Don’t be afraid of deflation

January 29, 2014

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.

True, Japan has not really had deflation, just consumer prices which have hardly budged since 1992. But the near-deflation has not wrought any obvious economic damage. On the contrary, the increase in GDP growth per person has been quite respectable, especially after adjusting for the sharp decline in the number of young Japanese people.

Whatever the historical record, Fisher’s debt deflations are easily preventable. All that is required are halfway credible governments to issue enough new money to keep the financial system afloat. For example, after Lehman Brothers was allowed to fail in 2008, the authorities soon came to their senses, rescuing banks, insurers and General Motors. They would do the same if deflation ever did threaten to turn into a true economy-devouring ogre.

The second purported reason to worry about deflation is the prospect that gently falling prices might reduce consumption. Rational people, economists say, will hoard their funds to await lower prices.

That argument is little short of ridiculous. Consider the sharp, predictable declines in the price of electronic goods. They have not noticeably hurt sales. Mild deflation might lead a few canny shoppers to delay some purchases, but the prospect of paying 1-2 percent less a year hence is a pretty weak motivation for restraint.

Finally, Lagarde might be concerned that deflation limits the ability of central bankers to provide helpful stimulus. After all, policy interest rates cannot easily go below zero, as theory would dictate they should when the economy under-performs while prices are falling. That is true enough, but the absence of rate cuts should not be a serious problem, despite what some central bankers think. In reality, the policy interest rate is rarely powerful and never the only available tool.

Of course, some rate moves can change the economic balance, but the statistical evidence suggests that monetary policy is less important than many other financial and economic forces. The economist Edward Prescott, a Nobel prize winner, even claims that “it is an established scientific fact” that the U.S. Federal Reserve’s monetary policy has had “virtually no effect on output and employment.”

Prescott’s view is extreme, but in any case the authorities have other ways to influence the economy. They can print new money, as the Fed is doing. Alternatively, they can change financial regulations, taxes or government spending. At worst, mild deflation would force central bankers and their political masters to be more creative.

It is fair to worry about anything which requires new thinking. Still, Lagarde missed the financial monster which really threatens economic health – the debt beast. Excessive financial leverage discourages helpful economic activity, widens the gap between mostly rich lenders and largely poor borrowers and enriches economically unhelpful financiers.

The creature has already grown huge, fed by government deficits, excess funds from trade surpluses and the wild credit creation of banks and brokers. Mild deflation would make the debt burden even heavier by reducing the cash available for debt servicing. But this genuine ogre needs far more than a diet of mild inflation. It needs to be cut down to a manageable size by writing down the value of many debts.

Unfortunately, no one has found a way to do that without severely damaging the financial trust on which modern economies rely. But with strong politicians, it should be possible to preserve that trust. If Lagarde really wants to help the global economy, she should stop scaremongering and encourage work on a politically acceptable global debt restructuring.


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The price of oil determines inflation/deflation. The price of oil will rise in the long term (don’t judge based on the typical annual price cycle fluctuations). In the long term the price of oil will rise and drive inflation.

This is backwards. “At worst, mild deflation would force central bankers and their political masters to be more creative.” The central bank is the masters and the politicians their flunkies.

Politicians pursue inflation to help minimize their past fiduciary failures. The debt can be reduced in it’s relative importance by devaluing the dollar, which they are doing right now. At 6% annual inflation, the debt can be reduced 20% in three years relative to real value. This is necessary for their propensity to overspend.

Posted by brotherkenny4 | Report as abusive

Excellent facts and conclusions, as usual. Well said, Mr. Hadas.

Posted by OneOfTheSheep | Report as abusive

Well at least he’s writing about economics and no longer making analogies to sex.

Posted by Foxdrake_360 | Report as abusive

Deflation, inflation and GDP are quantity measures only. They tell nothing of the quality of the expenditures people make. As you point out, the real problem is a debt spiral – another way of viewing this is that expenditures (debt repayments) are of poor quality to the average person. Come on Mr. Hadas – pioneer a measure of the quality of expenditures for a country the changes the way economics is viewed. How about this for a start – for each expenditure estimate a useful life of the expenditure and capitalise it and amortize over that useful life – a economic balance sheet of sorts.

Posted by BidnisMan | Report as abusive

Sensible comments, Mr. Hadas!

Posted by ExDemocrat | Report as abusive

Finally, A voice of reason.

Posted by nodeficit | Report as abusive

”At worst, mild deflation would force central bankers and their political masters to be more creative.”

Oh dear, when you frame things in such way one is inclined to look forward to some punitive and harsh deflation in Europe.

Posted by satori23 | Report as abusive

“the prospect of paying 1-2 percent less a year hence is a pretty weak motivation for restraint.”

