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Home Publications Blogs Beat the Press This Is What Deflation Looks Like

This Is What Deflation Looks Like

Tuesday, 16 July 2013 15:56

Bruce Bartlett has a good piece on fears of inflation from the Great Depression. It's worth reading if for no other reason to show that otherwise intelligent people are able to believe completely absurd propositions about the economy and the world. (Sorry, worrying about inflation in the 1930s was loony.)

Anyhow, the piece is useful for another reason; Bartlett has a chart showing the rate of deflation at the start of the depression. Prices fell by 2.3 percent in 1930, 9.0 percent in 1931, 9.9 percent in 1932, and 5.1 percent in 1933. These rates of a price decline are a serious problem. They hugely increase the real value of debt held by individuals and businesses.

They also create an environment in which investment is virtually pointless. Why would anyone borrow to expand a business when they will end up repaying the debt in money that is worth 25 percent more? It would make more sense to park the money under a mattress.

While this may be pretty obvious, it is worth contrasting the rates of deflation at the start of the Great Depression with the rates that we may have plausibly seen in the United States in 2009-2010, if things had gone more poorly. In a worst case scenario, we might have seen Japanese style deflation, which has been less in absolute value than -1.0 percent in all but one year. (In 2009 it was -1.3 percent).

This would have been unfortunate, since it would have implied higher real interest rates and some increase in the real burden of debts held by students and homeowners. However, this sort of deflation is bad in the same way that 0.5 percent inflation is worse than 1.5 percent inflation. In a time when the economy is operating well below full employment, higher inflation will encourage more spending than lower inflation, and lower inflation will encourage more spending than low rates of deflation.

However the deflation that we saw at the start of the Great Depression was a qualitatively different beast than the deflation that we might have plausibly seen at the start of the Great Recession. There was really no basis for fearing the sort of destructive inflation the economy saw at the start of the Great Depression. Wages and prices are too sticky today.

This point is important for both conceptual and political reasons. At the conceptual level, we should realize that there is no magic about the inflation rate turning negative. It is just an inflation rate that is too low. Politically, since moderate deflation is not a depression causing disaster (nor was it likely in the cards in any case), we probably should not be giving too much credit to the Bernanke-Geithner crew for heading it off. The fact that inflation stayed positive through the crisis was good news, but it really was not that big a deal. Bernanke will have to do something else to get the Nobel Prize in economics.  


Note: The year 1930 was written "2030" in the original post. Thanks Tracer.

Comments (11)Add Comment
written by tracer, July 16, 2013 5:34
Minor typo in second paragraph: "Prices fell by 2.3 percent in 2030." Should it be 1930? Everything else checks out.
Why Did the Inflation Monster Eat the Deflation Monster? Because It Was Cheaper
written by Last Mover, July 16, 2013 8:31

One thing is for sure, the high quality of Bartlett's article will never see the light of day on financial talk shows where everytime interest rates increase somewhere they give each other high fives to celebrate "evidence" that the beloved inflation monster has finally arrived to vindicate their doomsday predictions.

Hidden out there somewhere under a protectionist rock some financial lender of debt just may crawl out and face a sliver of risk that when it's paid back it won't be worth as much as when lent out, and we can't have that can we?

In fact we didn't have that did we? It only cost a trillion dollar output gap and all the jobs that went down the drain with it since all that stimulus spending and quantitative easing didn't do a goddamn thing but raise the risk of inflation, right?

Until now it was only stupid liberals who wrote articles like this. What's economics coming too when a stupid conservative like Bartlett does it too?
written by skeptonomist, July 16, 2013 8:59
"higher inflation will encourage more spending than lower inflation".

Dean follows Krugman in ignoring the difference between price inflation and wage inflation - they seem to think they are the same thing, or that increasing prices automatically causes wages to increase even more. There can only be more spending if wages go up *more* than prices. If nominal wages remain the same, people can only buy fewer things as prices go up. Consumption expenditures are dominated by cash flow, not by some calculation of where prices will be in the future. With high unemployment, labor does not have the inclination or the ability to demand wage increase in the face of price inflation (if you don't believe me, read Keynes, General Theory, Ch. 2).

