Should we be spooked by deflation?

By Paul Walker 19/04/2015

Concerns about deflation – falling prices of goods and services – have loomed large in many recent policy discussions. In such discussions deflation is seen as always and everywhere a bad phenomenon. But as I have discussed a number of times before, see for example herehere and here, you need to draw a distinction between good and bad deflation The basic point is that we indeed do have two forms of deflation, the bad driven by demand shrinking and the good caused by supply expanding. The good kind of deflation is the result of increases in productivity. Research and development means new technology, efficiency gains, cost-cutting, price-cutting and, yes, deflation. Productivity gains mean that businesses could afford to sell their products for less since it is costing less to make them. The bad kind usually follows a collapse of aggregate demand. There is a severe drop in spending: producers have to cut prices to find buyers. This has the effect of causing recession, high unemployment and widening financial stress. This the 1930s type deflation that people fear.

The deflation debate is shaped by the deep-seated view that deflation, regardless of context, is an economic pathology that stands in the way of any sustainable and strong expansion. This view is largely based on the experience of the Great Depression. But in a new column, Should we be spooked by deflation? A look at the historical record by Claudio Borio, Magdalena Erdem, Andrew Filardo and Boris Hofmann, at it is argued that it is misleading to draw inferences about the costs of deflation from the Great Depression since it was the archetypal example.

Borio, Erdem, Filardo and Hofmann write,

The evidence from our historical analysis raises questions about the prevailing view that goods and services price deflations, even if persistent, are always pernicious. It suggests that asset price deflations, and particularly house price deflations in the postwar era, have been more damaging. And it cautions against presuming that the interaction between debt and goods and services price deflation, as opposed to debt’s interaction with property price deflations, has played a significant role in past episodes of economic weakness.

Inevitably, our results come with significant caveats. The data set could be further improved. We have focused on only a few drivers of output costs. We have only a few episodes of persistent deflation in the postwar period. And present debt levels are at, or close to, historical highs in relation to GDP. This should caution against drawing sweeping conclusions or firm inferences about the future.

Even so, the analysis does suggest a number of considerations relevant for policy.

  • First, it is misleading to draw inferences about the costs of deflation from the Great Depression, as if it was the archetypal example.

The episode was an outlier in terms of output losses; in addition, the scale of those losses may have had less to do with the fall in the price level per se than with other factors, including the sharp fall in asset prices and associated banking distress.

  • Second, and more generally, when calibrating a policy response to deflation, it is critical to understand the driving factors and, as always, the effectiveness of the tools at the authorities’ disposal.

This can help to better identify the benefits and risks involved.

  • Finally, there is a case for policymakers to pay closer attention than hitherto to the financial cycle – that is, to booms and busts in asset prices, especially property prices, alongside private sector credit […].

So deflation is not a good reason for running round screaming the sky is falling as many commentators, journalists and politicians seem to want to do. Reality is more complex and subtle. The column finds a link between output growth and asset price deflations, particularly during postwar property price deflations, that there is no evidence that high debt has so far raised the cost of goods and services price deflations, in so-called debt deflations and that the most damaging interaction appears to be between property price deflations and private debt.