Depending on the good in question, even 10-20 percent would be a weak motivation for restraint. If you thought food would be 20% cheaper next year would you give up eating for a year?

Posted by walstir | Report as abusive

“If you thought food would be 20% cheaper next year would you give up eating for a year?”

No, but if one thought autos would be 20% cheaper next year, you might continue to drive your junker for another 12 months.

If you thought houses would be 20% cheaper next year you might continue to rent for another year.

If you were a businessman who thought construction costs would be 20% lower next year you would probably postpone your plans to build a new factory.

Posted by Ed62 | Report as abusive

A little deflation would be a welcome thing for those of us that are nearing retirement and a fixed income. Chasing inflation is a young mans’ game.

Posted by UnicoiLew | Report as abusive

If you think that deflation is the cause of something [or in the case of Hadas, that it is not the cause of something] then you are standing economics on its head. Deflation is above all a symptom and certainly not one arising from economic success.

Posted by JWL | Report as abusive

A “little” Deflatiion would be nice for one approaching retirement and a fixed income. Chasing inflation is a young mans’ game. Promoting inflation in order to minimize societal debt doesn’t seem like a healthy, sustainable track to me.

Posted by UnicoiLew | Report as abusive

The fall out from emerging markets will result in much lower import costs in the EZ which won’t help inflation and this combined with stagnation in export markets and at home could be terminal. e-nhs-accident-waiting-happen.html

Posted by daviddenton | Report as abusive

The big issue that faces Policy Makers around the globe in 2014 will be as follows; the cost of free, deflation in 2014 and beyond. Major companies look to form monopolies or near monopolies, this has been made easier by the Internet as they now have global reach for a lower cost base.

The pivotal point is this, the business model of these businesses is to offer a particular service for free (the ultimate deflationary force), eg Google and Facebook, as companies they absolutely get it.

These companies sell advertising and collect personal and private information that the consumer so eagerly hands over in exchange for FREE, nada, zippo, nothing, the companies then use this information to better target their audience and make additional money by selling this information to third parties who then use it themselves.

If you look at the top 500 websites by popularity you will notice that the majority offer services for free.

How many people would pay for Facebook if it wasn’t free, you think they want to find out? 
This means that wealth is then concentrated at the top and what follows is a hollowing out of the middle class.

And so it began. As more things become digitised the cost of distribution falls, and jobs are further eroded, e.g. iTunes and software distribution, e.g. Music and movie Industries.

How does one keep their job when fewer people are required to perform a task, the company they work for is receiving less revenue and making less profits?
This may end badly! I expect we will continue to see anger increase as more people are thrown on to the unemployment scrapheap.

Posted by Nextclick | Report as abusive

Excellent article Mr. Hadas.
The generl public is not afraid of deflation. Truly they wouldn’t know what you were talking about, but if they did, they would welcome it, not be afraid of it. Corporations of all sizes are the ones afraid of deflation. So of course, so are the politicians and most economists.

Posted by tmc | Report as abusive

> Don’t be afraid of deflation
Why would I be afraid of something I’ve never experienced? Currently we are in massive inflation. Price of barrel of oil in 1998 = 10$ Price of barrel of oil today = 120$. Today I pay 6 dollars for a gallon of milk. The fed is printing a trillion dollars a year. What did you expect printing a trillion dollars a year, deflation?

Posted by UScitizentoo | Report as abusive

Debt is indeed a big problem. But to say that ” the authorities soon came to their senses, rescuing banks, insurers and General Motors”? Big banks should have been saved, AFTER they were cut into tenths. General Motors? Maybe. They actually produce something. Banks and insurance companies do not produce anything. They do have their place however. Contrary to the AT&T commercial, bigger is NOT better. Smaller banks respond to individuals better. Policies are geared to the community.
Still, we the 99% have the opportunity to correct the wrongs of congress. If EVERYONE simply moved their money to a credit union there would be no banks too large to fail. What is preventing us? Nothing. Don’t buy from Walmart, etc. Find a local retailer.
Overall, I find the arguments in this article weak and unsubstantiated.

Posted by rocque | Report as abusive

The head of the IMF brings to the table all the experience of a French lawyer who never studied economics. Deflation is a word that was relevant in the 1930s UK when Hayek and Keynes theorized about policies that would end the UK’s massive depression. Today only those oriented to the polices of the 1930s use it. Any one knowledgable about the problems and policies relevant today, eighty years later, and how to identify “experts,” “analysts,” French lawyers, and Federal Reserve officials would do well to read something from this era’s premier economists, Stigler and Lindauer. They certainly would not agree that the policies of the past are relevant. Try “Inflation, Unemployment and Government Deficits” if you are a layman; “The General Theories of Inflation, Unemployment, and Government Deficits” if you are a professional economist.

Posted by RobertMorrisIV | Report as abusive