I have a couple of questions: 1) some data out there indicates that persistent deflation in the manufactured good sectors already is occurring and that the inflation rate is only positive due to service-sector prices; is there a correlation between the two and is manufactured goods a leading indicator for service price changes? 2) Conventional wisdom is that a quarter or two of deflation followed by the resumption of low inflation would not be particularly destructive. Is that accurate? And for how long would deflation have to persist to turn into a real problem?

This may be a stupid question, but isn't it possible for a government to reverse deflation through massive deficit spending? (Or just by printing more money?)

I don't see what the danger of deflation is.

We had deflation on and off throughtout the post-Civil War period until the early Twentieth Century. There were periodic recessions then, same as today, and booming growth. Corporate corruption and steep financial inequality made the recessions seem worse but there was never a period of Japan style or 1970s stagnation. Of course, there were no economists worried about their power to use open market operations to move the economy; in retrospect, the experiement in fine-tuning with open market operations between the 1920s and 1980 makes me think we're better off without economists running the economy.

The Free Silver movement tried to fight deeflation but they never managed to move the american public enough to change policy. We didn't make our move off the deflationary Cross Of Gold that the likes of Paul Krugman so fear until the big bankers got with the program and built, with the Progressives, the Fed.

And we've had persistent deflation in the goods sector and especially in my field of technology for about 20 years now. Some of that is from improved techniques, some from great improvements in goods that fetch about the same prices as ever, and some is from cheap overseas imports. With labor fetching ever higher prices it has never managed to blossom into wholesale deflation in the economy but it has never smashed the sectors it does affect. Some of those sectors have prospered.

I don't think deflation is much to worry about in itself. But I'm willing to listen to reason. What I really worry about is the bursting of the housing bubble and the subsequent failure of FNMA and her siblings.

>Germany, unlike Japan in the early 1990s or >America today, is not free to cut interest rates >or run a looser fiscal policy.

True to some extent. But no pain no gain. Germany might be hit harder due to a certain fiscal and monetary inflexibilty thus increasing the necessity to finally get on with structural reforms. Looking at the reelected government's first desperate weeks, I see the pressure working.
It is true that a lot of rigidity is democratically stable even under current conditions, so some more pressure can only improve things in this respect. Politicians need to have conditions which make change "unavoidable" and thus don't leave the stain of killing "social (distributional) justice", which is still (rethorically) the holy grale of consensus demcracy in Germany. Without the Stability and Growth Pact the current red-green coalition and the unions would probably go on another "social reengineering spending spree" increasing inflexibilty even further, as they did back in 1999/2000 when the economy briefly looked a bit brighter, while the current constraints reinforce their socially important function to explain some fundamental truths and necessary changes to their constituency and then implement them.

The pundits keep writing about deflation as though it were some form of ill-understood exotic disease ("Catch it and you're finished, brother.") Stephen Roach is worst offender.

It would be helpful if analysts resisted the use of hyperbole to describe it and instead confined their writing to cold logic. We all understand, I think, that the causes of persistent deflation can be debilitating, but what does deflation do, given the level of aggregate demand and supply? The traditional stuff about expanding the real value of outstanding debt, raising real interest rates, and leaving no room for further credit easing by the central bank is all well and good. But it doesn't seem to provide a compelling reason to fear a shift from a 1 percent inflation economy to a 1 percent deflation economy. Other than confirming that demand is weak, what is the issue?

Feel free to educate me.

Right - deflation.
Let's say Widgets Inc takes out $3,000,000 3 year five percent note when the prevailing rate of deflation is your theoretical 1% per year. Let's say this note compounds daily.
Total payments: $3,230,827.92
nominal cost of the note: $230,827.92
real total payments adjusted for deflation: $3,283,228.03
real cost of the note: $283,228.03
That's an effective interest rate of 7%, not 5%.
Or, a 22% increase in borrowing costs over the three year period of the note. That's not small, and that's real money, not something you can hide in the interstices of generally rising costs and income, and it's not a tax deductible business expense.
Remember, price levels have *also* been declining for Widgets, Inc. They've got to sell more unit products proportionately to cover the increased borrowing costs - ergo, they've got to produce more. All things being equal, the equilibrium price for widgets declines, and deflation is fed further.

