Deflation Skeptics

Michele Boldrin, Giovanni Federico and  Giulio Zanella have an excellent essay on noisefromamerika, Should we worry about deflation? Maybe yes, maybe no. (If your Italian is rusty, Google translate does a fine job with it.) This matters of course, as deflation is the great European preoccupation at the moment.

They remind us that, although deflation was correlated with the Great Depression in the US and some other countries,

Source: noisefromamerika.org. "PIL" is GDP

that correlation is not universal. For example, in the late 19th century, deflation coincided with strong growth,

What's the difference?


Well, read the article, but in short the key to becoming an economist is recognizing that there are always two forces at work, something like "supply" and "demand." Demand-driven deflation is -- or is a sign of -- something bad. (Actually, the "bad" comes from prices being "sticky" which one might argue means not enough deflation!) Supply-driven deflation -- productivity growth making things cheaper -- is a sign of something good. Most analysis presumes it's always "demand," and that the cause runs from deflation to output, not the other way, and not some third cause. It's never so obvious. Is Europe's deflation bad or good? Neither they nor I take a stand, but it's enough to shout from the mountaintops "wait a minute, it's not so obvious."

They blow up the standard story that with deflation people wait around to spend later when their money is worth more.

They remind us of a few articles with similar findings, including David Beckworth on Aggregate Supply-Driven Deflation and  Andy Atkeson and Pat Kehoe in the AER, who confirm some cross-sectional relation between deflation and Great Depression,

Source: Atkeson and Kehoe, American Economic Review

but likewise point out the absence of any relationship in larger more comprehensive historical experience,

Source: Atkeson and Kehoe, American Economic Review.

Andy and Pat conclude,

The data suggest that deflation is not closely related to depression. A broad historical look finds many more periods of deflation with reasonable growth than with depression, and many more periods of depression with inflation than with deflation.

i.e, hyperinflation is usually accompanied by depression,  not a boom. 

"What about Japan?" I hear you ask?

Figure 4 essentially shows a 40-year decline in the output growth rate (Fig. 4A) and a 30- year decline in the inflation rate (Fig. 4B). We think standard theories, either neoclassical or new Keynesian, would have a hard time blaming Japan’s secular growth slowdown on its secular decline in inflation. [JC: What they're saying is that monetary policy is eventually neutral. Prices are not sticky for 30 years in any model.] 

But that slowdown would naturally arise in many growth models in which a country grew rapidly in the early postwar period because it had been below its steady state growth path; as it caught up to this path, its growth would naturally slow. Has Japan’s growth slowed too much? Not relative to countries like Italy and France. At 1.41, Japan’s growth in the 1990’s was dismal compared to the U.S. growth of 3.20, but not compared to the growth of Italy (1.61) or France (1.84)

Boldrin, Federico and  Zanella update and expand on the comparison

Two decades from the beginning of the "deflationary depression" in Japan, it's worth noting that Real GDP per capita in Japan in 2012 was about 18% higher than it was in 1990, while in Italy it was slightly lower. GDP per hour worked (productivity) in Japan is today roughly 35% larger than 20 years ago. In Italy it is 6% larger. The unemployment rate in Japan is nearly a third (1/3!) of the Italian rate, in the face of a 25% larger labor force participation rate. 

In other words: If Japan is in a twenty year recession caused by persistent deflation, we (Italians) have been in a twenty-year disaster that is much worse, and this notwithstanding that the Italian inflation rate, in the same time period, has been positive and among the largest in the euro area.

An intriguing question is left a bit open, what does cause these long periods of slow deflation? Boldrin, Federico and  Zanella endorse a demographic view, that aging societies have low inflation. I find it interesting but not quite obvious to "anyone who doesn't have salami slices on their eyes" (best expression of the month prize.)

Conclusions:

Neither theory nor data suggest that deflation may be the cause of a deep economic depression. Even in the one significant historical case in which deflation and depression went together, the 1930s, the causal relationship is  dubious, and the object of ongoing debate among researchers in economic history. On average, deflation is associated with economic growth, not a recession. From the point of view of economic theory, the argument that "when prices are expected to fall, you defer purchases and this creates a vicious circle of recession / deflation" is, with all due respect to Mike Woodford and all the theorizing about "forward guidance", unfounded both in logic and in predictions. Removing that theory, nothing, or practically nothing remains to motivate the great fear of deflation. 

The only reason by which today, in Europe in 2014, a serious and persistent deflation could be a negative factor is the risk of public debt, whose costs are not indexed to price changes. Countries, such as Italy, which are highly indebted and have issued a substantial amount of long-term debt, at fixed nominal rates,  would see the real burden of debt rise if the price level began to decline or stagnate for many years. This is a real risk, no doubt. But, on the one hand, does not have anything to do with the problems of growth and development, and, second, there is a solution...

where they describe a clever swap of non-indexed for indexed debt.

It's fascinating how many economists, pass on stories that just ain't so, selected anecdotes, and ignore that there is always the possibility of supply, not demand; of reverse or third causality, and so forth.