the 1970s that is the significant exception.
Thus it is probably best to think of the current relatively low rate of inflation as a return to a typical American pattern. Anyone forecasting the future from today has to be willing to give long odds that the low levels of inflation America has experienced since the early 1980s will continue.
If it is the case that we are likely to be entering a prolonged era of very low inflation, what should we expect that era to bring? What potential dangers does history tell us that low inflation brings to the forefront? History does tell us lessons. The lessons are relatively simple and straightforward. But they are also important.
There are three sets of issues where America's long-run historical experience with low inflation might be of help in forecasting the future, or at least in aiding those of us who want to play the role of Cassandra in pointing out potential dangers.
The first set of issues revolves around low inflation and the credit channel. The current leading theory of the causes of the Great Depression stresses the destruction of the web of financial intermediation by deflation between 1929 and 1933: the Great Depression appears from today's perspective to be more of a credit than a monetary phenomenon. Low inflation raises the chance that at some point the turning of the wheel of the business cycle will generate deflation. How great is this danger? How is it to be guarded against?
The answer is: not very great. Low trend inflation does raise the chance that a contractionary shock might push goods-and-services price indexes down. But what we fear about deflation can be generated by asset price "deflations" and foreign-currency debt "deflations" as easily as by goods-and-services price index "deflations." A period of price stability certainly does not increase the chances of either of these alternative sources of contractionary shocks.
The second set of issues revolves around low inflation and real interest rates. All economists believe deep in their bones in the theory of the Fisher effect: theory tells us that if one changes the average trend rate of inflation, and if one then waits long enough, nominal interest rates will adjust point-for-point (or possibly more than point-for-point given the interaction of inflation and the tax system) to the change in the rate of inflation, and real interest rates will return to equilibrium. Is this in fact the case? Or does low inflation pose a danger in terms of being likely to generate persistently high real interest rates?
The lessons of history here are double-edged. On the one hand, history teaches us that we should not expect the Fisher effect to hold. On the other hand, there are no signs that the failure of the Fisher effect to hold has any bad consequences other than (in a low inflation era) a certain degree of wealth redistribution from creditors to debtors.
The third set of issues concerns inflation and productivity growth. The idea behind low inflation is to remove some sand from the wheels of the price mechanism. In an effectively-zero-inflation climate, people can have more trust that the real prices they see are likely to persist near their current levels rather than being always in motion as some (s, S) mechanism recurrently ratchets real prices of individual commodities to levels that are temporarily high and then temporarily low. In an effectively zero-inflation climate, people don't have to worry about inflation. Instead, they can devote their mental attention to worrying about other things--and we hope that some of that worry about other things will translate into improvements in productivity.
But does low inflation in fact produce faster productivity growth? And if it does not, then what is the rationale behind pursuing policies to guarantee low inflation--policies that may incur substantial costs in terms of other objectives sacrificed?
In the last analysis, confidence that low inflation is a goal worth pursuing has to rest on (i) the consequent reduction in tax-system distortions, (ii) a theoretical belief that removing managers' and workers' attention from the problem of forecasting inflation must be worthwhile, and (iii) from voters' and citizens' expressed preference for low rates of inflation.
Does the absence of significant inflation increase the chance of significant deflation? And should we care? Does deflation have destructive macroeconomic consequences?
Today the price level no longer has a noticeable upward trend. Does this absence of inflation mean that the chances of a sharp downward movement in prices--a deflation--are increased? Certainly people who write articles for newspapers and magazine believe that it does. DeLong (1999) reports that in a recent six-month period major newspapers printed 467 articles that fall within the scope of the keyword "deflation." A similar search records only 36 such articles in the first six months of 1997, and only 10 in the first half of 1990.
John Maynard Keynes (1924) may have been the first economist to explicitly set out the damaging effects of deflation working through the credit channel. Keynes argued that deflation was damaging. In his view entrepreneurs, could not profitably carry on their businesses in times of deflation:
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, 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 (see Keynes (1924), pp. 40-42)
In Keynes's analysis it is not so much the fact as the fear of falling prices that is destructive: entrepreneurs fear that they will lose in times of deflation, so expected deflation leads them to cut back their activities. It was Irving Fisher (1933) who thought the principal danger was not the the fear of falling prices but the fact that prices had fallen that was the principal source of danger. Fears that past price declines meant that the banks in which you placed your money were insolvent and chains of bankruptcies both disrupted Fisher's equation of exchange. Past deflation produced a decline in present velocity.