When you consider that deflation adds to the cost of bearing all kinds of debt, you begin to see what kinds of distortion falling price levels introduce into the general economy.

OK, maybe I don't get it. Deflation just turns the economy from a borrower biased system to a lender biased system. What does this hurt in the end? It changes the balance between a few sectors of the economy, but why does it hurt the economy in general? It seems to really hurt banks, as no one will save (pointless) and no one will borrow unless they really need to.

Other than appealing to some psychology, how does deflation hurt the economy _as a whole_? The only reason I can figure is that the structure of the economy is based on a set of inflationary expectations, and deflation would require a big retooling. Is that it?

B

David G.,

That's a non sequitur. Real interest rates are what they are. With real interest rates at 6% for a business loan, the nominal rate will be quoted at 7% in an economy with 1% inflation and 5% in an economy with 1% deflation. With 10% inflation the nominal rate will be 16%, ceteris paribus.

Let's hear a real reason why deflation would be bad for the economy.

Inflation makes debt less of a problem. We are not a country of savers, rather a country in love with borrowing. A bias to inflation means that we pay back debt with cheaper dollars as time goes by. Deflation will make debt a more significant problem.

A GDP growth rate that is not fast enough to account for the fine productivity increases we have plus the growth of potential workers, will give rise to less and less inflation. There will be less and less price pressure and deflation may result. Japan should be an important warning, rather than the brunt of jokes.

We are at a 40 year low in inflation now, Japan is in deflation, China is in deflation, Germany is in danger of deflation, several of the Asian tigers are in deflation. There is reason for concern until we find GDP growth over 4 percent for a number of quarters. GDP this quarter will probably be about 1 percent.

Wish there were more posts to this important site by WOMEN.

here

'The other view is that while deflation can be a real danger, that danger arises less because of an inherent deflationary bias than as the potential consequence of policy mistakes; the general idea is that once mistaken policies have allowed deflation to get started, expectations of continuing deflation can be self-reinforcing. And once the economy is in such a deflationary "death spiral", the story goes, it can be very hard to get it out again.'

Example: Japan.

Thank you David, Jason, Anne, Brian, Brennan, etc.

I accept the arithmetic, of course.

I would note that since 1995, global real interest rates have been falling, notwithstanding receding levels of inflation. (See IMF WEO.)

The "Death Spiral" image is pretty powerful, and if we had a truly elegant explantion behind it, I'd even join the Stephen Roach fan club.

Maybe our esteemed host? Can you explain this Brad?

Thanks.

Deflation and Inflation are troublesome for specific groups in an economy.

The threat of deflation is primarily directed towards holders of debts, and the psychological impact of declining net worth on asset holders.

Most Americans wealth is in their homes. Most homes are mortgaged. It is clear that the impact on this group could be significant. Significance is caused by the strength of the deflationary pressure as well as the debt loading. What economists and soothsayers argue about is what rate begins to impact the purchasing decisions of the consumer, who is the bulwork of the economy.

This type of disagreement on macroeconomic impact is precisely what makes the marketplace function. Buyers and Sellers are rational players with differing expectations of the future. This is precisely what a command directed lacks and is the weakness of rigid economies. The Economist article hinted at this with the Germany discussion but it did not go into it deeply, as that it has covered this topic in prior articles.

Uh... many loans are made with fixed nominal interest rates, not fixed real interest rates. If they're long term (say, a mortgage), deflation raises the REAL interest rate while leaving the nominal interest rate unchanged.

Oh, and, also, if you hoarde cash in inflation of 3%, the cash loses 3% of its value every year, so you put it into investments or spend it on consumption. If you hoarde cash in deflation of 1%, the cash appreciates 1% every year. Given that hoarding cash worsens the problem of inadequate demand (which is very likely if we're in deflation in the first place), it make ol' Alan Greenspan's job that much harder.

