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Home Publications Blogs Beat the Press NYT Says Economists Still Don't Understand Inflation/Deflation

NYT Says Economists Still Don't Understand Inflation/Deflation

Friday, 31 January 2014 06:23

There has been a bizarre cult of deflation phobia over the last decade in which we are supposed to be terrified that very low positive rates of inflation can decline further and turn into low rates of deflation, which then create really big problems. The NYT tells us this cult is still dominating economic thinking. In an article on the latest data on inflation and unemployment in the euro zone, it noted that European Central Bank President Mario Draghi unexpectedly lowered interest rates in November:

"amid concern that Europe might be headed toward a Japan-style deflationary quagmire."

In reality Europe is already in a Japan-style deflationary quagmire. It suffers from an inflation rate that is too low. A higher inflation rate would translate into lower real interest rates, giving firms more incentive to invest. It would also reduce debt burdens for homeowners as the real value of their mortgage debt fell. It would also allow the peripheral countries like Greece, Spain, and Italy to regain competitiveness, if they held wage and price increases below the rates in Germany and other core countries. 

For these reasons the near zero inflation rate is making Europe's problems more difficult, delaying the adjustment process that could allow it to return to a healthy growth path. If the inflation rate were to fall further, say from a positive 0.7 percent to a negative 0.3 percent, this would make matters worse, but only in the same way that a drop in the inflation rate from a positive 1.7 percent to 0.7 percent also makes the situation worse. The issue is a one percentage point decline in the inflation rate, there is no importance to crossing zero.

This should be obvious to people familiar with the construction of price indices. The indexes are based on the collection of millions of different price changes. When the index is near zero, many prices are already falling. Going from a low positive to a low negative rate means that the percentage of falling prices in the index has risen somewhat. How could this possibly have catastrophic consequences for the economy? (In this context it is worth noting that computers and cell phones have had rapidly falling prices for decades. Has everyone noticed the disasters befalling these industries?)

Also, the prices recorded for each item depend on quality adjustments imputed by the statistical agencies. Often the price of a product like a refrigerator or a car might show an increase, but due to imputed quality adjustments it will be recorded as a price decline. Is it plausible that the economy would face some horror story if the pace of quality improvement in these products increases slightly?

The notion that something bad happens if inflation crosses the zero line and becomes deflation is silly on its face. (There is a bad story where the rate of deflation continually accelerates, but even Japan never saw this.) It is often said that economists are not very good at economics. The concerns over a deflation horror story provides a good example of this proposition.

Comments (8)Add Comment
Beating a dead horse
written by anon, January 31, 2014 12:35
You are beating a dead horse on this one. People use "deflation" as shorthand for "inflation that is very low or negative". No one thinks there is anything magical about 0.
written by urban legend, January 31, 2014 1:39
Isn't there something almost magical in the difference between seeing the value of your house actually decline compared to seeing it grow, even if very slowly?
written by Dave, January 31, 2014 10:03
Given what I've seen from other economists, the zero crossing would matter only for durable goods and as somebody mentioned above, for housing. It sems to me that the interpretations of the great depression did lead some economists to bad conclusions on this. Perhaps it is lowereing wages that would cause a bigger problem, but since modern, skilled labor employers don't tend to lower wages, whereas depression era employers did, makes the difference. But also since farmers were losing income-producing land in the great depression, this loss of supply and demand was mistakenly overlooked in favor of the drop in prices as a cause for the steep decline in GDP.
written by Kirk, February 01, 2014 3:57
I would agree that crossing zero isn't a big deal, but surely a prolonged period of even slight deflation (-0.5%) would be quite a bit worse than slight inflation. Like the other guy mentioned, housing is the first thing that comes to mind. That mortgage debt is looking bigger and bigger and so is the monthly payment. That's a good chunk of money out of the economy and one would expect it to fuel further deflation.
never look a dead gift-horse in the mouth ...
written by Squeezed Turnip, February 01, 2014 4:05
From the article Dean linked to:
Some economists have argued that falling inflation in the euro zone, coming after five years of recession or very slow growth, means that the currency bloc faces an acute risk of deflation.

This indicates some economists engaged in magical thinking about 0. So anon seems to have a very pollyanna-ish abd overly generous viewpoint of 'people'.
Malefactors of Great Wealth
written by jonny bakho, February 01, 2014 7:03
The Malefactors of Great Wealth want low inflation to protect their excessive claims on future wealth. The bubble and bailout left the wealthy with more claims on wealth than are sustainable. Protecting their claims with low inflation denies income to those at the bottom who need inflation to reset relative prices and wages and to allow inflation to erode claims of the wealthy for more than is fair. By protecting the claims of the wealthy and not addressing unemployment and production, we have lower GDP today than we should which gives the wealthy even a larger percentage of the future claims. The wealthy are powerful. The poor are weak. The result is bad policy that makes the population relatively poorer and more unequal.
written by J Jordan, February 01, 2014 10:07
Monetary policy becomes inefective around 3%.
Since monetary policy works through credit costs, and mostly through housing credit which actually never follows interest rates bellow 3%, monetary policy becomes ineffective around 3% when going down. Going up is another story, it stays effective at any low point if going up.
The interest rates are doing the work through making interest cost against profit rates of indebted corporations. Going up, interest rate will shoot the profit rates and cause bankrupcies of highly leveraged companies. Going down and it increases profits while allowing for more toward wages.
This is the reality of monetary policy.

So the inflation should be about 4-5% in order to be optimal. This can only be achieved by wage growth.
Wages are the prime mower of inflation, not the money supply.
Isn't it nice to have this crisis where variables are reduced to constants and to see that money supply did not raise inflation? It is the wages that control inflation, not money supply, not energy prices, not government offered price, not destruction of production. They can only support already present inflation, not cause it.
Dead gift-horse indeed.
written by Kirk, February 01, 2014 3:41
I don’t really care for my last comment.

There is nothing in this article that I disagree with on the economic merits. Yet I found it a dog whistle I had to instinctively respond to. Much like the “cult” the author is referring to. I just realized what my instincts got to before my rational thoughts.

The author makes the argument that Europe is already in a deflationary quagmire due to misguided austerity policies therefore this obsession with avoiding a negative number is wrong as they should have been pursuing stimulative policies long ago due to the very obvious suffering that isn’t getting any better. Just look at the unemployment figures in the south. People are hurting bad.

The problem with the article is if the issue is stated in these terms by enough people that recognize the problem with demand in Europe, you would have ministers removing the only floor that exists for their insane policies. You aren’t going to convince confidence idol worshippers about actual economics, but I can guarantee you that you can get them to claim that even their critics agree that deflation isn’t really an issue. Therefore, the beatings shall continue until confidence returns.

That’s the alarming thing about this article. Not the economics. The politics. I like what the guy above said, “Never look a dead gift-horse in the mouth.” At least this obsession is finally causing action in the right direction.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.