Governments tell you deflation is bad. Is it?
- Ivo Vegter
- 20 Apr 2015 09:33 (South Africa)
South Africa’s inflation rate has been plummeting, in step with the rest of the world. It recently hit a four-year low of 3.9%, and shows no sign of stabilising. But while our prices continue to increase, inflation is hitting the zero mark in many other countries around the world.
The US recorded an annual inflation rate of -0.1% in January. The downward trend in the US is dominated by petrol and overall energy costs, which declined 29.2% and 18.3% respectively. Europe has dipped into deflationary territory, although government economists there also hope it has something to do with the oil price or tough retail competition. The same is true for the UK, which “narrowly missed” deflation. Japan has been trying to fight deflation and stagnation for many years, and recently warned there’s more deflation to come. New Zealand has just recorded its second consecutive quarter of deflation. China, as I warned three years ago, is on the brink of a crisis too.
The question is, is price deflation really as scary as it’s made out to be? The most obvious effect of deflation seems like a boon to consumers. Who wouldn’t want their pay packet to stretch a little further each month? Deflation makes saving preferable to borrowing, and cheaper goods and services improve general living standards.
There are several fears, however. One is that postponed or lower consumption will hurt businesses, which will reduce output and economic growth. Another is that as prices decline, wages will fall less quickly, or not fall at all, which could increase unemployment. Perhaps a more valid concern is that consumers are by historical standards heavily indebted, and deflation will make it more expensive to service these debts.
The debt argument is especially true for governments themselves, of course. Inflationary monetary policy has traditionally been used as a way for governments to reduce their debts without appearing to raise any taxes. By printing money, they devalue the money in your pocket, but also reduce the value of debt. A consequence of this policy is price inflation.
(Although the terms are the same, and are often used interchangeably, monetary inflation – printing money – and price inflation – rising consumer prices – are not the same thing. Price inflation is an effect of monetary inflation, but more on that later.)
For thousands of years, pharaohs, emperors and kings have known that if they want to sustain their own spending without raising obvious taxes, all they had to do is add some cheap base metal to the gold or silver coinage as it makes its way through the treasury. This would “inflate” the amount of coinage in circulation. The left-over precious metal could be used to fund infrastructure that supports public welfare or economic growth, but more commonly was used to pay for grand palaces and glorious wars.
The Roman denarius was debased from 93.5% silver in 64AD, to less than 2% silver 200 years later. Entirely new coinage had to be minted, but then the Empire collapsed, so nobody cared about dodgy denarii anymore.
The history of the US dollar is not much different. Since 1800, it maintained a stable value for over a century, with equal periods of mild price inflation and mild price deflation. But since the US Federal Reserve was founded in 1913, prices have shot up relentlessly. The real value of the dollar has plummeted. A dollar in 1913, when the US Federal Reserve was founded, would be worth $23.85 today. Conversely, today’s dollar would buy you 4¢ worth of goods in 1913.
As was the case with the Roman Empire, over the long term there is a direct correlation between how much money central banks create and price levels. The US has not been coy about it, either. In 2012, the Fed announced outright that its 20-year goal was to devalue the dollar by 33%. All other central banks target a positive inflation rate, believing it to stimulate economic activity, as Lord Keynes had promised.
If monetary inflation causes price inflation, why aren’t we seeing price inflation? The effect of monetary inflation on price inflation can be masked or delayed, because money doesn’t just appear in consumers’ pockets when it is created. It is created when central banks buy back government debt from the banks who issued it. The banks now have more money available to lend or invest, but that doesn’t mean it automatically trickles down to consumer spending.
As Patrick Barron put it: “A Scrooge McDuck swimming in his supply of money in his basement does not affect the price level until he actually spends some of his money.” When the economy is weak, and lending to consumers poses high risks, banks prefer to save or invest spare cash, so a lot of the money the government prints ends up corporate treasuries or in asset classes like stocks, rather than in consumer spending.
If consumer prices don’t rise, that means some asset classes must be getting overvalued. Those bubbles inevitably burst, which makes people poorer, reduces investment spending, and keeps a lid on other prices. And so the cycle continues.