And concerning the stuff about the post-Civil War economy performing fantastically, I don't think it was as great as is often claimed. People hear about consistent GDP growth of 4% and "Gee whiz!" Birthrates, though, were also something like 4/woman, and immigration was unrestricted. As such, population growth was about 2.3% per year (38,558,371 in 1870 to 76,212,168 in 1900). That gives about 1.7% GDP/capita growth. While that is by no means a small feat (better than the 1973-1995 productivity growth, worse than the WW2-1973 or 1995-present productivity growth), it is not really exceptional (I'm assuming that labor-force growth is about the same as population growth, though if someone can find census labor-force figures that show different labor-force growth than population growth, correct me).

Julian Elson

Uh... many loans are made with fixed nominal interest rates, not fixed real interest rates. If they're long term (say, a mortgage), deflation raises the REAL interest rate while leaving the nominal interest rate unchanged.

Oh, and, also, if you hoarde cash in inflation of 3%, the cash loses 3% of its value every year, so you put it into investments or spend it on consumption. If you hoarde cash in deflation of 1%, the cash appreciates 1% every year. Given that hoarding cash worsens the problem of inadequate demand (which is very likely if we're in deflation in the first place), it make ol' Alan Greenspan's job that much harder.

And concerning the stuff about the post-Civil War economy performing fantastically, I don't think it was as great as is often claimed. People hear about consistent GDP growth of 4% and "Gee whiz!" Birthrates, though, were also something like 4/woman, and immigration was unrestricted. As such, population growth was about 2.3% per year (38,558,371 in 1870 to 76,212,168 in 1900). That gives about 1.7% GDP/capita growth. While that is by no means a small feat (better than the 1973-1995 productivity growth, worse than the WW2-1973 or 1995-present productivity growth), it is not really exceptional (I'm assuming that labor-force growth is about the same as population growth, though if someone can find census labor-force figures that show different labor-force growth than population growth, correct me).

Julian Elson

>'The other view is that while deflation can be a real danger, that danger arises less because of an inherent deflationary bias than as the potential consequence of policy mistakes; the general idea is that once mistaken policies have allowed deflation to get started, expectations of continuing deflation can be self-reinforcing. And once the economy is in such a deflationary "death spiral", the story goes, it can be very hard to get it out again.'

I am appropriately impressed but how does that explain this:

"The fourteen years between 1865 and 1879 represent the longest period of sustained deflation in US economic history. During these years, wholesale prices, on which there are good data, fell at an annual rate of over 6 per cent. The same item that cost $1-00 1865 cost only $0-42 in 1879. This deflation wasn't caused by a decline in the money stock. On the contrary, the nominal stock of money rose by about 15 per cent between 1865 and 1879. The cause was the substantial growth in US real GDP which drove up the demand for money. Between 1965 and 1879, the US population rose almost one third and per capita real GDP rose at roughly 4 per cent per year." Source: AJ Auerbach + LJ Kotlikoff: Macroeconomics; MIT Press (1998), p. 187.

If a deflationary spiral was compatible with strong GDP growth for fourteen years in the 19th century we presumably have to invoke as explanations some combination of differences in policy, the structure of the American economy then, responses by consumers and investors or the differences in institutions then as compared with now. But all that leaves me a little uneasy since it means the economic damage inflicted by deflation nowadays is contingent on other factors besides changes in the price level and expectations thereof. If so, what are the other critical factors?

Currently deflation and slow growth seem to be subtle problems for Japan. Japan has grown through the last decade, but far too slowly. There is a more even income and wealth distribution in Japan than in America, and personal savings is far higher. Japan has used deficit spending to keep the economy growing slowly and kept employment reasonably high. Middle class Japanese are contented enough with the lives not to have forced dramatic economic changes. People know the economy could be more robust, but they are on the whole content.

The problem in Japan is subtle. America is growing too slowly and has structural economic problems that need correction, but there seems no mandate for dramatic change in America. We too could experience a slow growth period for quite a while.

This discussion is most interesting. Thank you all.

Question: Could the strong growth between 1865 and 1879, a period of deflation, be explained by the cheapness of land and an inflow of foreign capital? Could plentiful land and capital have spurred growth even through a deflation?

>Question: Could the strong growth between 1865 and 1879, a period of deflation, be explained by the cheapness of land and an inflow of foreign capital? Could plentiful land and capital have spurred growth even through a deflation?