Others disagreed. DeLong (1997) points out that academics like Joseph Schumpeter and policy makers like U.S. Treasury Secretary Andrew Mellon both argued that periodic deflations were necessary for economic growth. Anyone could make money during an inflation. Only during deflation could the collection of the economy's entrepreneurs be pruned through bankruptcy which would release factors of production that could then be re-employed by more skillful entrepreneurs during the next boom.
We today believe that back before World War II deflation could cause depression because of the side effects of the principal-agent problem confronting investors. An investor has limited ability to assess what is going on at the level of the operating business. Thus investors need to structure contracts so that they must monitor the progress of the business they invest in as little as possible. A good way to achieve this end is through a debt contract (see Townsend (1979), Gale and Hellwig (1985)). In economic theory there is no reason that a debt contract has to be a nominal debt contract, unconditioned on macroeconomic signals of production, price levels, and unemployment. But in practice the economy has and has long had a lot of nominal debt contracts.
In an economy with many debt contracts deflation impairs the ability of entrepreneurs to service their nominal debt obligations. Thus to the financial system deflation appears to be a signal that entrepreneurs have failed, and that as a result of their failure enterprises need to be liquidated. This makes deflation destructive: valuable organizations and webs of intermediation are eliminated for no fundamental purpose. And there is significant evidence that deflation has worked to diminish production through this credit channel both before and since World War II.
There would be little need to worry about the destructive consequences of goods-and-services price deflation if we were confident that the monetary authority could effectively peg the price level--or at least keep prices from declining. So a natural question to ask is: "how fast can monetary policy act to influence the price level?" The answer since Milton Friedman stated that monetary policy works with "long and variable lags" has been "not very" (see Gordon (1975)). Monetary policy is powerful, but power and speed of action are two different things.
Recent econometric estimates continue to bear out this assessment. Christiano, Eichenbaum, and Evans (1998), for example, proclaim that there is substantial agreement on the impact monetary policy "in the sense that inference is robust across a large subset of the identification schemes that have been considered in the literature." But the time delays in the effect of a change in monetary policy on prices are large. According to Christiano, Eichenbaum, and Evans (1998), 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 does remain the stabilization policy tool of choice: other discretionary policy lags are longer and more variable. But all evidence suggests that the ability of the Federal Reserve to offset price-level movements that take place at any time horizon of less than three or four years is limited. DeLong (1999) reports calculations--assuming a symmetrical distribution of price shocks--that suggest at least a one-in-twenty chance that the price level two-and-a-half years hence will be eight percentage points or more below today's best forecast.
But this credit-channel analysis of the macroeconomic dangers of deflation leads immediately to the conclusion that declining goods and services price indexes are not the only source of "deflation." That is, declining goods-and-services prices are not the only potential source of macroeconomic danger from the credit channel. A large-scale asset price decline has similar destructive consequences for the credit channel. Indeed, to the extent that financial assets and real estate play a key role as collateral in the web of financial intermediation, there is much more to fear from a large stock- and real estate-market crash than from slow declines in goods-and-services price indexes. One prominent theory of the source of todays macroeconomic difficulties in Japan stresses just these credit-channel consequences of large-scale asset price declines.
Another source of potential deflationary effects is harder-currency borrowing by banks, companies, and governments. When debt contracts are denominated in outside currencies, an exchange rate depreciation has destructive credit-channel consequences analogous to those of goods-and-services price index deflation. When demand for a private business's products falls, it is natural for the business to cut its price. When demand for a country's products--either its exports or its properties--falls, it is natural for the country to cut its price by letting its exchange rate depreciate. But if its banks and corporations have borrowed abroad in harder currencies, then depreciation looks like deflation: it writes up the home-currency value of their debts, erodes entrepreneurial net worth, and sets the destructive credit channel in motion.
For the United States today the risk of large-scale declines in goods-and-services price indexes is small, the risk of large-scale declines in stock-market values is large, and the interaction of harder-currency borrowing with exchange-rate depreciation is not a concern--or, at least, it is not a concern unless a large chunk of foreigners holding dollar-denominated assets have bought derivative contracts that insure them against large-scale depreciations in the dollar.
Nevertheless, it is important to recognize that the credit channel effects we fear from deflation have more potential sources than simply a fall in broad goods-and-services price indexes alone. And this carries the possible implication that deflation is most dangerous when it follows hard on the heals of a previous period of inflation.
