Christine Lagarde says deflation is an “ogre which must be fought decisively.” The managing director of the International Monetary Fund is merely dramatising the current conventional wisdom, but she is wrong.
Lagarde did not explain why she thought deflation was so dangerous. Most likely, she had three commonly-made arguments in mind.
First, deflation might make a tragic debt cycle more likely. The fear is not totally irrational; a generalised price decrease can lead to economic disaster. The American economist Irving Fisher described the toxic cycle: prices fall, debts go bad, banks collapse, businesses fail, desperate workers take pay cuts and then companies cut prices even more. The downward spiral lasts until something happens – war, anarchy or a new monetary order.
Fisher wrote in 1932, during the Great Depression. Then the consumer price index declined by 27 percent over a little more than three years, as output and employment shrivelled. That experience, though, was unusual.
In a 2004 study, academics Andrew Atkeson and Patrick J Kehoe looked at a century’s worth of price and output trends in 17 countries. They identified 73 five-year periods of price decline and found “virtually no evidence” of any link between deflation and decreased output. The record of contemporary Japan – often cited as an example of the dangers of deflation – fits with that not-at-all alarming pattern.