With some outstanding exceptions, land intensive economies have not generally performed as well as densely populated countries over the last 50 years or, perhaps, for a century - Argentina was one of the most relatively affluent countries in the world a century back. The favoured explanation for the better performing densely populated countries relates to there being just more people to have innovative ideas and the lower cost of networking, initially because of higher population densities. But how do we explain those exceptional land intensive economies which performed well - of which America is the outstanding example?

The usual accounts are that what mattered in the case of America, beside capital inflows, was relatively well educated and skilled labour through immigation from Europe and that the difficulty or cost of recruiting labour to work in factories was a powerful incentive for process innovation in manufacturing. Rising real wages and living standards then created the incentives for product innovation - in the 19th century, America started off importing farming machinery from Britain but ended up exporting it.

However, that does not quite explain how and why the American economy thrived for fourteen years despite deflation. For whatever reasons, consumers and investors adapted to deflation and the economy continued to grow.

>> This deflation wasn't caused by a decline in the money stock. On the contrary, the nominal stock of money rose by about 15 per cent between 1865 and 1879. The cause was the substantial growth in US real GDP which drove up the demand for money. Between 1965 and 1879, the US population rose almost one third and per capita real GDP rose at roughly 4 per cent per year.<<

IOW the deflation *was* caused by restricted money supply growth under the gold standard relative to strong demand in the growing economy -- 15% money growth versus 70% real GDP per capita growth over the period.

As long as there is healthy demand there's no reason why modest-to-moderate deflation should be harmful -- in fact there's an argument that deflation sufficient to reduce nominal interest rates to zero could be beneficial. (See "The Friedman Rule", e.g., http://www.rich.frb.org/pubs/eq/search.cfm/article%3D31)

The problem with a "deflationary spiral" is if demand should weaken. The central bank can't lower interest rates from a starting point of nominal zero to increase demand, and if people should then see money appreciating in value relative to goods their demand for money could rise as a result, meaning consumer demand would fall further and deflation would intensify, and so on in cycle. Fear of this makes the Friedman Rule something of a theoretical consideration these days, nothing a real central bank would want to approach in reality, I'd think.

There are lots and lots of differences between the economies of the deflationary 19th Century gold-standard USA and today's USA, and even more regarding today's Japan. In 19th C USA deflation resulted from a constrained money supply in the face of strong demand. In Japan today demand is weak, and although there is a loose money supply the money transmission system is broken (base money goes up, other measures of money don't) due to the broken banking system, which obstructs a simple "monetary fix". For starters.

To expand on a point made earlier, it is perfectly reasonable to expect that the post civil war economy did well with deflation, if the economic structure at teh time wasn't particularly biased towards debt financed expansion.

Actually, if I remember correctly, the expansion of Standard Oil was mainly by cash, and when the company finally went public, their asset to debt ratio was astounding. To buy a company, Rockefeller would just open his books, show his profit per barrel, and make an offer--he was rarely refused.

Jason: That is fine, but inflation begets inflation, as well. That whole article assumes that the economy is naturally biased one way. In that case, all departures far from equilibrium are bad. High inflation is just as bad as some deflation. Even if the falls into a liquidity trap, the dollar value of teh economy decreases...but does the productivity decrease? Do standards of living.

Worse, that argument is mostly about psychology. There is some legitimacy to the prospect, but I don't see the net harm. Likely I am just missing somethign really basic.

And this brings up another question. Won't times of high productivity growth lead to deflation? Especially if the consumer desire level is relatively saturated? (basic goods of high quality all generally exist, and psychological/cultural bias against luxury)

B

Brennan: If you have disincentives towards bank-based savings, and disincentives towards debt-financed investment (because the real cost of borrowing is much higher than the nominal cost), you lose banks as a means towards allocating investment resources. Which means that the total amount of investment goes down, which is very, very bad for a modern economy.

Brian: Huh? No non-sequitur. I set up a spreadsheet for a standard simple loan amortization, and calculated the steady increases in real value of each payment at each interval. It's pretty simple math. If the economy is in 1% deflation, that means that price levels are declining by 1 per cent per annum, or it means that the real value of a dollar is appreciating at a rate of 100/99 per year.

Real interest rates fluctuate with inflation and deflation.

I understand and agree with the points made here and elsewhere as to why deflation is a bad thing.