Inflation leads to an increasing degree of leverage in the financial system: more debt contracts, and a greater chance for falls in asset prices to set off contractions in the web of financial intermediation. Whether this increased degree of leverage springs from inflation alone or from the powerful interaction of inflation with a tax system that assess tax liability based on nominal income is not clear. But it is reasonably clear that even if a period of inflation lowers the danger of debt-deflation from a downward spiral in goods-and-services price indexes, it does not reduce--and may increase the potential danger from these other sources of pressure. Thus there is a case to be made that the most damaging effects of deflation, at least of asset-price deflation, are likely to be set up by a previous period of inflation. If true, then we would have to conclude that any effect that a low trend rate of inflation has in increasing the risks of a debt-deflation credit-channel downward spiral is presumably not a very large increase.
The end of moderate inflation in the United States in the early 1980s also saw a substantial increase in real interest rates--an increase in real interest rates that has now persisted for a decade and a half.
The real interest rates plotted in the figure above are naively constructed by subtracting the rate of inflation over the previous twelve months from the nominal interest rate. They are thus very imperfect measures of changes in real interest rates in the short term. To the extent, however, that investors believe that inflation is persistent and that changes in inflation are nearly unforecastable, this figure will nevertheless manage to provide a reasonable guide to differences in real interest rates across decades.
The three most striking features of the figure are (i) the downward trend in real interest rates from the 1960s into the inflationary 1970s, (ii) the upward jump in real interest rates to what were (for the United States) extraordinary levels during the Volcker disinflation, and (iii) the continued high level of real interest rates since. Real interest rates today are some one hundred basis points higher at the short end and at least one hundred fifty basis points higher at the long end than in the early 1960s.
Back in 1984 when economists first noted this rise in interest rates, Olivier Blanchard and Lawrence Summers (1984) attributed it to an increase in the return on capital springing from Carter-era deregulation and Reagan-era reductions in marginal tax rates. But one would have expected to see an increase in economic growth over the following decade if higher real interest rates had been the result of a higher marginal product of capital from a reduction in inefficient government regulation. The investment boom of the 1980s wasn't. And the 1980s saw not an acceleration but a retardation of productivity growth that is hard to square with a belief that higher real interest rates were driven by higher marginal social products of capital.
Thus today it seems much more likely that relatively high real interest rates in financial markets are a result of some failure of the Fisher effect. Perhaps investors believe that there is a significant chance of a renewal of inflation like that of the 1970s, or perhaps they do not fully understand how changes in inflation ought to change equilibrium nominal interest rates.
Historical experience tells us that such failures of the Fisher effect for prolonged periods of time--generations--are not at all uncommon. Lawrence Summers (1983) argued that there was essentially no evidence for the existence of a response of nominal interest rates to changes in long-term trend rates of inflation back before World War II, and only a partial response to changes in long-term trend rates of inflation since World War II. In response to the criticism that pre-World War I rates of inflation were essentially unforecastable--and hence that there was no predictable component to shifts in pre-World War I inflation--Barsky and DeLong (1991) pointed out that the link under the gold standard between mining and prices did provide a way to forecast pre-World War I inflation. Although the log of the pre-World War I price level is almost a random walk, there is a component of future price changes that can be forecast by changes in the world stock of gold.
Worldwide gold production was a well-known and closely-followed quantity at the time. And the correlation between pre-World War I rates of inflation and rates of increase in the world gold stock was significant.
Financial markets back before World War I could have used the information implicit in gold mining to forecast in the years immediately after 1896 that the world economy was shifting from a regime of slow deflation to one of slow inflation. Yet they do not appear to have done so. Thus instead of a Fisher Effect, we have a pre-World War I Gibson Paradox. Interest rates respond to the turnaround of the direction of movement of the price level around 1896 so slowly and hesitantly that the nominal interest rate is correlated not with the inflation rate but with the integral of the inflation rate, the price level.
Irving Fisher himself attempted to reconcile his point-for-point adjustment of nominal interest rates to inflation, and concluded in The Rate of Interest that the failure of the nominal interest rate to rise after 1896: " must, in all probability, have been due to inadvertence. The inrushing streams of gold caught merchants napping. They should have stemmed the tide by putting up [nominal] interest two or three percent[age] points higher "
It is clear that long-run historical experience gives us little reason to be confident in the power of Fisher effect. So should we be surprised when the Volcker disinflation of the early 1980s turns out to have had a significant and long-lasting effect on the level of real interest rates?
Yet has the persistent rise in real interest had significant economic effects? Has it led to a reduction in real investment below its counterfactual path? It is not at all clear that it has had any such effect. Untangling the causes of secular changes in savings and investment rates is next to impossible because the changing composition of the capital stock has been shortening its average lifetime. Gross investment as a share of GDP has certainly not fallen since 1980. Net investment as a share of GDP may have fallen. Moreover, the opposed effects of income and substitution mean that it is not even clear which way we would expect a rise in the ex ante real interest rate to shift the savings rate, and thus investment.
