Don’t be afraid of deflation
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.