However, I do have some perhaps unorthodox concerns regarding one of the traditional cures for deflation; specifically loose monetary policy resulting in low interest rates.

It seems to me that, at least in the U.S., low interest rates have led many households into riskier investments than they engage in when interest rates on CDs and government bonds are higher. Indeed, I believe that much of the stock market bubble was due to this phenomenon. The quest for higher returns simply inflated valuations to unsustainable levels, but unsophisticated investors didn't comprehend what was happening.

Again, regarding average American households (if there is such a thing), low interest rates increase incentives to borrow against assetts; especially housing assetts. This seems to me to ultimately increase the negative impact of a deflationary environment.

Investors desperate for some kind of meaningful return on their cash are driving up the price of real estate investment properties. Where a 20% cash on cash return was possible (at least where I live) just a few years ago, an 8% return is now considered acceptable;10% is difficult to find. These investors could be devestated by several possible scenarios.
Perhaps low interest rates are now leading to a bubble in the real estate investment market.

Similarly, low mortgage rates are leading single family home purchasers to pay more for housing; thus creating a bubble in the residential housing market. A very bad circumstance if deflation is soon coming.

Finally, incentive to save for long term future needs (college tuition for the kids, etc) is reduced. Making future borrowing of larger amounts more likely.

I guess what I'm getting at is that for many the cure could be worse that the cold (focusing especially on the working class to upper-middle class household).

Is there anyone else concerned that lower rates are not entirely a good form of stimulus and an even worse policy when deflation is a threat?

Having read back my own jiberish........I guess what I meant to say was that the article seems to acknowledge that cheap capital leads to bubbles in markets and to greater amounts of debt across the board; which are "deadly" in a deflationary environment.

Yet the article does not explicitly state that low interest rates (which create bubbles, cheap capital and increased debt loads) are a problem.

Why is the connection not made?

Or is the connection written off as a component of the "liquidity trap", "death spiral", etc. If so, then wouldn't it be better to stimulate the economy through well targeted defecit spending and/or well designed tax cuts while leaving interest rates relatively high?

Comments please

This seems a good argument.

And yet I note the extraordinary turnabout in risk aversion since the mid-1990s. We remember well when novices became enthralled with the stock market and when IPOs of questionable companies sold down all too easily. Since then, as real interest rates, nominal interest rates, and inflation have receded, the risk aversion regime has changed as the bubble burst. We now witness high spreads on corporate bonds and emerging market debt, and extraordinary liquidity preference, as savings deposits have reached a record $2.7 trillion. Nobody is taking a chance these days. Business spending is weak, even if household spending seems not to be. In this environment, the reduction in interest rates cannot be said to be prompting risky investments; instead, the reduction in rates may be preventing risk aversion from getting even more pronounced.

Maybe this is just post-bubble irony. But it might say something about policy.

One historical point needs to be made immediately before this discussion can progress: the post- Civil War period was not one of steady growth. The Depression of 1873 was one of the country's most severe. It was initiated by a default on one of the major railroad companies' bonds, which was caused by management larceny (it may have been Jay Gould's but I honestly can't remember). The default set of a string of bank failures and bank runs. The 1873 crash was preceded by an ominous bout of asset inflation and speculative fever (sound familiar?). Within six months of the initial default, something like 25% of the NY Metro area's men were out of work, so we are talking about a serious and painful economic trough. The political consequences included the resignation of several scandal-clouded members of Ulysses Grant's cabinet and the de facto reversal of Reconstruction efforts in the South. Interestingly enough, business forces -- in their then-ignorance -- combined to block a congressional bill to reflate the economy and print money under the false fear that such a bill would cause inflation. Instead, the falling amount of money available helped the crash worsen. So the 1870's economy in the US is something no current person would want to experience.

JT

Important point: I am reading up on the 1870's. Also, we need to attend to labor conditions during the decade. Who won, who lost and why.

The 1870's did indeed include a "depression."

I am not sure what comparisons can be made between possible deflation now and deflation after the Civil War. The end of the war and slavery and the "uniting" of a country with vast physical resources allowed for a period of expansion that could not be duplicated today. The continual opening of the west was a wonderful draw for labor and capital that might have negated the weakening effects of deflation.