Thus the lesson of history for the effect of an age of low inflation on the real interest rate is double-edged. First, do not expect the Fisher effect to hold: expect the real rate of interest in low-inflation times to be relatively high. Second, do not expect this failure of the Fisher effect to have any significant effect on the level of investment. The failure of expectations to adjust fully to the low-inflation environment may well be present on both sides of the market. (There remain, of course, the substantial effects of unanticipated inflation on the relative wealth of debtors and creditors).
Economists' faith that low inflation is a goal worth pursuing rests in the end on a belief that low inflation is a source of higher real productivity and real material standards of living. Yet this association appears to be surprisingly hard to document empirically.
Alesina and Summers (1993) showed that there is no evidence at all that independent central banks that pursue low-inflation policies are sacrificing any other worthwhile macroeconomic objective in the long run. But that is only half of what needs to be demonstrated. Rudebusch and Wilcox (1994) found striking correlations between productivity growth and inflation, but could not convincingly show causation. After all, if total nominal demand is predetermined then a strong correlation between high productivity and low inflation is guaranteed by the identity that quantity times price equals expenditure.
Here economic history is of no help. As long as inflation remains moderate, there is no chance of teasing out of the data any convincing causal chain at the macroeconomic level running from lower inflation to faster productivity growth.
Nevertheless, economists' confidence that it is there remains strong. Rates of inflation low and stable enough that nobody has to worry about confusing overall changes in the nominal price level with real changes in relative prices reduce the magnitude of the problem economic agents have in interpreting the price signals they see. With one less thing to worry about, the organizational time and effort that had gone into forecasting inflation and interpreting news in an inflationary environment can be devoted to analyzing other things instead--and at least some of those other things should raise economic productivity. In the absence of convincing evidence to the contrary, economists' priors will remain centered on the belief that low inflation is a source of stronger economic growth.
But the case for pursuing and welcoming low enough inflation to be called "price stability" does not have to rest there. Politicians welcome low inflation for a reason: they believe that to come out against low inflation is electoral death. It was Arthur Okun in the mid-1970s who popularized the "misery index"--the sum of the annual inflation and unemployment rates. It proved an effective rhetorical weapon in the presidential campaign of 1976 against Gerald Ford, and in the presidential campaign of 1980 against Jimmy Carter.
Robert Shiller (1997) has explored the reasons for people's distaste for inflation, and came up with two broad conclusions. First, that the public believes that inflation is a sign that all is not right with economic policy--it is a signal of possible incompetence on the part of economic policy makers. Second, that the public finds inflation to be one additional source of risk in an already risky world--moreover, a source of risk that they cannot easily assess or understand without learning much more about macroeconomics than they would wish. Thus a distaste for inflation appears to be in the utility function.
And if a distaste for inflation is indeed in the utility function, economists should recognize that low inflation is an appropriate policy goal for that reason alone.
A look back at America's historical experience with low inflation carries at least five potential lessons for the future.
The first is that we should recognize that the inflation of the 1970's was a marked deviation from America's typical peacetime historical pattern as a hard-money country. Thus we should expect that there is a good chance that America will continue to be a hard-money--low inflation--country in the future, at least in peacetime.
The second is that the increased risk of deflation and depression in a low-inflation environment can be oversold. A low level of trend inflation does make a downward spiral in the goods-and-services price index slightly more likely. Such a spiral could be the source of a severe recession. But such risks are lower than one might think: starting a deflationary spiral in today's economic environment would be very difficult, and there is probably more to fear from asset price "deflations" which are effectively unlinked to the trend of overall consumer or producer prices.
The third lesson is that we should not expect the Fisher effect to hold. A low inflation era will in all likelihood be a high real interest rate era. But we should also expect that such high real interest rates will probably not significantly discourage investment or growth--even though they will transfer wealth from debtors to creditors.
The fourth lesson is that it is hard to tease out of the historical record any significant macro causal link running from low inflation to faster growth. Economists' belief that low inflation is good for growth continues to rest on our common theoretical priors.
And the fifth and last lesson is that history teaches us that voters dislike inflation. Political parties that preside over episodes of significant inflation in industrial countries have a good chance of getting bounced. The "misery index"--the sum of inflation and unemployment--resonates at the political level. Whether voters and citizens dislike inflation for what we economists would consider to be good reason may not be fully relevant. A taste for low inflation appears to be in the utility function. To the extent that low inflation reduces this potential for anxiety, it is a policy goal that is worth pursuing for that single reason alone.
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