Governments around the world have been trying to stave off deflation, for fear that something terrible will happen if things become less expensive. They worry that consumers will do something reckless, like save, or postpone buying a new car until next year. Since this thoughtless behaviour supposedly compromises the ability of big business to make profit, it should be discouraged, no matter what you were taught as a child. And because deflation makes it harder for government to pay down its own debts, consumers cannot be allowed to believe that deflation might actually benefit them.
The reality is far more ambiguous, however.
A case in point is the technology sector. Through boom, bust and recovery, the one constant was that the price of technology kept dropping. If you waited six months with a purchase, you could get a more powerful box for the same amount, or you could get the same box for less. The trick to buying technology was always to buy sufficiently expensive kit that it would last you a few years, and could be upgraded as technology improved.
This is a classic case of consumer price deflation, yet none of the claimed dangers of deflation happened. Companies scrambled to innovate to keep customers coming back for new kit. There was no decline in consumer demand, leading to loss of output. There were no falling wages or wage rigidity that caused unemployment. The technology sector has been the most successful industry of the late 20th and early 21st century. Deflation be damned.
Is the tech sector somehow unique? Spaniards don’t think so. They’ve had deflation since August last year, but also enjoy rising consumer spending. Germans don’t think so. Despite deflation, their spending growth hasn’t been stronger since the financial crisis began. The Swiss don’t think so either. They had a long period of sustained deflation in 2012/13, and have dipped into deflation again since the end of last year. Yet Swiss economic growth remains steady and positive, and unemployment remains low.
A recent paper by the head of the monetary and economic department of the Bank for International Settlements, Claudio Borio, agrees that deflation is not the bogeyman it is made out to be. Having examined data spanning 140 years and 38 countries, Borio and his colleagues find that consumer price deflation does not significantly affect output growth. Asset price deflation, however, does.
They point out what really ought to be self-evident for economists: deflation is an effect not only of lower consumer demand, but can also be caused by increased supply. “Examples include improvements in productivity, greater competition in the goods market, or cheaper and more abundant inputs, such as labour or intermediate goods like oil,” the authors write. “Supply-driven deflations depress prices while raising incomes and output.”
The paper continues: “We highlight three conclusions. First, before accounting for the behaviour of asset prices, we find only a weak association between goods and services price deflations and growth; the Great Depression is the main exception. In some respects, this confirms previous work. Second, the link with asset price deflations is stronger and, once these are taken into account, it further weakens the association between goods and services price deflations and growth. Finally, we find some evidence that high private debt levels have amplified the impact of property price deflations but we detect no similar link with goods and services price deflations.”
The authors believe that the effects of consumer price deflation and asset price deflation have been confounded, because most of the theory on deflation comes from the Great Depression, when John Maynard Keynes published his magnus opus, The General Theory of Employment, Interest and Money. In fact, consumer price deflation was already a feature of the Roaring Twenties. What was new in 1929 was the rapid collapse of asset prices. As the paper points out: “it is misleading to draw inferences about the costs of deflation from the Great Depression”.
This can also be seen in a re-examination of Japan’s so-called Lost Decade. While price deflation and low per-capita growth appear to coincide after 1990, adjusting for demographic changes (aging) makes growth figures over this period look much healthier. Meanwhile, a strong asset price boom and bust started this period.
The long data set that Borio and his colleagues assembled “raises questions about the prevailing view that goods and services price deflations, even if persistent, are always pernicious.”
That, in turn, raises questions about the theoretical basis for maintaining a positive inflation target as the key metric of central bank policy. Rising prices are not a 20th century invention, but they do go hand-in-hand with periods of monetary debasement. Inflating away debt as a matter of monetary policy provides a perverse incentive to both governments and consumers to take on debt. We’ve seen the serious consequences that over-indebtedness can have for consumers when their assets fall in value, and also for entire countries, like Greece, which is on track to default on its debt obligations next week.
The response to the 2008 financial crisis has largely been Keynesian in nature. An asset boom caused by easy money was, predictably, followed by a bust, to which the solution supposedly was even easier money. It looks like the inconsistent and counter-intuitive theory of Lord Keynes really is wrong, and price deflation on its own is not something to fear. DM
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