May 19, 2003

Deflation Warnings

Ed Hugh points out and links to the IMF's Deflation Storm Warning.

Posted by DeLong at May 19, 2003 07:29 AM | TrackBack


This is a very naive question: If there was substantial deflation in the 19th century as well as solid growth, what is it about deflation that is actually a problem?

Is it at all likely that deflation is really a symptom of something else that is happening that is possibly very different from some previous deflations and that by attempting to treat it by conventional course trimming methods we may be missing the point?

Are there for example any external situations such as demographic change that would make deflation more likely?

Posted by: Jack on May 19, 2003 11:37 AM

WSJ, today:

"In the U.S., despite the lingering effects of the equity price bubble," the IMF said in a report released Sunday, "risk of deflation appears relatively low, but not minimal."

Serious deflation is unlikely unless unemployment, now 6%, reaches 8% or economic growth remains below 1% over the next 18 months, the task force said...

Examining 35 economies that comprise 90% of the global economy, the IMF described the risk of significant deflation as "moderate" in Singapore and seven small European economies. It rated the deflation risk "low" in 16 countries, including the U.S. and China, and "minimal" in eight others.

The task force called particular attention to Germany, where underlying inflation is below 1% already, unemployment and unused capacity are high and rising and banks are struggling. "The probability of mild deflation taking hold over the next year is considerable," the task force said. Yet German fiscal policy is turning contractionary as the government tries to keep its budget deficit below ceilings set by treaty in Europe. And because deflation risks are lower elsewhere among countries that share the euro, the European Central Bank has been slow to cut interest rates...

The task force said it "didn't find evidence to support strong concerns of generalized global deflation." Although deflation spread from one country to another via the gold standard in the late 1920s and 1930s, the task force argued that exporting deflation is less likely today, partly because exchange rates are flexible...

The IMF said it sees "only marginal signs of deflationary pressures waning" in Japan, and repeated previous calls for "more vigorous" monetary policy there.

The task force praised the "remarkable flexibility" of the U.S. Federal Reserve, and said the falling dollar lessens the likelihood of deflation in the U.S.

Posted by: Jim Glass on May 19, 2003 11:38 AM

There was a perfectly comical exchange today over the issue of deflation in Germany which Edward would have liked if he had had access to a news wire at the time. It went something like "Germany has a considerable deflation risk" (IMF) followed by "There is no sign of deflation" (German Finance Minister Eichel) followed by "the IMF assessment is exaggerated" (German Chancellor Schroeder - who meanwhile threatened to quit his job over another issue), followed by "we share the IMF's assessment" (the DIW institute- a big deal think tank in Germany) followed by "I rule out any risk of deflation in the Eurozone" (Duisenberg of the ECB). Sorry, these aren't precise quotes, but the gist is there.

On the sidelines, French Finance Minister Mer said that the US doesn't have a policy of weakening the dollar, followed by an advisor to Schroeder named Tacke saying it's completely understandable that the US would be talking down its currency.

Posted by: K Harris on May 19, 2003 12:36 PM

"This is a very naive question: If there was substantial deflation in the 19th century as well as solid growth, what is it about deflation that is actually a problem?"

Well, first, in general, the economy over the last third of the 19th C was very different from ours (almost no gov't sector by our standards, for one thing). Deflation in the US averaged over 5% fairly steadily, IIRC, due to the economy growing faster than the money supply did under the gold standard (until the Yukon gold strikes).

Growth over the entire period on average was quite strong as the US turned into an industrial world power, but it was very volatile -- there were some real sharp downturns. I don't think anyone would be happy with that performance today. Though most of that performance was due to things other than price levels, I think most everyone would agree that they'd have been better off back then with stable prices rather than deflation.

Second, more in particular, deflation would be worse today than it was then because the expectation of it isn't built into financial arrangements. Back then people expected deflation so it was adjusted for in the terms of long-term contracts, loans, and such. Today people haven't been expecting it so it's a different story.

E.g., say you are a business that took on long-term debt expecting 2% inflation. You project both your future revenue and debt obligations using that rate. But instead you get 2% deflation. The real interest rate you are paying goes up 4% -- which probably means the real interest rate you are paying has doubled or more. At the same time, even if your real revenue stays up as high as it was, your nominal revenue, which you use to pay off your debts, is down 4%. So real debt service doubles as nominal income falls -- not good.

But your real picture may be worse than that. Because of the shift above you are going to start hacking your costs to remain able to pay your debts. Everyone else in the your situation will be doing the same -- meaning they will be spending less, including spending less with you, so your real income will fall too, compounding your fall in nominal income.

At the same time, individuals who see their jobs put at risk by hacking employers like you may think they need to save more and spend less, while deflation gives them a higher positive return for saving as the value of money goes up, rewarding them for saving and spending less. And banks will lend less as a defensive measure too. That all means less is spent by customers on you and everyone like you, further reducing your real revenues and pushing the deflation yet further into unanticipated territory, so you are in a nasty feedback loop, a vicious cycle. One can see how a couple years of unexpected 10% deflation opened the Great Depression.

OTOH, if that sounds too scary, there's a academic argument that a modest amount of deflation actually is a *good* thing. Say a couple points worth. I don't think central bankers put much stock in it these days, but one can read about it e.g. in the downloadable paper at

" contrast to the current fashion among central banks, one of the most famous -- and robust -- results in monetary theory is that the optimal rate of inflation is negative... "

Posted by: Jim Glass on May 19, 2003 12:54 PM

Frankly, I can not remember an economic analysis by the IMF that was wroth the reading. Lord love a duck, what gibberish they set out.

Posted by: dahl on May 19, 2003 12:55 PM
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