Inflation will be beneficial only if it is brought about by increasing wages, which will increase demand. A helicopter drop might do the same, but that is not what Krugman is calling for. If the monetary-credibility fairy does convince producers to increase prices, this will only decrease demand. There is no way that the monetary-credibility fairy can convince employers to raise wages in expectation of inflation.

Inflation has been associated with high growth in the past because there was low unemployment and consumer-goods shortages - you can't just reverse the causation by decree of the central bank. The very great confusion about inflation/deflation among economists seems to arise from the assumption that everything is controlled by monetary manipulations.

Of course fears of inflation are absurd - again what the central bank does is just not the controlling factor.
@ skeptonomist
written by ellen1910, July 17, 2013 12:24
Aggregate demand increases if investment increases, because wages -- a factor in the carrying out of the investment -- increase in the aggregate. Whether the individual worker experiences an increase in his or her wages is neither here nor there.

In order to increase private investment (government investment isn't on offer, today) borrowers must believe that the real interest rate is below the particular project's return on capital. Assuming the Fed -- that is, the only game in town -- cooperates by keeping the funds rate low, the higher the expected inflation rate the likelier it is that the investment will be made.
further @ skeptonomist
written by ellen1910, July 17, 2013 12:30
Whether the Fed can convince businessmen that it has the ability to induce future inflation is a separate question.

Krugman -- Fed promising to act "irresponsibly" -- seems to think it can. I suspect he's right, since the majority of CEOs appear to be simple-minded monetarists convinced that large bank reserves lead to inflation. And the Fed can certainly produce large bank reserves -- any time it wants to.
written by James Schipper, July 17, 2013 5:15
Dear Mr Baker

If deflation in the US was that high, and if nominal wages didn't come down much, then people who didn't lose their jobs must have had an increase in real income. Shouldn't that have helped to increase aggregate demand?
wage inflation
written by jonny bakho, July 17, 2013 5:39
Wage inflation is needed. When it comes to college loans, they only make sense if they are paid back in inflated dollars. In the new normal, with inflation under 2 percent, paying back those loans will be far more difficult. It makes college less affordable.

Anyone who has a fixed mortgage or student loan payment knows that in periods of inflation, wages do rise and that fixed payment takes a lesser percentage of the paycheck. We have a too low inflation target without clear thinking about why 2 percent might be better, or worse!, than 4 percent. Inflation in the 1970s might have been an issue for bankers, but many homeowners had an easy time paying their mortgage in inflated dollars. Much inflation in that era was trying to reset prices relative to the rapidly rising energy prices. It was only after we had better energy policy under Carter, that the energy prices stabilized around a mean price.

Inflation targets have become a holy grail on the mistaken notion that a little inflation always leads to runaway inflation. It doesn't despite the mindless propaganda that captures the popular imagination. Setting inflation too low has implications for borrowing and investing that change the dynamics of the economy,
Inflate wages
written by jonny bakho, July 17, 2013 5:50
A quick way to inflate wages would be to increase Min Wage. Ten percent per year until balance sheets repair would be a reasonable target. It would at least keep inflation on target instead of less than 2 percent.
Investment pointless given falling prices?
written by Ralph Musgrave, July 17, 2013 7:41

Herewith a wonkish point. I’m not sure about Dean’s idea that investment is pointless given rapidly falling prices.

Suppose prices are falling at 25&#xpa; (as per Dean’s example). I spot an investment that can make 10&#xpa; in real terms. So I go along to my bank, which creates $X out of thin air for me and charges me a 5% real rate of interest (minus 20% nominal).

Net result: I make a profit in real terms, as does the bank. Everyone is happy. (Except me if I’ve made a mistake there...:-))

written by freebird, July 17, 2013 2:26
Maybe Dr Baker's prescription is worth a try?
Seriously, perhaps negative nominal interest rates (and negative share prices) can get us rolling again.
Deflation myth
written by cas127, July 17, 2013 8:23
"Why would anyone borrow to expand a business when they will end up repaying the debt in money that is worth 25 percent more."

Yes and a single computer has never been sold in the last 30 years due to a well-established record of price depreciation.

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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.