Deflation is a dangerous distraction (part 2)
— John Kemp is a Reuters columnist. The views expressed are his own —
For part one of this column, please click here.
The current downturn and fears about falling prices are prompting a plethora of historical comparisons with previous periods, many with the Great Depression of 1929-1933, some based on a very shaky understanding of the historical record.
HISTORICAL BUSINESS CYCLES
The attached chart provides a long-term overview of developments in both U.S. output and prices for the last century using official data published by the Federal Reserve and the Bureau of Labor Statistics. To remove some of the month-to-month volatility, the chart shows the twelve-month percent change in both series for a rolling three-month period, providing a better indication of the underlying trend (http://customers.reuters.com/d/graphics/us_business_cycle.pdf).
Three points stand out immediately:
(1) The business cycle was much more pronounced in the first half of the period from 1913 to the early 1950s when there were massive booms interspersed with regular slumps. Year-on-year changes in industrial output of more than 10 percent and occasionally more than 20 percent were the norm.
Since 1950, the cycle has been much more muted. Only twice in the last 50 years has output grown briefly by more than 10 percent year-on-year, and only once has it shrunk more than that amount.
What made the Great Depression 1929-1933 unusual was not the suddenness of the contraction (which was not abnormal for the period) but its duration and depth. Previous downturns lasted a few months but this one dragged on for years with a massive loss of cumulative output. Industrial activity peaked in September 1929 and did not begin expanding again significantly until the second half of 1933.
What seared the Great Depression even more deeply into the collective memory was that by mid 1938, barely five years after the expansion had resumed, the economy slipped into another deep though mercifully much shorter slump, with output down by almost a third compared with the previous year. Only the advent of war ensured a sustained expansion for the next five years, before another slump in activity in 1946 when the economy was demobilized.
(2) Changes in real output were far more pronounced than changes in consumer prices throughout the 1913-153 period. Falling prices undoubtedly made conditions worse, especially for farming communities and other primary producers. But the loss of output and jobs created far more misery.
(3) Changes in output tended to occur ahead of changes in prices. In each slump, causality ran from falling output to falling prices, not the other way around. In the crucial 1929-1933 period, output began falling from October 1929, while inflation turned negative from March 1930 onwards. By May-July 1930, output was down 17 percent compared with the previous year, while prices were down only 2 percent. Deflation is best viewed as a symptom of severe business-cycle downturns, not the cause.
THE GHOST OF TOM JOAD
Much of the folk memory about the horrors of deflation stems from two factors:
(1) Prolonged deflations in the United Kingdom after the Napoleonic Wars and in the United States between 1879 and 1896 were characterized by an especially brutal compression of agricultural prices and wages that had devastating impacts on rural economies and rural states (especially southern and western parts of the United States during the final quarter of the nineteenth century).
Something similar though far less enduring occurred to rural communities in the United States during the early 1930s. Poverty and unemployment were widespread, but it was rural farming communities that were hit hardest by a combination of falling prices and prolonged drought.
Perhaps the most iconic representation of the Depression, the Joad family, in John Steinbeck’s “The Grapes of Wrath” were farmers driven west by a combination of depression and crop failures.
(2) What characterized all these prolonged deflations was an attempt to restore convertibility of the dollar and sterling to gold at the pre-war parities after they had been suspended during wartime conditions.
Britain tried to restore sterling to the pre-Napoleonic gold parity; the United States restored gold to the pre-Civil War parity; and both the United States and the United Kingdom restored convertibility at pre-1914 parities during the 1920s.
In each case, economic conditions, relative prices and the stock of money had changed significantly during the wars.
Policymakers were well aware resuming previous parities would involve a downward adjustment in wages and prices. But in each case, officials decided to attempt this compression because of the symbolic importance attached to resuming pre-war parities as an indication that pre-war “normality” could be restored.
Unemployment and a downturn in “trade” (as the business cycle was then known) was considered a price worth paying for the resumption of convertibility and a return to old certainties and sound money.
William Jennings Bryan, the Democratic Party’s populist presidential nominee in the 1896 election, captured the political calculations that lay behind these resumptions of the gold standard and deflations in his famous speech to the party’s convention in Chicago in July 1896:
“Having behind us the producing masses of this nation and the world, supported by the commercial interests, the laboring interests and the toilers everywhere, we will answer their demand for a gold standard by saying to them: You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold”.
THE POLICY OF LIQUIDATION
The same strategy intensified the Great Depression, as the United States and other countries initially tried to sacrifice employment and output in an ultimately failed attempt to protect their links to gold at the old parities.
This approach (sacrificing real values to monetary goals) reached its apogee in the chilling and now infamous notorious advice of Treasury Secretary Andrew Mellon to President Herbert Hoover:
“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate … purge the rottenness out of the system”.
Like other liquidationists at the Treasury and in the Federal Reserve System, Mellon believed the slump was a necessary (and desirable) corrective to the excesses of the late 1920s (including excessive borrowing and speculation) and that only in this way could the crucial link to gold and sound banking and economic practices be maintained.
It was these episodes, in which employment and output were sacrificed for gold and “soundness” that have been seared into the collective folk memory giving rise to a horror of falling prices.
But in no case was deflation the cause of the slump. It was the consequence of policy decisions taken largely to defend gold parities in a world of fixed exchange rates. The deflations of the nineteenth and early twentieth centuries are simply not relevant in a world where flexible exchange rates have freed monetary and fiscal policy to respond to a downturn in demand.
OUTPUT AND EMPLOYMENT
Policymakers’ fixation with the theoretical dangers of deflation has been a dangerous distraction from the real issue: the need to stabilize output and employment. Past experience suggests once output and employment have been stabilized and start expanding again, deflationary forces generally disappear.
The emphasis on preventing deflation (largely through monetary policy) risks diverting policymakers from the more urgent and important task of stabilizing output and jobs (which can only really be achieved through fiscal policy).
But there are signs of a shift. President-elect Barack Obama used the Democratic Party’s weekend radio address to commit his incoming administration to saving or creating 2.5 million new jobs over the next two years. Obama’s senior adviser Lawrence Summers has advocated a substantial and sustained fiscal stimulus.
This is a much more promising route out of the crisis. If the incoming administration can successfully end the spiral of pre-emptive production and employment cuts by business, falling real incomes, and declining consumer spending, the stabilization of real activity will lead to a stabilization of prices as well, and worries about deflation can return to the textbooks where they belong.