Outside voices and views for advisers

Deflation: We fear you not

Why deflation is misunderstood, and differentiating between good and bad deflation is key

Jun 17, 2014 @ 8:17 am

By Jeffrey Cleveland

+ Zoom

Do you like low prices? Relish discovering a bargain online or hidden on a store's shelf? Do you celebrate better and cheaper electronic devices each passing year?

Well, the world's most powerful central banks stand ready to prevent such a global economic disaster. Christine Lagarde, managing director of the International Monetary Fund, described the phenomenon of falling prices, known to economists as deflation, as an "ogre stalking the world economy.”

But deflation does not send shivers down our spines. We think deflation is misunderstood, particularly by economists and, by extension, investors who subject themselves to the vagaries of economic advice. At worst, deflation is a symptom of other problems, not the disease. At best, it is a benign byproduct of rapid economic progress.


Central bankers abhor deflation for three reasons.

First, they claim, falling prices curtail consumption and harm producers. When people expect falling prices, they become less willing to borrow or spend.

Appealing though the logic may be, the world works differently. Take computers. As technology improved exponentially, the price of computing plummeted. Since 1994, the cost of a personal computer fell 95%. In spite of the knowledge that prices would fall in the future, the prospects of faster, cheaper technology have continually brought buyers out in droves.

Economists also worry that deflation, where borrowers repay debts with more expensive currency, will crimp borrowing and investment. But it is less the price level and more uncertainty about the price level that stifles investment. Throughout much of the 18th century, deflation was a fact of life yet loans were made and bonds were purchased.

Third, the economics orthodoxy worries that in a recession, employers are reluctant to slash nominal wages. Such reluctance forestalls the adjustments necessary to heal the economy. The solution is to have the government unleash a surreptitious campaign to lower wages. How? By creating inflation. With inflation during a recession, employers can pay employees less in real terms without lowering the nominal number on the paycheck.

As you may have guessed, we aren't buying it. We think most workers are much smarter than economists give them credit for: they adjust their expectations based on real wages (adjusted for inflation) and do not simply focus on nominal wages.


The deflation worriers' case further disintegrates in the face of history. Historically, deflation is common. Some instances of historical deflation represent cases of “bad deflation” (where actual currency hoarding caused a severe decline in the money supply), but the vast majority of deflation episodes in Western history were harmless.

In the 19th and early 20th centuries, deflation was a frequent occurrence. In the U.S., in 33 of the years between 1801 and 1879, the price level fell but growth continued. How? Productivity-induced growth fueled by the second industrial revolution and the connecting of railroads across North America and Europe brought more, better goods, more cheaply, to U.S. (English and European) consumers.

What's changed in recent history? We are accustomed to inflation and rising prices (for many goods and services). So for most people born after 1950, deflation would indeed be a strange outlier. But let's not confuse strange with bad. On a long enough timeline, deflation is anything but an outlier.


Not all periods of falling prices are good, though. Bad deflation is a decline in the price level caused by a monetary disturbance which goes unchecked by central bankers. The modern example of “bad” deflation is the Great Depression of 1929-1933. Real output plunged across most of the developed world, led by a 7.6% contraction in the U.S. between 1929 and 1933. In such an inclement economic environment, banks failed by the scores, depositors scrambled for currency, the money supply declined by 30% in the space of two years, and prices plunged.

Instances such as this, disturbing as they are, are surprisingly rare.


Financial writer Jim Grant recently opined, "Deflation is a word for progress — and central banks seek to forestall progress.” We think that critique is a bit too harsh. While deflation does represent progress, central banks misdiagnose deflationary pressures as signs of economic distress or even depression (Japan). However, one must distinguish between good periods of deflation, driven by productivity growth and supply shocks, and bad deflation, induced by monetary distress caused by financial crisis.

Failing to do so can have significant consequences. Never more so than today, as central bankers around the developed world debate the danger of (and the appropriate policy response to) historically low levels of inflation. The passionate dedication to preventing even a period of low inflation, let alone deflation, will prompt further unconventional policy measures from the world's central banks in the years ahead.

Jeffrey Cleveland is principal and senior economist at Payden & Rygel.


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